How Trustworthy are the Bad Loans Numbers of Banks?

The Reserve Bank of India (RBI) in the Financial Stability Report (FSR) released in January had said that by September, the bad loans of banks, under a baseline scenario, could shoot up to 13.5% of their total loans. In September 2020, the bad loans rate of banks had stood at 7.5%. Bad loans are largely loans, which haven’t been repaid for a period of 90 days or more.

If the economic scenario were to worsen into a severe stress scenario, the bad loans could shoot up to 14.8% of the loans. For public sector banks, the rate could go up to 16.2% under a baseline scenario and 17.8% in a severe stress one.

What this meant was that the RBI expected the overall bad loans of banks to shoot up massively in the post-covid world, even more or less doubling from 7.5% to 14.8%, under a severe stress scenario.

A past reading of the RBI forecasts suggests that in an environment where bad loans are going up, they typically end up at levels which are higher than the severe stress level predicted by the RBI.

Given all this, there should be enough reason for worry on the banking front. But as things are turning out the dire predictions of the RBI are still not visible in the numbers. The quarterly results of a bunch of banks for the period October to December 2020 have been declared and it must be said that the banks look to be doing decently well.

In a research note, CARE Ratings points out that the bad loans rate of 30 banks which form the bulk of the Indian banking system (including the 12 public sector banks, IDBI Bank and the big private banks), stood at 7.01% as of December 2020. The rate had stood at 8.72% as of December 2019 and 7.72% as of September 2020.

In fact, when it comes to public sector banks, the bad loans rate has improved from 11.22% as of December 2019 to 9.01% as of December 2020 (This calculation includes IDBI Bank as well, which is now majorly owned by the Life Insurance Corporation of India and not the union government, and hence is categorised as a private bank).

When it comes to private banks ( a sample of 17 banks), the bad loans rate has improved from 4.87% as of December 2019 to 3.49% as of December 2020.

On the whole, these thirty banks had bad loans amounting to Rs 7.38 lakh crore on loans of Rs 105.37 lakh crore, leading to a bad loans rate of a little over 7%. Do remember, the RBI’s baseline forecast for September 2021 is 13.5%. Hence, things should have been getting worse on this front, but they seem to be getting better.

What’s happening here? The Supreme Court in an interim order dated September 3, 2020, had directed the banks that loan accounts which hadn’t been declared as a bad loan as of August 31, shall not be declared as one, until further orders.

This has essentially led to banks not declaring bad loans as bad loans. Nevertheless, the banks are declaring what they are calling proforma slippages or loans which would have been declared as bad loans but for the Supreme Court’s interim order.

A look at the results of banks tells us that even these slippages aren’t big. The proforma slippages of the State Bank of India between April and December 2020, stood at Rs 16,461 crore, which is small change, given that the bank’s total advances stand at Rs 24.6 lakh crore. When it comes to the Punjab National Bank, the total proforma slippages were at Rs 12,919 crore between April to December 2020.

Similarly, when we look at other banks, the proforma slippages are present but they are not a big number. An estimate made by the Mint newspaper suggests that India’s ten biggest private banks have proforma slippages amounting to around Rs 42,000 crore.

The 30 banks in the CARE Ratings note had total bad loans of Rs 7.38 lakh crore or a rate of 7.01 %. If this has to reach anywhere near, 13.5-14.8% as forecast by the RBI, the overall bad loans need to nearly double or touch around Rs 14 lakh crore.

The initial data doesn’t bear this out. As the RBI said in the FSR, “[With] the standstill on asset classification… the data on fresh loan impairments reported by banks may not be reflective of the true underlying state of banks’ portfolios.”

Hence, the situation will only get clearer once the Supreme Court decision comes in and the banks need to mark bad loans as bad loans. While banks are declaring proforma slippages, it could very well be that the Supreme Court interim order along with restructuring schemes announced by the RBI and the fact the Insolvency and the Bankruptcy Code remains suspended, have led to a situation where they are under-declaring these numbers.

