Will RBI’s Latest Rescue Act Clean the Mess in Public Sector Banks?


Late last week, the Reserve Bank of India(RBI) unleashed yet another weapon to clean up the mess that India’s public sector banks are in. The RBI reviewed and revised the preventive corrective action (PCA) framework for banks.

At a very simplistic level, the PCA framework essentially will restrict the ability of any bank to go about their normal business, in case they don’t meet certain performance parameters. The idea is to ensure that banks do not get into a further mess.

The RBI has basically set three risk levels for the PCA framework to kick-in. Take the case of bad loans or net non-performing assets(NPAs) of banks. (NPAs are essentially loans which borrowers have defaulted on and are no longer repaying. These NPAs are referred to as gross NPAs. Against, the gross NPAs, the banks set aside a sum of money referred to as provisions. Once these provisions are subtracted from gross NPAs what remains are net NPAs).

Let’s say the net NPA of a bank is greater than or equal to 6 per cent but less than 9 per cent. In this case, the bank will face a restriction on dividend distribution. This is the first risk level of the PCA framework. In case, the net NPA is greater than or equal to 9 per cent and less than 12 per cent, along with dividend restrictions the bank will also face a restriction on branch expansion and at the same time will have to increase its provisions or the money it sets asides against gross NPAs. This is the second risk level of the PCA framework.

If the net NPA is greater than or equal to 12 per cent, then along with the dividend restrictions, restrictions on bank expansion, greater provisioning, the banks will have to limit the management compensation and directors’ fees. This is the third risk level of the PCA framework.

Along with net NPAs, the other performance parameters that the RBI plans to take a look at as a part of the PCA framework are the capital adequacy ratio, return on assets and the leverage of the bank. If the bank does not meet the RBI set levels of these parameters, the actions highlighted above will kick-in.

Over and above this, there are other actions that can kick-in. These include:

  1. Special audit of the bank
  2. A detailed review of business model in terms of sustainability of the business model of the bank.
  3. RBI to actively engage with the bank’s Board on various aspects as considered appropriate.
  4. RBI to recommend to owners (Government/ promoters/ parent of foreign bank branch) to bring in new management/ Board.
  5. RBI to supersede the Board.
  6. Reduction in exposure to high risk sectors to conserve capital.
  7. Preparation of time bound plan and commitment for reduction of stock of NPAs.
  8. Preparation of and commitment to plan for containing generation of fresh NPAs.
  9. Strengthening of loan review mechanism.
  10. Restriction of staff expansion.
  11. Restrictions on entering into new lines of business.
  12. Restrictions on accessing/ renewing wholesale deposits/ costly deposits/ certificates of deposits.
  13. Reduction in loan concentrations; in identified sectors, industries or borrowers.

If you look at the above actions, other than the RBI superseding the board of the bank, the other steps are more or less what any bank which is in trouble would undertake. The question is will the PCA unravel the mess that the Indian banks, in particular the government owned public sector banks, are currently in.

The biggest problem for the public sector banks has been the fact that their gross NPAs have been increasing at a very rapid rate. Between December 2014 and December 2016, the gross NPAs of public sector banks increased by 137 per cent to Rs 6.46 lakh crore.

What is the reason for this huge and sudden increase in gross NPAs? A major reason lies in the fact that banks have been recognising their bad loans as bad loans at a very slow speed. The question is the recognition of bad loans as bad loans over? Have all bad loans been recognised as bad loans? Or are banks still resorting to accounting gimmicks and postponing the recognition of bad loans? This is a question which only the banks or the RBI can answer.

The most important step in cleaning up the balance sheets of Indian banks is ensuring that all the bad loans have been recognised as bad loans. A problem can be solved only after it’s properly identified. The tendency not recognise bad loans as bad loans and project a financial picture which is incorrect needs to end.

The second biggest problem for Indian banks has been the poor recovery rate of bad loans (i.e. net NPAs in this case). Data from RBI shows that in 2015-2016, the recovery rate fell to 10.3 per cent of the net NPAs. In 2014-2015, it was at 12.4 per cent. In 2013-2014 and 2012-2013, the recovery rates were even better at 18.4 per cent and 22 per cent, respectively.

