There is no plan in sight for public sector banks

rupee-foradian.png.scaled1000One of the points that I forgot to talk about in the recent Master Series chat (“Looking Behind The Modi Smokescreen with Vivek Kaul”) that I and Rahul had, was the bad state of public sector banks in India.
As S S Mundra, one of the Deputy Governors of the Reserve Bank of India pointed
out in a recent speech: “asset quality [of banks] has seen sustained pressure due to continued economic slowdown.” The primary reason for this is the fact that banks have lent too much money to companies. And many companies right now are not in a position to repay the loans they had taken on.
The gross non-performing assets(or bad loans) of banks have been on their way up. As on March 31, 2014, they had stood at 3.9% of their total advances. By March 31, 2015, the number had shot up to 4.3% of the total advances. Crisil Research expects this number to touch 4.5% of the total advances of banks, during the course of this financial year.
What is worrying is that 40% of the loans restructured during 2011-2014 have become bad loans. A restructured loan is 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. If 40% of restructured loans have gone bad, it is safe to say that the banks have been essentially restructuring loans in order to postpone recognizing them as bad loans.
Interestingly, bad loans are expected to go up during this course of the year primarily because more and more restructured loans will turn into bad loans. As Crisil Research points out in a recent research note titled
Modified Expectations: “Reported gross non performing assets[bad loans] will still remain at elevated levels as some of the assets restructured in the previous 2-3 years, especially in the infrastructure, construction, and textiles sectors, degenerate into non-performing assets again.”
And this is clearly worrying. In fact, Mundra during the course of his speech went on to refer to the recent Global Financial Stability Report of the International Monetary Fund(IMF) and said: “Referring to the high levels of corporate leverage, the [IMF] report highlights that 36.9 per cent of India’s total debt is at risk, which is among the highest in the emerging economies while India’s banks have only 7.9 per cent loss absorbing buffer, which is among the lowest. While these numbers might need an independent validation, regardless of that, it underscores the relative riskiness of the asset portfolio of the Indian banks.” This statement coming from one of the top officials of the RBI needs to be taken seriously.
Mundra also pointed out that because of this inability of corporates to repay loans that they had taken on, the public sector banks are in a much bigger mess than other banks.  He pointed out that the stressed assets ratio of banks in India as a whole stood at 10.9%.
The stressed asset ratio is the sum of gross non performing assets(or bad loans) plus restructured loans divided by the total assets held by the Indian banking system. The borrower has either stopped to repay this loan or the loan has been restructured, where the borrower has been allowed easier terms to repay the loan by increasing the tenure of the loan or lowering the interest rate. Hence, a stressed assets ratio of 10.9% essentially means that for every Rs 100 given out as a loan, Rs 10.9 has either been defaulted on or has been restructured.
As Mundra pointed out: “The level of distress is not uniform across the bank groups and is more pronounced in respect of public sector banks…The stressed assets ratio[of public sector banks] stood at 13.2%, which is nearly 230 bps[one basis point is one hundredth of a percentage] more than that for the system.” The stressed assets ratio of public sector banks as on March 31, 2014, was at 11.7%. The overall stressed assets ratio of banks was at 9.8%.
This is indeed very worrying. Between March 31, 2014 and March 31, 2015, the stressed assets ratio of public sector banks has gone up a whopping 150 basis points. This has hit the capital that public sector banks carry on their balance sheets. As Mundra pointed out: “Our concerns are larger in respect of the public sector banks where the CRAR [Capital to Risk (Weighted) Assets Ratio also known as capital adequacy ratio] has declined further to 11.24% from 11.40% over the last year.”
The government seems to have made it more or less clear that it is unlikely to pump in any more money into the weaker public sector banks. Also, given the poor perception and stock price of these banks, they are unlikely to be able to raise capital from the stock market. In such a situation it is imperative they be very careful in handling the capital they have. “The need of the hour for all banks, and more specifically, in respect of the PSBs, is that capital must be conserved and utilized as efficiently as possible,” writes Mundra.
What Mundra means in simple English is that banks need to take almost no risk while lending. And this unwillingness of banks to lend has hit the infrastructure sector the most. As Crisil Research points out: “In the past, many private developers have bid aggressively for projects, especially in roads and power. However, most projects have seen execution delays due to issues such as fuel availability, land acquisition and environmental clearances; resulting in significant cost overruns….As a result, poor operational cash flows coupled with rising debt burden have led to a sharp deterioration in the debt-servicing ability of many companies. Banks, too, are wary of lending to the sector.”
The PJ Nayak committee report released in May 2014, estimated that between January 2014 and March 2018 “public sector banks would need Rs. 5.87 lakh crores of tier-I capital.” The report further points out that “assuming that the Government puts in 60 per cent (though it will be challenging to raise the remaining 40 per cent from the capital markets), the Government would need to invest over Rs. 3.50 lakh crores.” The budget for the year 2015-2016 provided Rs 11,200 crore towards this, which is not even peanuts given the kind of money that is required.
It is clear that the government does not have the kind of money that is needed to recapitalize the public sector banks. But the money is needed. What is surprising that even though one year has more or less elapsed since the Modi government came to power, no comprehensive plan has been put forward to solve the mess in the public sector banking space.

