Financial Stability Report

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.

Indian Banks Will Have Rs 17-18 Lakh Crore Bad Loans By September

The Reserve Bank of India (RBI) publishes the Financial Stability Report (FSR) twice a year, in June and in December. This year the report wasn’t published in December but only yesterday (January 11, 2021).

Media reports suggest that the report was delayed because the government wanted to consult the RBI on the stance of the report. For a government so obsessed with controlling the narrative this doesn’t sound surprising at all.

Let’s take a look at the important points that the FSR makes on the bad loans of banks and what does that really mean. Bad loans are largely loans which haven’t been repaid for a period of 90 days or more.

1) The bad loans of banks are expected to touch 13.5% of the total advances in a baseline scenario. Under a severe stress scenario they are expected to touch 14.8%. These are big numbers given that the total bad loans as of September 2020 stood at 7.5% of the total advances. Hence, the RBI is talking of a scenario where bad loans are expected to more or less double from where they are currently.

2) Under the severe stress scenario, the bad loans of public sector banks and private banks are expected to touch 17.6% and 8.8%, respectively. This means that public sector banks are in major trouble again.

3) In the past, the RBI has done a very bad job of predicting the bad loans rate under the baseline scenario, when the bad loans of the banking system were going up.

Source: Financial Stability Reports of the RBI.
*The actual forecast of the baseline scenario was between 4-4.1%

If we look at the above chart, between March 2014 and March 2018, the actual bad loans rate turned out to be much higher than the one predicted by the RBI under the baseline scenario. This was an era when the bad loans of the banking system were going up year on year and the RBI constantly underestimated them.

4) How has the actual bad loans rate turned out in comparison to the bad loans under severe stress scenario predicted by the RBI?

Source: Financial Stability Reports of the RBI.
*The actual forecast of the baseline scenario was between 4-4.1%

In four out of the five cases between March 31, 2014 and March 31, 2018, the actual bad loans rate turned out higher than the one predicted by the RBI under a severe stress scenario. As Arvind Subramanian, the former chief economic advisor to the ministry of finance, writes in Of Counsel:

“In March 2015, the RBI was forecasting that even under a “severe stress” scenario— where to put it colourfully, all hell breaks loose, with growth collapsing and interest rates shooting up—NPAs [bad loans] would at most reach about Rs 4.5 lakh crore.”

By March 2018, the total NPAs of banks had stood at Rs 10.36 lakh crore.

One possible reason can be offered in the RBI’s defence. Let’s assume that the central bank in March 2015 had some inkling of the bad loans of banks ending up at around Rs 10 lakh crore. Would it have made sense for it, as the country’s banking regulator, to put out such a huge number? Putting out numbers like that could have spooked the banking system in the country. It could even have possibly led to bank runs, something that the RBI wouldn’t want.

In this scenario, it perhaps made sense for the regulator to gradually up the bad loans rate prediction as the situation worsened, than predict it in just one go. Of course, I have no insider information on this and am offering this logic just to give the country’s banking regulator the benefit of doubt.

5) So, if the past is anything to go by, the actual bad loans of banks when they are going up, turn out to be much more than that forecast by the RBI even under a severe stress scenario. Hence, it is safe to say that by September 2021, the bad loans of banks will be close to 15% of advances, a little more than actually estimated under a severe stress scenario.

This will be double from 7.5% as of September 2020. Let’s try and quantify this number for the simple reason that a 15% figure doesn’t tell us about the gravity of the problem. The total advances of Indian banks as of March 2020 had stood at around Rs 109.2 lakh crore.

If this grows by 10% over a period of 18 months up to September 2021, the total advances of Indian banks will stand at around Rs 120 lakh crore. If bad loans amount to 15% of this we are looking at bad loans of Rs 18 lakh crore. The total bad loans as of March 2020 stood at around Rs 9 lakh crore, so, the chances are that bad loans will double even in absolute terms. If the total advances grow by 5% to around Rs 114.7 lakh crore, then we are looking at bad loans of around Rs 17.2 lakh crore.

6) The question is if this is the level of pain that lies up ahead for the banking system, why hasn’t it started to show as yet in the balance sheet of banks. As of March 2021, the RBI expects the bad loans of banks to touch 12.5% under a baseline scenario and 14.2% under a severe stress scenario. But this stress is yet to show up in the banking system.

This is primarily because the bad loans of banks are currently frozen as of August 31, 2020. 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.

As the FSR points out:

“In view of the regulatory forbearances such as the moratorium, the standstill on asset classification and restructuring allowed in the context of the COVID-19 pandemic, the data on fresh loan impairments reported by banks may not be reflective of the true underlying state of banks’ portfolios.”

The Supreme Court clearly needs to hurry up on this and not keep this hanging.

7) Delayed recognition of bad loans is a problem that the country has been dealing with over the last decade. The bad loans which banks accumulated due to the frenzied lending between 2004 and 2011, were not recognised as bad loans quickly enough and the recognition started only in mid 2015, when the RBI launched an asset quality review.

This led to a slowdown in lending in particular by public sector banks and negatively impacted the economy. Hence, it is important that the problem be handled quickly this time around to limit the negative impact on the economy.

8) Public sector banks are again at the heart of the problem. Under the severe stress scenario their bad loans are expected to touch 17.6% of their advances. The sooner these bad loans are recognised as bad loans, accompanied with an adequate recapitalisation of these banks and adequate loan recovery efforts, the better it will be for an Indian economy.