This basically means that the ability of banks to recover bad loans has gone down over the years. Will the PCA framework be able to help on this count? It doesn’t seem so. A greater portion of the bad loans need to be recovered from corporate India. As the Economic Survey points out: “The stressed debt is heavily concentrated in large companies.” Hence, any major recovery from large companies will need a lot of political will something, which is something the RBI cannot do anything about.

The PCA framework will kick-in depending on the performance of banks as on March 31, 2017. But taking the net NPA numbers as on December 31, 2016, how does the scene look like for public sector banks? There are 21 public sector banks which currently have a net NPA ratio of greater than 6 per cent. Hence, the PCA framework will apply to all of these banks. The first risk level of the PCA framework will apply to all these banks.

Of these ten banks have an NPA of greater than 9 per cent. The second risk level of the PCA framework will apply to these banks. Two banks have an NPA of greater than 12 per cent. The Indian Overseas Bank is the worst of the lot at 14.3 per cent. The State Bank of Patiala came in next as of December 2016. This bank has since been merged with the State Bank of India.

The PCA framework will essentially limit the ability of these banks to carry out business and hence, limit further damage to the bank and the financial system.

Nevertheless, there is no way the framework will clear up the mess that these banks are in. For that what is needed is a lot of political will to go after corporates and recover the bad loans that are outstanding. The question is do we have that kind of political will?

The column originally appeared on Firstpost on April 19, 2017 

Taxpayers will have to Pick-Up the Final Bill of the Mess in Govt Banks



In a column I wrote last week I said that I was happy that the profit of the State Bank of India, the country’s largest bank, had fallen by 62%. Along the same lines I need to say that I am happy that the Bank of Baroda has made a loss of Rs 3342 crore, for the period October to December 2015. This is the biggest loss ever made by any Indian bank. In fact, the losses would have been higher if not for a Rs 1,118 crore tax write-back that the bank got.

Over the years, banks have not been recognising bad loans as bad loans. This process that has started now and is bringing out the real state of the Indian public sector banks and that is a good thing. In case of Bank of Baroda, the gross non-performing loans (or bad loans) of the bank jumped by 152% to Rs 38,934 crore, in comparison to as on December 2014. In percentage terms, the bad loans as of December 2015 stand at 9.68% of total lending in comparison to 3.85% in December 2014.

What this clearly tells us is that the Bank of Baroda, like the other public sector banks, had been under-declaring its bad loans up until now. This can be easily said from the fact the bad loans as a percentage of total loans, as on September 2015, had stood at 5.56%. By December 2015, this had jumped up by 412 basis points to 9.68%. One basis point is one hundredth of a percentage.

The situation could not have become so bad over a period of just three months. This clearly tells us that the bank had not been putting out the correct situation of its loans earlier. But now that it is, the stock market is clearly happy about it, with the stock rallying by 22% to Rs 139.55 as on February 15, 2016.

It needs to be pointed out here that the public sector banks are finally getting around to presenting the right set of accounts because the RBI led by Raghuram Rajan has pushed them to do so, by unleashing the asset quality review on to them.

As Rajan pointed out in a recent speech: “ With markets generally in decline, the decline in bank share prices has been more accentuated. However, part of the reason is that some bank results, mainly public sector banks, have not been, to put it mildly, pretty. Clearly, an important factor has been the Asset Quality Review (AQR) conducted by the Reserve Bank and its aftermath.”

This leads to the question as to what was the RBI doing all these years, especially in the pre-Rajan years given that such a huge build-up of bad loans couldn’t have happened overnight.

Also, it needs to be clarified here that a bad loan doesn’t mean that the bank has lost all the money. This seems to be the general understanding and is incorrect. A loan is typically declared to be a non-performing asset (or a bad loan), 90 days after the borrower starts defaulting on the interest and principal payments. When this happens a bank can no longer continue to accrue interest on the portion of the loan that remains unpaid. It has to start making provisions i.e. start keeping money aside.

This basically means that the bank starts keeping money aside so that if the loan is totally defaulted on or partially defaulted on or the bank cannot recover enough money from the assets that it has as a collateral, then enough money has been set aside to meet the losses.

Along these lines, the Bank of Baroda has increased its provisioning. For October to December 2015, the bank set aside Rs 6,165 crore. This is an increase of 389% in comparison to the money it had set aside for September to December 2014.

