Why Large Corporates/Industrial Houses Owning Banks is a Bad Idea

 

An internal working group (IWG) of the Reserve Bank of India (RBI) has suggested that large corporate/industrial houses may be allowed to promote banks. Does this huge leap of faith being made by the Indian central bank, given their current extremely cautious and conservative approach, make sense? Let’s try and understand.

Why should large corporates be allowed into banking?

The IWG feels that allowing large corporates to promote banks can be an important source of capital. In a capital starved country like India this makes sense. Further, these corporates can bring “experience, management expertise, and strategic direction to banking”.

The group also noted that internationally “there are very few jurisdictions which explicitly disallow large corporate houses”. All these reasons make sense, but there are major reasons as to why the RBI in the last five decades hasn’t let large corporates enter the banking sector in India. At the heart of all this is the conflict of interest it would create.

Why have large corporates not been allowed into banking?

The IWG spoke to experts on the issue: “All the experts except one [said] that large corporate/industrial houses should not be allowed to promote a bank.”  The corporate governance in Indian companies isn’t up to international standards and “it will be difficult to ring fence the non-financial activities of the promoters.”

There will be a risk of promoters giving loans to themselves. Before bank nationalisation in 1969, some of the private banks were owned by large corporates. As Professor Amol Agrawal of Ahmedabad University puts it: “Since the private banks were run by big industrialists, they gave loans to themselves.”

What does history have to say in this regard?

As Pai Panandikar, an Advisor in the Finance Ministry, wrote in August 1967, regarding these banks : “Internal procedures… vest large discretionary powers in the Boards of Directors who have often acted as sources of patronage in deciding credit matters.”

A survey showed that 188 individuals served as directors on boards of 20 leading banks and held 1452 directorships of other companies. These individuals had directorships in 1100 companies.

What did these large discretionary powers lead to?

In an October 1967 report commissioned by politician Chandrashekhar, then the Secretary of the Congress Party, it was found that of the total bank loans of Rs 2,432 crore in 1966, Rs 292 crores was the debt due from the bank directors and their companies.

In fact, if indirect loans and advances were included, the actual debt-linked to directors was Rs 600-700 crore. There is a danger of something similar happening even now given the weak corporate governance structures.

*As of March 31, 2018.
Source: Rajya Sabha Unstarred Question No: 1492, Answered on 18 July 2018.

What does this mean in the current scheme of things?

As of March 2018, the domestic bad loans of Indian banks peaked at Rs 9.62 lakh crore. Of this, around 73.2% or Rs 7.04 lakh crore, were defaults made by industry.

The corporates have been responsible for a bulk of the mess in the Indian banking sector. Given that, handing over banking licenses to them is not a sensible idea, especially when the ability of banks to recover bad loans is limited.

What’s the Logic Behind Govt’s मांडवली (compromise) on Interest on Interest with Supreme Court?

Three institutions, the Reserve Bank of India (RBI), the Supreme Court and the Department of Financial Services, have spent more than a few weeks in deciding on waiving off the interest on interest on all retail loans and MSME loans of up to Rs 2 crore.

Resources at three systematically important institutions have been used to arrive at something which is basically largely useless for the economy as a whole, is bad for banks and sets a bad precedent which can lead to a major headache for both the government as well as the Supreme Court, in the time to come.

This is India’s Big Government at work, spending precious time on things which it really shouldn’t be. Let’s take a look at this issue pointwise.

1) By waiving off interest on interest on all retail loans and MSME loans of up to Rs 2 crore, for a period of six months between March and August 2020 when many loans were under a moratorium, the government is essentially fiddling around with the contract that banks entered with borrowers. A government interfering with contracts is never a good idea. If at all, negotiations for any waiver should have happened directly between banks and their borrowers, under the overall supervision of the RBI.

2) Some media houses have equated this waiver with a Diwali gift and an additional stimulus to the economy etc. This is rubbish of the highest order. The government estimates that this waiver of interest on interest applicable on loans given by banks as well as non-banking finance companies (NBFCs) is going to cost it Rs 6,500 crore. Other estimates made by financial institutions are higher than this. The rating agency Crisil estimates that this waiver is going to cost Rs 7,500 crore. Another estimate made by Kotak Institutional Equities put the cost of this waiver at Rs 8,500 crore.

Whatever be the cost, it is worth remembering here that the money that will go towards the waiver, is money that the government could have spent somewhere else. In that sense, unless the government increases its overall expenditure because of this waiver, it cannot be considered as a stimulus. Even if it does increase its overall expenditure, it will have to look at earning this money through some other route. The chances are, we will end up paying for it in the form of some higher tax (most likely a higher excise duty on petrol and diesel).

