Why Do People Still Have Deposits in Indian Overseas Bank and UCO Bank?

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That we are financially illiterate nation is a given. But even with this disclaimer I am sometimes amazed at how lackadaisical people are when it comes to their money.

Take the case of two public sector banks: a) Indian Overseas Bank b) UCO Bank. Recently, both the banks declared results for the three-month period ending June 30, 2016. As of June 30, the bad loans of Indian Overseas Bank amounted to 20.48 per cent. And that of UCO Bank were at 17.19 per cent.

This basically means that close to one-fifth of the loans given by these banks have not been repaid. The question is how do these banks or for that matter any bank, give loans? A bank raises deposits and then gives out those deposits as loans.

Of course, if the loans of a bank are not being repaid, it’s chances of returning deposits are also low. At least, that is how things should work in theory. But that is not the case primarily because everyone knows that a government is not going to let a public sector bank go bust. (Actually, the government won’t let even a private sector bank go bust, but that is a story we will leave for another day).

And this explains why people still have their money deposited with these banks. Take the case of Indian Overseas Bank. As on June 30, 2016, the total deposits with the bank stood at Rs 2.18 lakh crore, in comparison to Rs 2.32 lakh crore a year earlier. Now that is a fall of 5.85 per cent.

This drop is extremely marginal when one takes into account the fact that the bad loans of the bank have more than doubled during the same period. As on June 30, 2015, the bad loans of the bank had stood at 9.40 per cent of its total advances. What this clearly tells us is that the smart money has started to move out of the bank. But the bulk of the lot continue to hold on to their deposits in the bank.

How do things look for UCO Bank? I couldn’t find the deposits of the bank as on June 30, 2016, and hence, have worked with March 31, 2016, numbers, which are good enough to make the point I am trying to make.

As of March 31, 2016, the total deposits of UCO Bank were at Rs 2.07 lakh crore, down from Rs 2.14 lakh crore from a year earlier. This is a meagre fall of 3.4 per cent. During the same period, the bad loans of the bank have jumped from 6.76 per cent to 15.43 per cent.

While the investors in the stocks of these banks have realised the true situation that these banks are in, the same cannot be said about the depositors. The explanation for this is fairly straightforward. Most depositors do not keep track of the state of the bank they have deposited their money in, especially if it happens to be a public sector bank.

The de facto assumption is that money deposited in a public sector bank is safe, which it is. Nevertheless, if at all there is trouble, there might be transitional problems and during that period liquidity of these deposits might be an issue.

Also, for all the risk that depositors are taking on by investing in these banks, what is the extra return that they are earning? The interest on fixed deposits of UCO Bank for a period of one year or more vary between 7.25 per cent and 7.5 per cent. The interest rates on fixed deposits of Indian Overseas Bank for a similar period vary between 7 per cent and 7.25 per cent.

The State Bank of India, the largest public sector bank, offers interest rates between 7 per cent and 7.5 per cent, for fixed deposits of one year or more. Hence, the State Bank of India offers more or less the same interest rate as Indian Overseas Bank and UCO Bank, do.

At the same time, it is a much safer bank to have your deposits in given that its bad loans as on June 30, 2016, stood at 6.49 per cent of its total advances. They had stood at 4.29 per cent as on June 30, 2015.

So, the bad loans of State Bank of India are lower than that of both Indian Overseas Bank as well as UCO Bank. At the same time, they have gone up at a much slower pace. In case both Indian Overseas Bank and UCO Bank, the bad loans have more than doubled over the last one year. This is clearly not the case with State Bank of India.

Hence, even those depositors who like to hold their deposits in government owned banks, the State Bank of India, is a much safer bet. Also, it is the biggest government bank and the government has the most interest in keeping it going.

The only place human beings are known to be rational are in theoretical economics. In real life they clearly not. The above example clearly shows us that. The reasons of people holding on to deposits in Indian Overseas Bank and UCO Bank can be multiple

The first, is that they don’t know that the banks are in a bad shape. The second, is that they do know that banks are in a bad shape, but they also know that government banks don’t fail. The third, is that they have always had their deposits in these banks and are friendly with the people who run the branch they have their deposits in.

Nevertheless, none of these reasons is a rational one because the fixed deposits of these two banks do not pay a higher rate of return for the extra risk that the people are taking on.

The column originally appeared in Vivek Kaul’s Diary on August 16, 2016

Why Public Sector Banks Should Not Be Merged

Fostering Public Leadership - World Economic Forum - India Economic Summit 2010

Over the last few months there has been talk of the government merging public sector banks. The finance minister Arun Jaitley said so in his budget speech in February: “a roadmap for consolidation of Public Sector Banks will be spelt out.”