This is not the first time something like this will happen. Around a decade back in 2011, Indian banks had started accumulating bad loans on the lending binge carried out by them between 2004 and 2010, but they didn’t declare these bad loans as bad loans immediately.

Only after a RBI crackdown and an asset quality review in mid 2015, did the banks start declaring bad loans as bad loans. There is no reason to suggest that banks are behaving differently this time around.

It is important that the same mistake isn’t made all over again. Hence, the RBI should carry out an asset quality review of banks(and non-banking finance companies) and force them to come clean on their bad loans.

A problem can only be solved once it has been identified as one.

The article originally appeared in the Deccan Herald on February 14, 2021.

Corporate performance shows a clear trend of demand destruction

Last week the Reserve Bank of India (RBI) released the data on the performance of non-financial private corporate business sector during the second quarter of 2015-16 (July- September 2015). This data makes for a very interesting reading.

The data aggregates the financial results of 2,711 listed nongovernment non-financial companies during the period July to September 2015. Take a look at the following table which summarises the performance of the companies. Also, please keep in mind that “to compute the growth rates in any quarter, a common set of companies for the current and previous period is considered.” This has had to be done because the number of companies across quarters does not match. So while 2863 companies have been taken into account for July to September 2014 results. Only 2,711 companies have been considered for the period July to September 2015.

IndicatorJuly to September 2014April to June 2015July to September 2015
Amount in Rs billionYear on year growth in Per centAmount in Rs billionYear on year growth in Per centAmount in Rs billionYear on year growth in Per cent
No. of Companies2,8632,7232,711
Value of Production8,1484.27,694-2.47,479-5.6
Expenditure, of which7,0763.66,534-3.56,330-7.8
  Raw Material3,7603.43,199-11.82,994-18.7
  Staff Cost6497.768110.26899.0
  Power & fuel2973.7284-3.0276-4.2
Operating Profits (EBITDA)1,0738.31,1603.71,1498.9
Other Income27526.12151.8250-5.8
Gross Profits (EBIT)1,05114.11,0703.41,0996.5
EBT (before NOP)72522.17290.77665.6
Tax Provision20429.02116.02199.6
Net Profits53725.6514-9.55779.9

The table clearly shows that the sales of the companies during the period July to September 2015 fell by 4.6%, in comparison to the same period last year. Despite falling sales the net profits went up by 9.9%. There are a couple of important points that need to be made here.

Falling sales show that businesses lack pricing power. This is because the consumer as well as industrial demand for products hasn’t been going up at the same pace as it was in the past. Nevertheless, despite falling sales, the net profit went up by close to 10%. What is happening here? The raw material costs of businesses fell by 18.7% during the three month period in comparison to a year earlier.

As CARE Ratings pointed out in a recent research note: “The negative growth in net sales is largely attributed to weakness in demand and pricing power. Despite negative producer’s inflation as measured by the wholesale price index signalling also lower raw material costs, growth in profits do not appear to be satisfactory.” 

The raw material cost during the period stood at a total of Rs 2,99,400 crore. This was Rs 76,600 crore lower. Profit on the other hand jumped by around Rs 3,900 crore during the quarter. Hence, the entire jump in profits has come from lower raw material costs.

Raw material costs have fallen largely due to falling global commodity prices. Power and fuel costs have also eased by Rs 2,100 crore. This has helped businesses bring down total expenditure by Rs 74,500 crore during the quarter and in turn, help report greater profits.

Now let’s dig a little deeper and look at how manufacturing and services companies have done.