The question is even with this huge jump in provisioning, is the bank setting aside enough? The Reserve Bank of India(RBI) Master Circular on Prudential norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances: “Banks should build up provisioning and capital buffers in good times i.e. when the profits are good, which can be used for absorbing losses in a downturn. This will enhance the soundness of individual banks, as also the stability of the financial sector. It was, therefore, decided that banks should augment their provisioning cushions…and ensure that their total provisioning coverage ratio…is not less than 70 per cent.”

The provisioning coverage ratio is defined as the total provisions set aside by a bank as on a particular date divided by the total gross non-performing assets (bad loans) of the bank as on the same day.

The RBI wants banks to maintain a provision coverage ratio of 70%. But that doesn’t seem to have happened. In fact, as a recent news-report in The Indian Express points out: “An analysis of provisioning coverage ratio data of 20 public sector banks for March 2011 to March 2015 shows a steady fall in the coverage ratio. It has dropped from an average of 72 per cent for the group of 20 banks in the year-ended March 2011 to 57 per cent for the year-ended March 2015.”

In fact, for Bank of Baroda, the provisioning coverage ratio as on March 31, 2015, had stood at 64.99%. Since then, despite the absolute jump in provisioning, the provisioning coverage ratio of the bank has fallen to 52.70%. So, the bank clearly is not setting aside enough money against its bad loans, even though its setting aside more money in absolute terms, than it has done in the past.

How do things look for other banks? Let’s take the case of Punjab National Bank, the second largest public sector bank. The provisioning coverage ratio of the bank as on March 31, 2015, was at 58.21%, since then it has fallen to 53.85%. The same is the case with the State Bank of India. The ratio has fallen from 69.13% to 65.23%.

So none of the bigger public sector banks are fulfilling the provisioning coverage requirement of 70% as required by the RBI. What this tells us is that if the banks work towards achieving this ratio in the coming quarters, the losses of these banks will only go up. This would also mean eating into the capital of the bank.

Also, it is worth asking here what portion of the bad loans will the public sector banks be able to recover? The answer is not encouraging if we look at the numbers of the two biggest banks—the State Bank of India and the Punjab National Bank.

During the course of this financial year, the State Bank of India has managed to recover loans of Rs 2,761 crore. During the period its bad loans jumped up from Rs 56,725 crore to Rs 72,792 crore.

How do things look for Punjab National Bank? During the course of this financial year, the bank has managed to recover loans worth Rs 6,382 crore. During the same period, the bad loans of the bank have jumped from Rs 25,695 crore to Rs 34,338 crore. For both, State Bank of India as well as Punjab National Bank, there has been a huge jump in the loans recovered in comparison to April to December 2014. Nevertheless, the total amount of bad loans has gone up as well, in effect negating the recoveries. And this doesn’t augur well for the banks.

My guess is that public sector banks losses will eat into their capital in the months and years to come and the government (i.e. the taxpayer) will have to keep coming to their rescue by infusing fresh capital into these banks. Since 2010, the government has pumped in Rs 67,734 crore into public sector banks. It will have to put in a lot more money in the days to come.

As Michael Pettis writes in The Great Rebalancing: “Traditionally the cost of a banking crisis is borne directly or indirectly by households. Whether it is in the form of foregone deposits, government bailouts funded by household taxes…Households always foot the bill for banking crisis.”

The situation in India will be no different.

The column was originally published in the Vivek Kaul Diary on Equitymaster on February 16, 2016

Rajan Explains what’s Exactly Wrong with Public Sector Banks

In a speech he made last week Raghuram Rajan, the governor of the Reserve Bank of India, put forward some very interesting data points.

It is well known by now that the lending growth of public sector banks has been very slow as they grapple with burgeoning bad loans. Nevertheless, agglomerated data on the loan growth of public sector banks is generally not available in the public domain.

As Rajan said: “Non-food credit growth from public sector banks, the more stressed part of the system, grew at only 6.6% over the calendar year 2015. Industrial credit growth for PSBs was only 3.3% while growth in lending to agriculture and allied lending was only 10.4%. The only area of strength was personal loans, where growth was 16.9 %.”

Banks give out loans to the Food Corporation of India to run its operations. After adjusting for these loans, what remains is the non-food credit growth. The overall non-food credit in 2015 grew by around 9.3% (actually between December 25, 2014 and December 24, 2015) against 6.6% of public sector banks. This tells us very clearly that the loan growth of public sector banks has been significantly slower than the overall loan growth of banks.