3) Also, the question that is bothering me the most on this issue, is a question that no one seems to be asking. Who is this move going to benefit? Let’s take an extreme example here to understand this. Let’s say an individual took a home loan of Rs 2 crore to be repaid over 20 years at an interest rate of 8%. He or she took a loan in early March and immediately put it up for moratorium once it was offered.

The moratorium lasted six months. The simple interest on the loan of Rs 2 crore for a period of six months amounts to Rs 8 lakh (8% of Rs 2 crore divided by 2).

This is not how banks operate. They calculate interest on a monthly basis. At 8% per year, the monthly interest works out to 0.67% (8% divided by 12). The interest for the first month works out to Rs 1.33 lakh (0.67% of Rs 2 crore).

Since the loan is under a moratorium and is not being repaid, this interest is added to the loan amount outstanding of Rs 2 crore.

Hence, the loan amount outstanding at the end of the first month is Rs 2.013 crore (Rs 2 crore + Rs 1.33 lakh). In the second month, the interest is calculated on this amount and it works out to Rs 1.34 lakh (0.67% of Rs 2.013 crore).

In this case, we calculate interest on the original outstanding amount of Rs 2 crore. We also calculate the interest on Rs 1.33 lakh, the interest outstanding at the point of the first month, which has become a part of the loan outstanding. This is interest on interest.

At the end of the second month, the loan amount outstanding is Rs 2.027 crore (Rs 2.013 crore + Rs 1.34 lakh). This is how things continue month on month, with interest being charged on interest.

At the end of six months, we end up with a loan outstanding of Rs 2.081 crore. This is Rs 8.134 lakh more than the initial loan outstanding of Rs 2 crore. As mentioned initially, the simple interest on Rs 2 crore at 8% for a period of six months works out to Rs 8 lakh.

Hence, the interest on interest works out to Rs 13,452 (Rs 8.134 lakh minus Rs 8 lakh).

Why did I consider this extreme example? I did so in order to show the futility of what is on. An individual who has taken a home loan of Rs 2 crore is not in a position to pay a total interest on interest of Rs 13,452, is a question well worth asking? Who are we trying to fool here? Given that the moratorium was for a period of six months, the average interest on interest works out to Rs 2,242 per month.

Even at a higher interest rate of 12% (let’s say for MSMEs), the average interest on interest works out to a little over Rs 2,500 per month. Are MSMEs not in a position to pay even this?

So, who are we doing this for? No one seems to have bothered asking and answering this most important question.

4) I guess it’s not fair to blame the government, at least for this mess. The petitioners wanted interest on loans for the period during the moratorium waived off. The Judges entertained them and the government had to find a way out so that the Judges could feel that they had done something at the end of the day and not feel embarrassed about the entire situation.

Crisil estimates that an interest rate waiver of retail and MSME loans of up to Rs 2 crore (including interest on interest) would have cost the government a whopping Rs 1,50,000 crore. Both the government and the RBI wanted to avoid this situation and ended up doing what in Mumbai is called a मांडवली or a compromise. Hence, clearly things could have been worse. Thankfully, they aren’t.

5) The case has dragged on for too long. Currently, banks are not allowed to mark any account which was a standard account as of August 31, as a default. The longer the case goes on, the longer it will take the banking system to recognise the gravity of the bad loans problem post-covid. Bad loans are loans which haven’t been repaid for a period of 90 days or more.

Also, this isn’t good news for banks which had provisioned (or set money aside) to quickly deal with the losses they would face due to the post-covid defaults.

Even at the best possible rate, the gravity of the problem facing banks will come out in the public domain only by the middle of next year now. And that’s just too long. Instead of the government, this time around, the Supreme Court has helped kick the bad loans can down the road.

Ideally, banks should have started recognising post-covid bad loans by now and also, started to plan what to do about it.

6) The banks will have to first pass on the waiver to the borrowers and will then get compensated by the government. As anyone who has ever dealt with the government when it comes to payments will assure you, it can be a real pain. Thankfully, the amount involved on the whole is not very large and the banks should be able to handle any delay on part of the government.

7) This is a point I have made before, but given the seriousness of the issue, it needs to be repeated. Interest is nothing but the price of money. By meddling with the price of money, the Supreme Court has opened a Pandora’s box for itself and the government. There is nothing that stops others from approaching the Courts now and asking for prices of other things, everything from real estate to medicines, to be reduced. Where will it stop?