July to September 2014April to June 2015July to September 2015
Amount in Rs billionYear on year growth
in Per cent
Amount in Rs billionYear on year growth
in Per cent
Amount in Rs billionYear on year growth
in Per cent
No. of companies1,9101,8281,828
Expenditure, of which5,2703.54,732-6.24,534-11.3
  Raw Material3,3743.02,882-13.02,697-19.1
  Staff Cost29311.331110.83099.4
  Power & fuel16810.51642.8158-2.5
Operating Profits (EBITDA)6497.97174.069911.0
Other Income12720.1119-3.914012.5
Gross Profits (EBIT)59212.06492.465813.9
EBT (before NOP)40416.7453-0.447618.1
Tax Provision13130.11356.91376.2
Net Profits28121.6310-14.333319.8

The manufacturing sector includes companies operating in Iron & Steel, Cement & Cement products, Machinery & Machine Tools, Motor Vehicles, Rubber, Paper, Food products etc. The sales of these companies have fallen by 7.8% during the three month period between July and September 2015. This shows a slowdown in industrial as well as consumer demand.

The profits on the other hand, tell a completely different story jumping by 19.8%. This was primarily on account of raw material costs falling by 19.1%, during the period. It needs to be mentioned here that for profits to continue to grow raw material costs will have to continue to fall, so that expenditure can be controlled or brought down.

For raw material prices to continue to fall, commodity prices need to continue to fall. Commodity prices have already fallen quite a lot. Hence, for profits to grow in the next financial year sales of companies need to start growing as well.

Let’s take a look at the performance of services sector which includes companies operating in Real Estate, Wholesale & Retail Trade, Hotel & Restaurants, Transport, Storage and Communication industries.

July to September 2014April to June 2015July to September 2015
Amount in Rs billionYear on year growth
in Per cent
Amount in Rs billionYear on year growth
in Per cent
Amount in Rs billionYear on year growth
in Per cent
No. of companies465454450
Expenditure, of which5836.46554.86463.3
  Raw Material4912.9476.844-13.6
  Staff Cost5011.9558.0568.4
  Power & fuel403.431-21.730-25.9
Operating Profits (EBITDA)12928.316416.415719.4
Other Income6461.7242.943-33.3
Gross Profits (EBIT)13359.012019.5131-2.2
EBT (before NOP)88@*7031.575-14.3
Tax Provision17-9.32316.72335.4
Net Profits71@*486.647-33.9

* The ratio / growth rate for which denominator is negative or negligible
is not calculated, and is indicated as ‘$’ and ‘@’ respectively.

The sales of companies operating in the services sector have risen by around 7.2% but net profit has fallen by 33.9%. This despite the fact that raw material cost as well as cost of power and fuel has crashed. Nevertheless, this did not prevent overall expenditure from going up. This again shows that companies operating in this sector are going through tough times and lack pricing power. The consumption has still not picked up despite the RBI cutting the repo rate by close to 125 basis points since the beginning of this year.

The column originally appeared on The Daily Reckoning on December 7, 2015

Ratings shopping: Lessons from the Amtek Auto default

Amtek Auto was supposed to repay Rs 800 crore of its debt by Sunday (Sep 20, 2015). It has not been able to do so. Media reports suggest that the company has a total debt of Rs 18,000 crore, whereas the Amtek group has a debt of Rs 26,000 crore.

The interesting bit is that this debt that Amtek Auto has defaulted on will not be declared to be a bad loan immediately. As I have often written in the past in The Daily Reckoning, banks do not like to recognise bad loans immediately.

More often than not they kick the can down the road by restructuring the loan. When a loan is restructured a borrower is either allowed to repay the loan at a lower rate of interest or over a longer period of time or possibly both.

Deepak Shenoy makes this point on “For a bank holding the bonds[on which Amtek Auto has defaulted on] this account is technically not an NPA [non-performing asset or a bad loan] until 90 days is over. So they can extend and pretend and hope that Amtek manages to salvage itself. Since the banking system has exposure to more than Rs 7,000 crore of loans to Amtek, you can bet your next salary that they will restructure the loan in some way and manage to not call it an NPA at all.”

And that is not the only disturbing bit. Amtek Auto is also a very clear case of rating agencies having been caught napping on their job. The agencies should have seen this default coming. But that did not turn out to be the case.