In fact, the only area where lending of public sector banks has been robust enough is what RBI refers to as personal loans. These personal loans are different from what banks refer to as personal loans. Personal loans as categorised by RBI include home loans, vehicle loans, education loans, credit card outstanding, loans given against fixed deposits, shares and bonds and what banks call personal loans.

How does the situation of public sector banks look in comparison to private sector banks? As Rajan said: “In contrast, non-food credit growth in private sector banks was 20.2 %, in agriculture 25.4%, in industry 14.6%, and 23.5% in personal loans. Put differently, in each of these areas except personal loans, loan growth in private sector banks was at least 10 percentage points higher than public sector banks, while loan growth in personal loans was 6.6 percentage points higher.”

The loan growth of private sector banks at 20.2% was significantly higher than that of public sector banks at 6.8%. As Rajan put it: “The most plausible explanation I have is that the stressed balance sheet of public sector banks is occupying management attention and holding them back, and the only way for them to supply the economy’s need for credit, which is essential for higher economic growth, is to clean up. The silver lining message in the slower credit growth is that banks have not been lending indiscriminately in an attempt to reduce the size of stressed assets in an expanded overall balance sheet, and this bodes well for future slippages.”

Hence, public sector banks have been going slow on lending primarily because they already have a huge amount of bad loans piled up and they don’t want to continue to lend indiscriminately and have more bad loans piling up. What Rajan is essentially saying here is that the public sector banks could have continued on their indiscriminate lending spree and expanded on their loan books. In the process, the total amount of bad loans as a proportion of the total loans given out by banks, would have come down, at least for a short-time.

The fact that they did not do that is a good thing, feels Rajan. But the damage of their indiscriminate lending in the past is now coming out in the open. Take a look at the following table.


Extent of the problem

The bad loans plus restructured assets plus the assets written off in total made up for 17% of the books of public sector banks. This means that for every Rs 100 of loan given by public sector banks, Rs 17 worth of loans are in dodgy territory. Rs 6.2 have become a bad loan, where the repayment of the loan by the borrower has stopped happening. Rs 7.9 has been restructured i.e. the repayment of the loan has been placed in a moratorium for a few years. In some cases, the borrower does not have to pay the interest during the moratorium period. In some other cases the tenure of the loan has been extended. Further, Rs 3 out of every Rs 100 has been written off, with no hope of recovery of the loan.

Now how do private sector banks and foreign banks perform on the same parameters? Take a look at the following table.

Divergent NPA trends

What the table tells us very clearly is that the situation in private banks and foreign banks is significantly better than public sector banks. In private sector banks Rs 6.7 out of every Rs 100 of loans is in dodgy territory. In case of foreign banks, the number is even lower at Rs 5.8.

What this tells us very clearly is that the problem of bad loans is largely limited to public sector banks. And it is interesting that the large borrowers are primarily responsible for the mess in the banking system. This becomes clear from the following table. Public sector banks make up for close to three-fourths of the Indian banking system.

Divergent NPA trends


As can be seen from the table medium and large industries are primarily responsible for the mess in the banking sector. Rajan also said during the course of his speech that all bad loans were not because of malfeasance.  As he said: “Let me emphasize that all NPAs are not because of malfeasance. Indeed, most are not. Loans can go bad even if the promoter has the best intent and banks do the fullest due diligence before sanctioning. Nevertheless, where there is evidence of malfeasance by the promoter, it is extremely important that the full force of the law is brought against him, even while banks make every effort to put the project, and the workers who depend on it, back on track.”

Let’s sincerely hope that this happens, else we will have a situation where banks will have to write off more and more of their bad loans, with the taxpayer having to pick up the ultimate bill. And that can’t possibly be a good thing.

The column originally appeared on the Vivek Kaul Diary on February 15, 2016

The real story behind the bad loans of Indian banks

In several previous columns in The Daily Reckoning newsletter, I have talked about the bad loans that are accumulating with banks in general and government owned public sector banks in particular. A major portion of these bad loans is from corporates who had borrowed and are now not repaying the loans.