To conclude, India’s Big Government only keeps getting bigger in its ambition to do much more than it can possibly do. The interest on interest issue is another excellent example of this.

Why Mis-selling By Banks ‘May’ Have Gone Up Post-Covid

The basic idea for almost everything I write emanates from some data point that tells me something. But this piece is slightly different and comes from the experiences of people around me and what I have been seeing on the social media.

I think with this limited anecdotal evidence and some data that I shall share later in the piece, it might be safe to say that mis-selling by banks post-covid may have gone up. Mis-selling can be defined as a situation where an individual goes to a bank wanting to do one thing, and ends up doing something else, thanks to the relationship/wealth manager’s advice.

The simplest and the most common example of this phenomenon is an individual going to a bank with the intention of putting his money in a fixed deposit and ends up buying some sort of an insurance policy or a pension plan.

Let me offer some evidence in favour of why I think the tendency to mis-sell post covid may have gone up.

1) Between March 27, around the time when the seriousness of the covid pandemic was first recognized in India, and October 9, the latest data available, the deposits of Indian banks have gone up by Rs 7.36 lakh crore or 5.4%.

Clearly, there has been a huge jump in bank deposits this year. To give a sense of proportion, the deposits between October 2016 and December 2016, when demonetisation happened, went up by Rs 6.37 lakh crore or 6.4%.

The increase in deposits post covid has been similar to the increase post demonetisation. Of course, the post-covid time frame has been longer.

What does this tell us? It tells us that people haven’t been spending. This is due to multiple reasons.

The spread of covid has prevented people from stepping out and there is only so much money that can be spent sitting at home (even with all the ecommerce). This has led to an accumulation of deposits. Further, people have lost jobs and seen their incomes crash. This has prevented spending or led to a cutdown. And most importantly, many people have seen their friends and family lose jobs. This has automatically led them to curtail their spending. All this has led to an increase in bank deposits.

2) Why do banks raise deposits? They raise deposits in order to be able to give them out as loans. Between March 27 and October 9, the total non-food credit given by banks contracted by Rs 38,552 crore or 0.4%. Banks give loans to the Food Corporation of India and other state procurement agencies to help them primarily buy rice and wheat directly from farmers. Once this lending is subtracted from the overall lending of banks what remains is the non-food credit.

What does this contraction in lending mean? It means that people and firms have been repaying their loans and not taking on fresh loans. On the whole, between March end and early October, banks haven’t given a single rupee of a new loan. This explains why interest rates on deposits have come down dramatically. Interest rates have also come down because of the Reserve Bank of India printing and pumping money into the financial system to drive down interest rates.

3) Using these data points, we can come to the conclusion that banks currently have an incentive to mis-sell more than in the past. Why? Banks currently have enough deposits. They don’t need more deposits, simply because on the whole, people and firms are not in the mood to borrow.

All this money that is not lent ends up getting invested primarily in government securities, where the returns aren’t very high. As of October 9, around 31.2% of total deposits were invested in government securities. This is the highest since July 2018.

The trouble is that banks cannot stop taking deposits even though they are unable to currently lend them. They can only disincentivise people through lower interest rates.

Or they can set the targets of relationship managers/wealth managers in a way where they need to channelise savings into products other than fixed deposits.

While banks have to pay an interest on fixed deposits, irrespective of whether they are able to lend them or not, they earn a commission on the sale of products like unit linked insurance plans, pension plans, mutual funds, portfolio management services, etc. This commission directly adds to the other income of the banks.

Basically, the way this incentive plays out explains why mis-seling by banks may have gone up post covid. Also, the risk of repaying a fixed deposit lies with the bank. The same is not true about the other products where the bank is just a seller and the risk is passed on.

What to do?

So, what should individuals do in a situation like this, is a question well worth asking? Let’s say you go to a bank to invest your money in a fixed deposit. As explained above, the bank really does not want your money in fixed deposit form.

The wealth managers/relationship managers will resort to the contrast effect while trying to persuade you to not put your money in fixed deposits. The interest rates on fixed deposits are very low currently. An average fixed deposit pays an interest of 5-5.5%. Clearly, once we take inflation and taxes on the interest on these deposits into account, the returns are in negative territory.