9) At an individual level, it makes sense to have accounts in three to four banks to diversify savings, so that even if there is trouble at one bank, a bulk of the savings remain accessible. Of course, at the risk of repetition, please stay away from banks with a bad loans rate of 10% or more.

To conclude, from the looks of it, the process of kicking the bad loans can down the road seems to have started. There is already a lot of talk about the definition of bad loans being changed and loans which have been in default for 120 days or more, being categorised as bad loans, against the current 90 days.

And nothing works better in the Indian system like a bad idea whose time has come. This is bad idea whose time has come.

 

When it comes to bad loans of banking, the big boys are the bad boys

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The Reserve Bank of India(RBI) released the Financial Stability Report on December 23, 2015. One of the key themes in this report was the fact that large borrowers are the ones who have landed the banking sector in trouble. As the RBI governor Raghuram Rajan wrote in the foreword to the report: “corporate sector vulnerabilities and the impact of their weak balance sheets on the financial system need closer monitoring.”

That is a euphemistic way of saying that corporates are essentially responsible for the rising bad loans of banks. As on September 30, 2015, the bad loans (gross non-performing advances) of banks were at 5.1% of total advances [i.e. loans] of scheduled commercial banks operating in India. The number was at 4.6% as on March 31, 2015. This is a huge jump of 50 basis points in a period of just six months. One basis point is one hundredth of a percentage.

What is the problem here? The inability of large borrowers to continue repaying the loans they have taken on in the years gone by. As on September 30, 2015, loans to large borrowers made up 64.5% of total loans. On the other hand, bad loans held by large borrowers amounted to 87.4% of total bad loans.

What this means is that for every Rs 100 of loans given by banks, Rs 64.5 has been given to large borrowers. At the same time of every Rs 100 of bad loans, large borrowers are responsible for Rs 87.4 of bad loans. Hence, large borrowers are clearly responsible for more bad loans.

As on March 31, 2015, bank loans to large borrowers made up 65.4% of total bank loans. At the same time, the bad loans of large borrowers constituted 78.2% of the total bad loans. What this means is that for every Rs 100 of loans given by banks, Rs 65.4 was given to large borrowers. At the same time of every Rs 100 of bad loans, large borrowers were responsible for Rs 78.2 of bad loans. This has since jumped to Rs 87.4 for every Rs 100 of bad loans.

What these numbers clearly tell us is that in a period of six months the situation has deteriorated big time and large borrowers have been responsible for it. As the RBI Financial Stability Report points out: “While adverse economic conditions and other factors related to certain specific sectors played a key role in asset quality deterioration, one of the possible inferences from the observations in this context could be that banks extended disproportionately high levels of credit to corporate entities / promoters who had much less ‘skin in the game’ during the boom period.”

What does this mean? Banks gave loans to corporates/promoters who had put very little of their own money in the project they had borrowed money for. Banks essentially gave more loans than they actually should have, given the amount of capital the promoters put in. And this is now proving to be costly for them.

In fact, lending to industry forms a major part of the stressed loans of banks. Stressed loans are essentially obtained by adding the bad loans and the restructured loans of banks.  A restructured loan is a loan on which the interest rate charged by the bank to the borrower has been lowered. Or the borrower has been given more time to repay the loan i.e. the tenure of the loan has been increased. In both cases the bank has to bear a loss.

As the RBI report points out: “Sectoral data as of June 2015 indicates that among the broad sectors, industry continued to record the highest stressed advances ratio of about 19.5 percent, followed by services at 7 per cent. The retail sector recorded the lowest stressed advances ratio at 2 per cent. In terms of size, medium and large industries each had stressed advances ratio at 21 per cent, whereas, in the case of micro industries, the ratio stood at over 8 per cent.”

Lending to the retail sector (i.e. you and me) continues to be the best form of lending for banks. The stressed loans ratio in this case is only 2%. This means that for every Rs 100 lent by banks to the retail sector (home loans, car loans, personal loans and so on), only Rs 2 is stressed.

Why is this the case? For the simple reason that it is very easy for banks to go after retail borrowers who are no longer in a position to repay the loans they have taken on. Further, there is no political meddling when it comes to loans to retail borrowers, hence, the lending is anyway of good quality.

In comparison, lending to industry has a stressed loans ratio of 19.5%. This means for every Rs 100 that the banks have lent to industry, Rs 19.5 is stressed i.e. it has either been defaulted on or has been restructured. Interestingly, even within industry, the situation with the micro industries is not as bad as the medium and the large industries.

The large industries have a stressed loans ratio of 21% i.e. for every Rs 100 lent to large industries by banks, Rs 21 has either been defaulted on or has been restructured. In case of micro industries, the number is at 8%. This is because banks can unleash their lawyers on the small industries in case the loan is in trouble. They can’t do the same on large borrowers. And even if they do it does not have the same impact.

Five sectors have been responsible for a major part of the trouble. These are mining, iron & steel, textiles, infrastructure and aviation. These “together constituted 24.2 per cent of the total advances [i.e. loans] scheduled commercial banks as of June 2015, contributed to 53.0 per cent of the total stressed advances.” “Stressed advances in the aviation sector6 increased to 61.0 per cent in June 2015 from 58.9 per cent in March, while stressed advances of the infrastructure sector increased to 24.0 per cent from 22.9 per cent during the same period.”

To conclude, when it comes to the bad loans of banking, the big boys are the bad boys who are responsible for a majority of the mess.

The column originally appeared on The Daily Reckoning on January 5, 2016