A standard explanation from the corporates is that these are tough times for the economy and given that they are not in a position to repay. The trouble is that this is not always true. As a recent research brought out by EY and titled Unmasking India’s NPA issues – can the banking sector overcome this phase? points out: “While corporate borrowers have repeatedly blamed the economic slowdown as the primary factor behind it[i.e. defaulting on bank loans], periodic independent audits on borrowers have revealed diversion of funds or wilful default leading to stress situations.”

Nevertheless, despite many wilful defaults, banks don’t declare such defaulters as wilful defaulters. The RBI defines “wilful default” as a situation where a borrower has defaulted on the payment/repayment obligations despite having the capacity to pay up. Or the borrower hasn’t utilised the loan amount for the specific purpose for which the loan was disbursed and diverted the money for other purposes. Or the borrower has siphoned off the funds. Or the borrower has defaulted on the loan and at the same time sold off the immoveable property which acted as the collateral against which the loan had been granted.

The EY report explains quoting bankers, why banks and bankers don’t declare borrowers as wilful defaulters: “It is more or less certain that if we declare a borrower a “wilful defaulter,” he will approach the court. Then it becomes our responsibility to justify our action with supporting evidence. It is not always possible to establish that the borrower has siphoned off the money or used it for a purpose other than the one which loan has been taken. Hence, we need to be extremely cautious before we declare someone a “wilful defaulter.” Otherwise, we will not only lose the case, but we will also let the defaulter off the hook.”

What the survey does not point out is that unlike the corporate defaulters, public sector banks do not have the best lawyers on their speed dial.

As on December 31, 2014, the top 30 defaulters accounted for nearly one third of the bad loans of close to $47.3 billion, which is clearly worrying. Also, many high value loans have gone bad. And they keep piling up. In fact, in a survey carried out by the EY Fraud Investigation & Dispute Services found that 87% of the respondents that included bankers stated that diversion of funds to unrelated business through fraudulent means is one of the root causes for the NPA crisis.

Also, 64% of respondents believed that these bad loans resulted primarily because of lapses in the due-diligence carried out by banks before the loans were sanctioned. In fact, the report also talks about third party agencies that banks need to depend on while figuring out whether a borrower is good enough to be lent money to, as well as what he is doing with that money, once the loan has been given out.

As the report points out: “Third party agencies such as surveyors, engineers, financial analysts, and other verification agencies, etc., play a critical role in assuring financial information, proposals, work completion status, application of funds, etc. Lenders rely significantly on the inputs issued by such third parties.”

The trouble is that the system can and is being manipulated. “Reports are made as a routine, with little scrutiny. In some situations, the reports may be drafted under the influence of unscrupulous borrowers,” the EY report points out.

For the entire process of loan disbursal as well as monitoring mechanism to work well, the third party system needs to work in a transparent manner, which it currently doesn’t. As per the EY survey, two out of the three respondents agreed that third party reports could be manipulated in the favour of the borrower.

Further, 54% of the respondents attributed the bad loans to the inefficiencies in the monitoring process, after the loan had been given out.

And if all that wasn’t enough 72% of the respondents claimed that the crisis in banking because of bad loans is set to worsen before it becomes better. The reason for this is very simple—many loans which have gone bad have not been recognised as bad, and instead have been restructured i.e. the borrower has been allowed easier terms to repay the loan by increasing the tenure of the loan or lowering the interest rate.

As the EY report said quoting the bankers who had participated in the survey: “The stressed accounts that have been hidden till now would keep the NPA [non-performing asset] level rising at least for the next 2-3 years.” In simple English what this means is that many restructured loans will turn bad in the years to come, as borrowers will default.

The EY report further pointed out: “The reported numbers are quite high, and there are fresh additions every quarter, leading to further deterioration in asset quality. The portfolio of restructured accounts is adding to the problem at hand, thereby resulting in crisis.”

In fact, the corporate debt restructuring numbers have jumped up big time over the last few years. The number of cases has jumped from 225 to 647 between 2008-09 and December 31, 2014. This is a jump of 187%. In fact, in terms of the amount of loans, the jump is 370% to over Rs 450,000 crore.

The bankers that EY survey spoke to made several interesting points. Several borrowers go through the corporate debt restructuring mechanism just to ensure that they can drive down the interest rates on their loans or increase the repayment period. Also, even in cases where the borrower is in trouble nothing really comes out of the restructuring scheme. As the report points out: “These schemes are often used to soften the pricing terms, elongation of repayments, without improving the basic viability of the business.”