The relationship/wealth manager will contrast these low/negative returns with the possible returns from other products. His or her pitch will be that the returns will be higher in other cases. In the pitch, he or she will tell you that the returns from the other products are as good as guaranteed. A tax saving angle might also be sneaked in (for insurance products). (Of course, he or she will not present this in such a dull way. Typically, relationship/wealth managers tend to be MBAs, who can phaff at the speed of thought and leave you totally impressed despite their lack of understanding of things).

What’s the trouble with this? The returns in these other products are not fixed. In case of a fixed deposit the interest rate is fixed (which is why the word fixed is used in the first place). Now you might end up with a higher return on other products, but there is no guarantee to that. Also, sometimes the aim of investment is different. If you are putting your money in a fixed deposit, the aim might simply be return of capital than return on capital.

Further, the investment in these other products might be locked in for a long period of time, while you can break a fixed deposit at any point of time (of course you end up with lower returns). This is especially true for a tax saving investment.

To conclude, the next time you go to a bank, stick to what you want to do with your money and don’t fall prey to what the wealth/relationship manager wants you to do. Clearly, his and your incentives are not aligned. Also, if you can use internet banking to manage your money, that is do fixed deposits online, that’s the best way to go about it.

Corporates Will Continue to Default on Bank Loans

rupee

We have extensively written about how corporate loan defaults have screwed up the state of banks in general in India, with public sector banks in particular.

This can be made out from the fact that the aggregate domestic corporate lending non-performing assets (or bad loans) of scheduled commercial banks, as of December 31, 2017, stood at Rs 6,63,877 crore. Bad loans are loans on which repayment has not been made for 90 days or more.

The total domestic bad loans of scheduled commercial banks on December 31, 2017, stood at Rs 8,31,141 crore. This means that the corporate bad loans account for 80% of the overall bad loans of banks.

Having said that, it doesn’t make much sense to paint all the corporates with the same brush. Borrowing is an essential part of corporate growth and that cannot suddenly go out of the equation.

Care Ratings has carried out a very interesting study on corporate borrowing and how the different kinds of borrowers (as per the total amount of borrowing) are placed in their ability to repay bank loans, at this point of time.

Care Ratings took a sample of 2,314 companies, which excludes banks and other finance companies. The total borrowing of these companies stands at Rs 20.02 lakh crore as of March 31, 2017.

The interest coverage ratio of these companies stood at 3.92. Interest coverage ratio is basically obtained by dividing operating profit of a company (or companies) by interest payments that need to be made on outstanding loans, during a particular period. This ratio fell to an almost similar 3.9 for the period April to December 2017.

This tells us that on the whole, the corporates are making enough money to keep servicing the interest that is due on their debt. But averages as usual hide the real story, which starts to change, as soon as we start to dig a little more.

Let’s look at this in detail one by one:

  1. For the period April to December 2017, 578 companies in the sample with an outstanding debt of Rs 4.78 lakh crore, which amounted to 24% of the total debt, had an interest coverage ratio (ICR) of less than 1. This basically means that companies which have taken on one fourth of the corporate debt (as per the sample used) are not earning enough money to keep servicing the interest payments on their debt.

    When the interest coverage ratio is less than one, the operating profit made by the company is less than the interest payment that is due. In such a situation, neither the company, nor the bank is left with many options. If the company’s situation does not improve, it is more than likely to default on the bank loan.

    How has the situation changed when we compare the financial year 2016-2017 with the period April to December 2017? In 2016-2017, 524 companies with total debt amounting to Rs 5.42 lakh crore, had an interest coverage ratio of less than 1.

    What this means is that in April to December 2017, more companies ended up with an interest coverage ratio of less than one. Nevertheless, a smaller amount of money was at stake.

  2. Let’s take a look at Table 1:

    Table 1: Distribution of companies and ICR according to debt sizeTable 1 makes for a very interesting reading. Let’s start with the large companies with a debt of Rs 5,000 crore or more. There are 68 such companies. Their interest coverage ratio has come down from 3.22 to 3.08. But this fall is not huge.

    Further, there are 23 companies with a total debt of Rs 2.82 lakh crore, with an interest coverage ratio of less than one. This basically means that large companies form a bulk of the debt of Rs 4.78 lakh crore of companies, with an interest coverage ratio of less than one.

    This basically means that the banks haven’t seen the last of corporate defaults and more defaults will happen in the time to come.

  3. The companies with a debt of Rs 2,500-5,000 crore are in the worst possible space. The interest coverage has fallen from 2.26 for 2016-2017 and to 1.73 during the period April to December 2017, respectively. Clearly the positon of these companies on their ability to keep paying interest on their debt has come down.