In an interview to the Business Standard newspaper published on May 15, 2016, Jaitley said, “wait for a few days,” when he was asked for a timeline on consolidation of public sector banks. Between February and May, there have been other occasions on which Jaitley has said that the merger of public sector banks is on the cards.

What is the logic behind the idea of consolidating or merging public sector banks? The government currently owns twenty-seven public sector banks, which is way too many. The idea is to merge some of these banks so that they can also compete globally. The size of these banks varies a lot. The State Bank of India is the biggest public sector banks and its balance sheet is seventeen times larger than the smallest public sector bank.

As Jaitley told Business Standard: “Our public sector banks(PSBs) also must be global players and therefore the idea of consolidating some of them.”

While this is a noble idea, it does not solve the problem of bad loans from which all public sector banks are currently dealing with. This is something that first needs to be solved. It doesn’t help anyone if a weak bank is merged with what looks like a relatively strong bank. And the problem of bad loans of public sector banks still hasn’t gone away. It’s alive and kicking.

As R Gandhi, deputy governor of the Reserve Bank of India, the banking regulator, said in a recent speech: “Merger of a weak bank with a strong bank may make combined entity weak if the merger process is not handled properly. The problems of capital shortages and higher non-performing assets (or bad loans) may get transmitted to stronger bank due to unduly haste or a mechanical merger process.”

Gandhi also pointed out that there was very little past precedent to go on. As he said: “Recent merger of State Bank of Saurashtra and State Bank of Indore into State Bank of India may be seen as basically merger among group companies. The only example of merger of two PSBs is merger of New Bank of India with Punjab National Bank in 1993. However, this was not a voluntary merger.”

Research evidence suggests that mergers tend to work when they lead to firing of employees. When two similar organisations merge, it leads to many sets of people having the same kind of expertise and skillsets. Hence, one set is gotten rid of.

For two banks merging this could mean, shutting down one of the two branches operating in the same area and then firing the employees of the branch which has been shut-down. This will bring down employee cost as well as operational costs. This is a good example of synergy that often gets talked about in case of mergers.

Having said that, nothing of that sort will be possible in India. Even a hint on this front can lead to labour unions going on a rampage. Jaitley made this clear in his interview where he said that consolidation shall be looked at “without adversely affecting labour employment considerations”.

And without fewer employees after the merger of public sector banks, there is very little synergy that will be created.

Also, merging banks will not solve the most basic problem that the government owned public sector banks face—crony capitalism. A large part of bad loans that public sector banks are currently dealing with has been because of lending to crony capitalists. Till the public sector banks continue to be government owned, some set of crony capitalists will thrive.

If the government really wants to deal with this problem, then best way is to start privatising public sector banks. As far as fulfilling its social sector obligations is concerned, the government does not need to own 27 banks for that. Around five to six banks should be good enough.

(Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected])

The column was originally published in the Bangalore Mirror on May 18, 2016

How Black Money Helps Indian Banks Finance Real Estate

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Black money or money which has been earned and on which tax has not been paid, is a common phenomenon in India. The fact that only around 3-4% Indians pay income tax explains this. This hurts the government given that it is not able to raise as much tax as it could, if everybody or a substantial portion of Indians paid income tax. It also means that the government has to borrow more in order to meet its expenses, and this pushes up interest rates.

It is also not fair on those Indians, typically the salaried class, who have no option but to pay income tax. What has also happened over the years is that instead of trying to expand the tax base, various governments have tried to milk those who pay tax, for more and more tax.

But not everyone is hurt because of black money. In fact, in case of home loans, banks and housing finance companies benefit because of black money. As Kaushik Basu, current chief economist at World Bank and former chief economic adviser to the ministry of finance, writes in his new book An Economist in the Real World – The Art of Policymaking in India: “A lot of the buying and selling of homes in India occurs with a part of the transaction being made in cash with no record kept of this in order not to leave a trail of evidence.”

Basu then goes on to explain how this benefits banks and housing finance companies issuing home loans. As he writes: “You want to buy a house valued at Rs 100 from the private market. The chances are the seller will tell you that he will not take the full Rs 100 paid in cheque, but will ask for a part, maybe Rs 50 or Rs 60, in cheque with the rest paid in cash with no evidence of this payment. The latter is called a black money payment.”

And how does this help? As Basu writes: “This helps the seller not to have to pay a large capital gains tax. Even many buyers want to pay partly in cash and to show the value of the house to be less than it actually is in order to avoid having to pay too much property tax.”

In fact, what Basu misses out on is the fact that in many cases buyers also have black money and they need to put this to use. And real estate is the best place to put it use given the totally opaque way in which the sector operates.