Care Ratings suspended the rating of the company on August 7, 2015. Before suspending the company Care had rated Amtek Auto at AA−. Care defines an AA rating as: “Instruments with this rating are considered to have high degree of safety regarding timely servicing of financial obligations. Such instruments carry very low credit risk.”  Over and above the rating, Care also uses plus or minus for a certain level of ratings. These signs “reflect the comparative standing within the category.”

From a rating of AA−, Care stopped rating Amtek Auto. Another rating agency Brickwork Ratings downgraded the debt of the company from a level of A+ to C−. This was a downgrade of 12 levels in a single shot.

Brickwork defines an A rating as: “Instruments with this rating are considered to have adequate degree of safety regarding timely servicing of financial obligations. Such instruments carry low credit risk.” It defines a C rating as: “Instruments with this rating are considered to have very high risk of default regarding timely servicing of financial obligations.”

It is worth asking here that how did a company go from being categorised as having an “adequate degree of safety” to a “very high risk of default,” all at once. The only possible explanation here is that the rating agency was caught napping or just chose to look the other way.

In fact, Amtek Auto is not an isolated case. There have been other such instances as well. As a recent news-report in the Mint newspaper points out: “In the past one year, there have been other instances where ratings have been cut sharply by three notches or more in one revision. In July, CARE Ratings downgraded Jaiprakash Associates Ltd by six notches from a rating of BB to D-, a rating that reflects a default in the debt security. Non-convertible debentures of Bhushan Steel Ltd also saw their rating drop by six notches following a revision by CARE Ratings in December 2014. Punj Lloyd Ltd faced a similar drop in ratings in July.”

Monet Ispat and Energy Ltd, Bhushan Power and Steel Ltd, Shree Renuka Sugars and 20 Microns Ltd, are examples of other companies that the Mint news-report points out.

There is a basic problem with the way rating agencies operate. The company which they are rating is the one which pays them as well. In this scenario one rating agency can be played against another, and a company can indulge in ratings shopping.

In fact, ratings shopping was a major reason behind the financial crisis. Banks and other financial institutions looking to rate their sub­prime bonds and other mortgage backed securities played off one rating agency against the other. If they did not get the AAA rating (which is the best rating on a financial security), they threatened to take their business elsewhere.

There was a huge ratings inflation that happened as well. As George Akerlof and Robert Shiller write in their new book Phishing for Phools—The Economics of Manipulation and Deception: “One ratings agency alone, Moody’s, gave 45,000 mortgage-related securities a triple-A rating(for the period 2000 to 2007); that generosity for the mortgage-backed securities contrasts with only six US companies that were similarly rated AAA(in 2010).”

This possibly explains that the rating agencies were giving high ratings to subprime and mortgaged backed securities in order to continue to get business from investment bank issuing subprime bonds and other mortgage backed securities.

As Akerlof and Shiller point out: “The originator of the packages [i.e. subprime bonds and the mortgage backed securities], typically an investment bank, was rewarded by high ratings on its offerings. And the ratings agency, in turn, would be shunned if it did not give the investment bank what it wanted. It was in the interest of neither the investment banks nor the ratings agencies to go back and do that extremely difficult—and perhaps impossible—task of opening up the packages and carefully examining their innards [the emphasis is mine].”

This is precisely what has happened in the Indian context as well. In their zeal to get business, the rating agencies awarded these companies higher ratings than what they deserved in the first place. If they hadn’t done that the companies would have taken their business elsewhere. Pretty soon shit hit the ceiling and they had to cut ratings by several notches all at once.

To conclude, it is worth repeating here, something that a managing director of Moody’s told his employees: “Why didn’t we envision that credit would tighten after being loose, and housing prices would fall after rising, after all most economic events are cyclical and bubbles inevitably burst. Combined, these errors make us look either incompetent at credit analysis, or like we sold our soul to the devil for revenue, or a little bit of both [the emphasis is mine].”

The Indian rating agencies did something similar as well.

The  column originally appeared on The Daily Reckoning on Sep 24, 2015