    There are 56 companies in this bracket. Of these 22 companies have an interest coverage ratio of less than one. These companies have a total debt of around Rs 75,000 crore. These companies (along with large companies with an interest coverage ratio of less than one) primarily operate in the steel, engineering and textiles sector. Take a look at Table 2.

    Table 2:

  4. Interestingly, companies with lower levels of debt seem to be better placed on the interest coverage ratio front.
  5. The study further shows that the companies with higher levels of outstanding debt have seen sharper declines in their interest coverage ratio during April to December 2017, in comparison to 2016-2017. As Madan Sabnavis and Rucha Ranadive, the authors of this report put it: “A combination of declining interest coverage ratio and interest coverage ratio less than 1 is a good signal to identify debt service failure.”

To conclude, what these data points tell us for sure is that the banks haven’t seen the last of corporate defaults. There is more to come.

This column originally appeared on Equitymaster on April 17, 2018.

89% of Bad Loans Written Off by Public Sector Banks are Not Recovered

rupee
“You don’t get bored writing about bad loans of public sector banks?” asked a friend, a few days back.

We honestly told them, we don’t, simply because new details keep coming out, and we keep writing about them. And most of these new details show how messy the situation has become.

Yesterday, while digging through the questions raised by MPs in the Rajya Sabha, we came across another interesting data point, which again shows how messy the bad loans problem of public sector banks actually is and why it is not going to end anytime soon, irrespective of what analysts and politicians have to say about it.

Bad loans are essentially loans which have not been repaid for a period of 90 days or more.

After a point banks need to write-off bad loans. These are loans which banks are having a difficult time to recover.

When banks write-off bad loans, the total bad loans of the banks come down. At the same time, these bad loans are written-off against the operating profits of banks.

In an answer to a question raised in the Rajya Sabha, the government gave out the details of the total amount of bad loans which have been written off by public sector banks, over the last few years.

Take a look at Table 1:
Table 1:

YearLoans written off (in Rs Crore)
2014-201549,018.00
2015-201657,585.00
2016-201781,683.00
2017-2018*84,272.00
Total2,72,558.00
* Up to December 31, 2017

 

Source: RAJYA SABHA

UNSTARRED QUESTION NO: 3600

TO BE ANSWERED ON THE 27th MARCH, 2018

Table 1 tells us that between April 1, 2014 and December 31, 2017, the public sector banks wrote off loans worth Rs 2,72,558 crore. Hence, the profits of the bank have been impacted to that extent and so have the dividends that these banks give to the government every year.

Nevertheless, this is a point that we have made in the past. In this column, we hope to make a new point. While the loans that are written off are those that are deemed to be difficult to recover, there is still a certain chance that these loans may be recovered by the bank (given that loans are made against a collateral). How do the numbers stack up on this front? Take a look at Table 2.

Table 2:

YearLoans recovered(in Rs Crore)
2014-20155,461.00
2015-20168,096.00
2016-20178,680.00
2017-2018*7,106.00
Total29,343.00
* Up to December 31, 2017
 

Source: RAJYA SABHA

UNSTARRED QUESTION NO: 3600

TO BE ANSWERED ON THE 27th MARCH, 2018

 

From Table 1 and Table 2 we can conclude that over the last four years, Rs 29,343 crore of the bad loans that have been written off (Rs 2,72,558 crore) have been recovered by public sector banks. This basically means that the rate of recovery is 10.8%. Or 89.2% of the bad loans which are written off are not recovered.

Hence, technically there might be a difference between a write off and a waive off, but in real life, there isn’t. A write off is as good as a waive off with the banks failing to recover a bulk of the bad loans. Also, in case of a waive off, the government compensates banks to that extent.

As we have mentioned in the past
, loans to industry amount to 73% of the overall bad loans of public sector banks, whereas loans to the services sector amounts to another 13%. This basically means that corporates are responsible for more than 80% of bad loans of banks. And this explains why public sector banks have a tough time trying to recovering the bad loans they have written off.

A bulk of these bad loans are because of corporates who have access to the best lawyers as well as politicians and banks find it difficult to recover these bad loans by selling the collateral against which these loans have been made.

While, public sector banks have written off loans worth Rs 2,72,558 crore over the last four years, the total bad loans outstanding of public sector banks stood at Rs Rs. 7,77,280 crore, as of December 31, 2017. So, public sector banks aren’t done writing off bad loans as yet. There is more to come.

Stay tuned!

The column was originally published on Equitymaster on April 3, 2018.