The black money payment essentially helps banks because the risk they take on in giving out the home loan, essentially comes down. How? “Since mortgage loans [i.e. home loans] can only be taken on the “declared” part of the house price, a house valued at Rs 100 would typically be bought with a mortgage of less than Rs 50. This means that when house prices [fall], unless the price drops [are] extraordinarily large, banks [will] not have a balance sheet problem,” writes Basu. In simple English what this means is that unless home prices fall dramatically, the value of the home (which is a collateral for the bank) will continue to be greater than the home loan outstanding.

He further philosophises that “Economics is not a moral subject”. “Often what is patently corrupt, like the pervasive use of black money can turn out to be a bulwark against a crisis.” In fact, Basu feels that the black money payments ensured that Indian banks did not have their own version of the subprime home loan crisis that hit the United States in 2008-2009.

Let’s understand this phenomenon in a little more detail. The December 2015 investor presentation of HDFC, the largest home finance company in the country, points out that the average home loan that it gives out is Rs 25 lakh. The average loan to value of a home stands at 65%. This means that the average price of a home financed by HDFC stands at around Rs 38.5 lakh (Rs 25 lakh divided by 0.65). The borrower/buyer makes an average down-payment of Rs 13.5 lakh(Rs 38.5 lakh minus Rs 25 lakh).

Over and above this there is a black payment to be made as well. It is very difficult to estimate the average amount of black money that gets paid every time a home loan is taken on to buy a home. Let’s assume that a black money payment of Rs 11.5 lakh is made. This means the real price of the home works out to Rs 50 lakh(Rs 38.5 lakh plus Rs 11.5 lakh).

Against this, HDFC lends Rs 25 lakh. Hence, the real average loan to home market value ratio stands at around 50%. This also when we assume that black money forms around 23% of the total value of the transaction (Rs 11.5 lakh divided by Rs 50 lakh). Black money payments in large parts of the country, especially in the northern part, can be considerably larger than this.

Hence, what this clearly tells us is that banks and housing finance companies end up lending half or less than half of the market value of the homes they are financing through home loans. And this makes it a very safe deal. Home prices need to fall by more than 50% for the value of the home to be lower than the home loan outstanding.

What also helps is the fact that home loans in India are recourse loans. This means that in case a borrower decides to default on the home loan by simply walking away from it, the lender can go beyond seizing the collateral (i.e., the house) to recover what is due to him. He can seize the other assets of the borrower, be it another house, investments, or money lying in a bank account, to recover his loan.

This along with black money payments explains why home loans are such good business for banks and housing finance companies. In case of HDFC, the non-performing loans formed around 0.54% of the individual home-loan portfolio. In fact, even when loans go bad, the institution is able to recover a major part of what is due and this explains why “total loan write-offs since inception [for HDFC]  is less than 4 basis points of cumulative disbursements.” One basis point is one hundredth of a percentage.

In case of State Bank of India, another big home-loan lender, the non-performing loans formed around 1.02% of overall retail loans. The bank does not give a separate non-performing loans number for home loans.

The column originally appeared in the Vivek Kaul Diary on March 2, 2016

I am Happy that State Bank of India’s Profit Fell by 62%

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The country’s largest bank the State Bank of India (SBI) declared its results for the period October to December 2015 (or what analysts like to call the third quarter) yesterday. And the results were disastrous with the net profit falling by 61.7%.

The second largest public sector bank, the Punjab National Bank, declared its results for October to December 2015, earlier this week. And its results were even more disastrous than that of SBI, with the net profit falling by 93%. In fact, the bank would have made huge losses if not for tax reversals of Rs 910 crore.

Banking is a stable business, where banks borrow at a certain rate of interest and lend at a slightly higher rate of interest. Of course everybody who takes a loan does not repay it. But if banks keep provisioning (i.e. setting aside money) for such loans in a proper way, such a huge fall in net profit, can only happen under exceptional circumstances.

Over the last one year, I have written in great detail about the mess that public sector banks are in. And it’s all coming out in the open now. In fact, many banks have been evergreening their loans by giving fresh loans to borrowers so that previous loans can be repaid.

Further, they have been under-declaring their level of bad loans by restructuring loans and kicking the can down the road. Nearly 40% of the restructured loans have gone bad over the last two to three years.

When a bank restructures a loan it allows the borrower a certain moratorium period of few years, in which the borrower has to pay only the interest on the loan. In some cases, interest also does not have to be paid. This is done in the hope that after the moratorium the borrower would have managed to turn around the business and be in a position to repay the loan. In some other cases, the tenure of the loan is increased.