What all this clearly tells us is that the Indian banking system will continue to remain in a mess over the next few years, as restructured loans keep turning into bad loans.

Stay tuned and watch this space.

This column originally appeared on The Daily Reckoning on Sep 9, 2015

George Soros’ theory of reflexivity explains the rut in public sector banks

Public sector banks continue to remain in a big mess. In a recent research note
Crisil Research points out: “ Asset quality remained under pressure with gross non performing assets rising by 45 bps[basis points] to 5% of advances because of continuing stress across sectors such as infrastructure, construction and iron and steel. Also, restructured assets for public sector banks as a proportion of advances increased by 70-100 bps to around 7-8% as of December 2014.” One basis point is one hundredth of a percentage.
What this means in simple English is that for every Rs 100 given by Indian public sector banks as a loan(a loan is an asset for a bank) nearly Rs 12- 13(Rs 5 worth of non performing assets plus Rs 7-8 worth of restructured loans) is in shaky territory.
The borrower has either stopped repaying the loan or the loan has been restructured, where the borrower has been allowed easier terms to repay the loan (which also entails some loss for the bank) by increasing the tenure of the loan or lowering the interest rate. Crisil Research expects gross non-performing assets to remain at the current high levels, during the period January to March 2015, results for which will soon start coming out.
The question is how did the Indian public sector banks end up in this state? The simple answer as explained above is that they gave loans to borrowers who are no longer repaying them. The next question is whether the due diligence carried out by banks was adequate? This is where things get interesting.
A major portion of the loans which are now not being repaid were given out during the period 2002 and 2008. This was the period when the stock market in India was in the midst of a huge rally. The economy was also doing well.
This had created a massive “feel good” factor which ensured that corporates where willing to borrow and banks were willing to lend. Between end December 2001 and end December 2007, the lending by banks went up at a rapid rate of 26.8% per year. To give a sense of comparison, the lending by banks between December 2007 and December 2014 went up at the rate of 16.8% per year, which is significantly lower. If we consider a much shorter period between December 2011 and December 2014, the lending by banks went up by just 13.4% per year.
What this clearly tells us is that the growth in bank lending between December 2001 and December 2007 happened at a very rapid rate. This rapid rise was a reflection of the era of “easy money” that existed during that period due to the stock market and the Indian economy both going from strength to strength.
And this is where things started to get messy. Before we go any further it is important to understand, the theory of reflexivity proposed by hedge fund manager George Soros.
As Soros writes in
The New Paradigm for Financial Markets: The crux of the theory of reflexivity is not so obvious, it asserts that market prices can influence the fundamentals. The illusion that markets manage to be always right is caused by their ability to affect the fundamentals that they are supposed to reflect.” Reflexivity refers to circular relationships between cause and effect
Typically, the price of a stock is expected to reflect the underlying earnings potential of a company (or the kind of money that the company is expected to make in the days to come) or what analysts like to refer to as fundamentals of a company. What Soros implies through the theory of reflexivity is that the stock price of a company also impacts its earnings potential. Or to put it simply stock prices can have an impact on the fundamentals of a company.
In the feel good and easy money era that prevailed between 2001 and 2007, the stock prices of companies rallied at a rapid rate. This gave the companies the confidence to borrow a lot of money from banks, in the hope of expanding and earning much more money. But they bit more than they could chew and a few years down the line the interest that they paid on their outstanding debt was a major part of their total expenses. This had an impact on their profits. Hence, the stock price of a company ended up having an impact on its earnings.
As companies started defaulting on their interest payments and loan repayments, banks started becoming a part of this mess as well. They had to write off loans as well as restructure them. This has now led to a situation where the stressed assets of public sector banks are now close to 12-13%. In this way, a rapidly rising stock market ended up having an impact on the performance of banks. Also, in many cases the public sector banks were forced to lend to crony capitalists by politicians.
High GNPAs will restrict growth in net interest income to 5-7% year on year, in spite of lowering of deposit rates by some of the banks,” points out Crisil.
To conclude, the bad habits are usually picked up during good times. And that is precisely what happened to public sector banks in India.

The column originally appeared on The Daily Reckoning on April 15, 2015