But this facility has been abused by the banks, and loans which were bad in the first place (i.e. the borrower was not in a position to repay it), have also been restructured. This has allowed banks to pass off bad loans as restructured loans and continue to present a rosy set of numbers.

The Reserve Bank of India governor Raghuram Rajan calls this the band-aid approach. In fact, this approach entails banks giving fresh loans to the promoter as well. As Rajan said in a speech he made yesterday: “There are two polar approaches to loan stress. One is to apply band aids to keep the loan current, and hope that time and growth will set the project back on track. Sometimes this works. But most of the time, the low growth that precipitated the stress persists. The fresh lending intended to keep the original loan current grows. Facing large and potentially unpayable debt, the promoter loses interest, does little to fix existing problems, and the project goes into further losses.”

What Rajan is essentially saying here is that the band-aid approach followed by banks up until now has not been working. And what is needed is essentially a surgery. As Rajan said: “To do deep surgery…the bank has to recognize it has a problem – classify the asset as a Non Performing Asset (NPA).”

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 for the losses.

For the first year, after the loan has been categorised as a non performing asset, it is referred to as a sub-standard asset. On this loan, the 15% of the outstanding loan amount needs to be set aside a provision. At the end of the year, the loan becomes a doubtful asset. In this case the scale of provisioning goes up. In the first year that a loan remains a doubtful asset, the level of provisioning has to go up to 25%. In the second year, the level of provisioning has to go up to 50%. And in the third year, the loan is categorised as a loss asset and the provisioning has to go up 100%.

As Rajan said: “If the bank wants to pretend that everything is all right with the loan, it can only apply band aids – for any more drastic action would require NPA classification. Loan classification is merely good accounting…It is accompanied by provisioning, which ensures the bank sets aside a buffer to absorb likely losses. If the losses do not materialize, the bank can write back provisioning to profits. If the losses do materialize, the bank does not have to suddenly declare a big loss, it can set the losses against the prudential provisions it has made. Thus the bank balance sheet then represents a true and fair picture of the bank’s health, as a bank balance sheet is meant to.”

And this is precisely what has happened with banks like State Bank of India and Punjab National Bank. Let’s understand this in the case of the State Bank of India. The non-performing assets of the bank went up by Rs 20,692 crore (or what are referred to as fresh slippages). The number was at Rs 5,875 crore during the period July to September 2015. This implies a huge jump. What does this tell us? It tells us very clearly that the bank is finally recognising that there is a problem and that has led to this huge jump in non-performing assets. And that is a good thing.

The net increase in gross non-performing assets is Rs 15,959 crore after adjusting for recoveries and write-offs (i.e. loans on which 100% provisioning has been carried out).

Given that the fresh slippages have gone up by Rs 20,692 crore, the provisioning against these bad loans (i.e. setting aside money) has also gone up. The provisioning has gone up by 58.9% to Rs 7,645 crore, in comparison to the same period in 2014. This means more money is now being set aside to tackle the problem of bad loans. And this is the main reason why the bank’s net profit fell by 61.7% to Rs 1,115 crore. Interestingly, the operating profit of the bank (earnings before tax and provisioning) went up by 2.25% to Rs 9,598 crore.

This trend is visible right across public sector banks in their third quarter results. It tells us very clearly that the Rajan led RBI is cracking the whip and forcing banks to project a correct state of affairs. And that is a good thing as Rajan explained in his speech. I hope this continues in the coming months because the first step to tackling a problem is to recognise that it exists.

The column originally appeared in Vivek Kaul’s Diary on February 12, 2016

SBI’s FlexiPay Home Loan Basically Looks Like a Marketing Gimmick

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In yesterday’s column I discussed
why the State Bank of India(SBI) has launched the FlexiPay home loan. This home loan allows a borrower to borrow up to 120% of what he would have been able to do in the normal scheme of things.

Further, the borrower has the option to pay only interest on the home loan for the first three to five years. The EMI, which will lead to the principal being repaid as well, kicks in only after that.

The question to ask here is, how much will this benefit the borrower. Or is this just a marketing gimmick which the country’s largest bank has come up with in order to issue more home loans. It is clear that SBI wants to give out more home loans, given that they have a very low default rate in comparison to the other kinds of home loans that the bank gives out.

Let’s try and understand whether FlexiPay home loan is a marketing gimmick or does it ‘really’ benefit the borrower. Let’s take the example of a borrower, who in the normal scheme of things, is eligible to take on a loan of Rs 40 lakh. While this number may seem very low to those who live in metropolitan cities, the average home loan given out by HDFC, the largest housing finance company in the country, is around Rs 23.6 lakh. So a home loan amount of Rs 40 lakh is pretty decent by that comparison.

Getting back to the example. Let’s say a borrower is eligible to take on a loan of Rs 40 lakh. In the case of FlexiPay home loan, he will be eligible for a loan of up to Rs 48 lakh (1.2 times Rs 40 lakh). The interest that SBI charges on its home loan is 9.55% (It’s 9.5% for women).

The interest only option of the FlexiPay home loan allows the borrower just to pay interest on the home loan for the first three to five years. As the SBI press release on FlexiPay home loan points out: “Further, to lower the impact of such additional loan amount on monthly repayments in the form of EMIs, the customers availing Home Loan under ‘SBI FlexiPay Home Loan Scheme’ will also be offered the option of paying only interest during the moratorium (pre-EMI) period of 3 to 5 years, and thereafter, pay moderated EMIs.”

The idea, as SBI puts it, is to give the borrower the option to pay a lower amount every month during the initial years. But is this amount really low? Let’s do some maths to understand this point. I had done this in yesterday’s column as well, but on reading it later, I found that the point did not come out as strongly as it should have.

Let’s say the borrower opts for an interest only option for the first five years. He has taken a loan of Rs 48 lakh, as is allowed under the FlexiPay home loan. An interest of 9.55% would amount to a total payment of Rs 4,58,400 during the course of the year.

This means a monthly payment of Rs 38,200 to service the interest on the loan. If the borrower had taken on a normal home loan, he would have got a home loan of Rs 40 lakh. The maximum tenure of an SBI home loan is 30 years. Hence, the EMI on a Rs 40 lakh, 30-year home loan, at an interest rate of 9.55%, would work out to Rs 33,780. This is lower than the monthly payment of Rs 38,200 that needs to be paid as interest on a Rs 48 lakh home loan, if the borrower opts for the interest only option for the first five years.

So there is clearly no moderation in the payment as SBI claims. And that is primarily because the interest to be paid on the FlexiPay home loan is the same as a normal home loan. If the interest were to be lower, then the interest payment would have been lower as well and the moderation claim would have been true to a certain extent. But in that case the bank would have been taking on more risk as well.

Now let’s flip the situation. If the borrower were paying an EMI of Rs 38,200, what is the loan amount he would be able to service. The maximum tenure of an SBI home loan is 30 years. Hence, paying an EMI of Rs 38,200, for a tenure of 30 years, at an interest of 9.55%, the borrower would be able to service a home loan of Rs 45.23 lakh. The EMI for this loan works to around Rs 38,197.

The loan amount of Rs 45.23 lakh is around 5.8% lower than the loan amount of Rs 48 lakh. Hence, is it worth paying only an interest of Rs 38,200 per month for a Rs 48 lakh home loan, when for the same EMI one could get a loan of Rs 45.23 lakh. And that is the question that any borrower should be asking himself.

SBI will not give the borrower a loan of Rs 45.23 lakh under a normal home loan scheme, given the borrower is eligible only for a loan amounting to Rs 40 lakh. But the bank is willing to give a loan of up to Rs 48 lakh under the FlexiPay home loan scheme.

Hence, the borrower should take this opportunity of taking on a higher loan amount of Rs 45.23 lakh, if the need be, under the FlexiPay home loan scheme. But at the same time ensure that he does not opt for the interest only option but repay an EMI. Why do I say that? If the borrower takes on a loan of Rs 48 lakh and opts for the interest only option, he has to pay an interest of Rs 38,200 per month.

Over a period of five years this amounts to Rs 22.92 lakh, close to half the loan he has borrowed. Further, at the end of five years, not a single paisa of the loan amount has been repaid and he has to start repaying the loan. The borrower will have to repay the loan over a period of the next 25 years. For this, he needs to pay an EMI of Rs 42,104 per month, which is 10.2% more.

Now what would have happened if the borrower had opted to pay an EMI of Rs 38,200 per month on a home loan of Rs 45.23 lakh, and repaid it over thirty years. At the end of five years, he would have repaid around Rs 2.03 lakh of the loan already. In the interest only option, not a single paisa would have repaid. Also, it is worth pointing out here that the difference between a loan of Rs 45.23 lakh and Rs 48 lakh is not huge. Further, when a borrower pays an EMI, the principal amount of the EMI is allowed as a deduction under Section 80C of the Income Tax Act. And this deduction will not be available if interest only option is chosen.

What these numbers tell us very clearly is that the FlexiPay home loan looks more like a marketing gimmick to lure in prospective home loan borrowers. The borrowers are better off opting for the EMI option rather than the interest only option.

The column originally appeared on the Vivek Kaul Diary on February 3, 2016