The column appeared on The Daily Reckoning on May 22, 2015

While corporates continue to screw banks, the small guy is paying up

rupee
One of the themes that I have explored since I started writing for
The Daily Reckoning last year, is the bad state of banks in India. And the way things are right now it doesn’t seem like the situation is going to improve on this front any time soon.
In a research note titled
For banks, no respite from bad loans this year released yesterday, Crisil Research estimates that gross non performing assets or bad loans of banks will touch Rs 4,00,000 crore during the course of this year. This will mean an increase of Rs 60,000 crore. More precisely, the bad loans of banks will increase to 4.5% of the total advances of banks, from 4.3% currently.
What is worrying is that 40% of the loans restructured during 2011-2014 have become bad loans. A restructured loans is
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. If 40% of restructured loans have gone bad, it is safe to say that the banks have been essentially restructuring loans in order to postpone recognizing them as bad loans.
Crisil Research also points out that
the weak assets of banks are are expected to stay high at 6 per cent of advances or Rs 5,30,000 crore. The public sector banks which are essentially in major trouble with their weak assets forming around 7% of their advances. For the private sector the number is around 2.9% of their advances.
In fact, Jayant Sinha, the minister of state for finance
in a written reply told the Rajya Sabha yesterday, that around 23% of the projects to which public sector banks had given loans worth Rs 54,056.75 crore in 2014-2015, have turned into non performing assets. He told the Upper House of Parliament that 17 out of the 74 projects to which public sector banks had given loans had turned bad.
Further, some year end results of public sector banks reaffirm the bad state that they are in. Take the case of Punjab National Bank. As of March 31, 2015, its stressed assets ratio increased to 16.2%. It was at 15.4% at the end of December 2014.
The stressed asset ratio is the sum of gross non performing assets(or bad loans) plus restructured loans divided by the total assets held by the Indian banking system. The borrower has either stopped to repay this loan or the loan has been restructured, where the borrower has been allowed easier terms to repay the loan by increasing the tenure of the loan or lowering the interest rate.
In Punjab National Bank’s case of every Rs 100 of loan given out by the bank, Rs 16.2 has either gone bad or has been restructured. How does the situation look on the whole? S S Mundra, deputy governor of the Reserve Bank of India gave an indication of this in a recent speech. He pointed out that the stressed assets ratio of banks in India as a whole stood at 10.9%. This meant that for every Rs 100 given out as a loan, Rs 10.9 has either gone bad or has been restructured.
As Mundra pointed out: “The level of distress is not uniform across the bank groups and is more pronounced in respect of public sector banks…The stressed assets ratio[of public sector banks] stood at 13.2%, which is nearly 230 bps[one basis point is one hundredth of a percentage] more than that for the system.” The stressed assets ratio of public sector banks as on March 31, 2014, was at 11.7%. The overall stressed assets ratio of banks was at 9.8%.
This is clear indicator that the banking sector in general and the public sector banks in particular continue to remain in a mess. In fact, the bad loans of most public sector banks which have declared results up till now, have gone up. This is primarily because the exposure of public sector banks to “vulnerable sectors is expected to remain high, just the way it was in 2014-15”. The vulnerable sectors include
infrastructure, mining, aviation, steel, textile etc.
What this means is that corporates who had taken on loans from banks have been unable to repay and are now in the process of defaulting on loans or renegotiating the terms. That was the bad news. Now some good news.
A
newsreport in the Daily News and Analysis points out that the defaults by small borrowers have fallen. The newsreport points out that data from the Credit Information Bureau (India),  the country’s leading credit information company, shows that as on December 31, 2014, the defaults on home loans dropped to 0.5% of total advances of banks. It was at 1.06% of advances at the end of 2010.
A similar trend has been seen when it comes to personal loans as well. Defaults have fallen to 1.01% of advances from 2.65% earlier. In case of unsecured loans (like credit cards) the defaults have fallen to 1.19% of advances from 3.27% earlier.
While, the corporates have been on a defaulting spree, the individuals who take on various kinds of loans have been repaying them at a much better rate than they were in the past.
To conclude, the bigger learning here is that the small guy in this country continues to do his job well, tries to earn an honest living, repay his loans on time, and so on. The big guy, on the other hand, is out screwing the others including the banking system.

(The column originally appeared in The Daily Reckoning on May 13, 2015)

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

george-soros-quantum-fund
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

What Arun Jaitley can learn from Rajan’s IRMA speech

ARTS RAJANVivek Kaul

A few days back I wrote a piece questioning the logic of the State Bank of India entering into a memorandum of understanding with Adani Enterprises to consider giving it a loan of up to $1 billion. My logic was fairly straightforward—Adani Enterprises already has a lot of debt (around  Rs 72,632.37 crore as on September 30, 2014) and is just about earning enough to service that debt.
Several readers wrote in on the social media saying what was the problem if Adani was offering an adequate security against the loan? Raghuram Rajan, the governor of the Reserve Bank of India, answered this question in a speech yesterday. Rajan was speaking at the third Dr. Verghese Kurien Memorial Lecture at IRMA, Anand.
As Rajan said “The amount recovered from cases decided in 2013-14 under DRTs (debt recovery tribunals) was Rs. 30,590 crore while the outstanding value of debt sought to be recovered was a huge Rs. 2,36,600 crore. Thus recovery was only 13% of the amount at stake. Worse, even though the law indicates that cases before the DRT should be disposed off in 6 months, only about a fourth of the cases pending at the beginning of the year are disposed off during the year – suggesting a four year wait even if the tribunals focus only on old cases.”
So, just because a bank has a collateral does not mean it will be in a position to en-cash it, as soon as the borrower defaults on the loan. As big borrowers (read companies and industrialists) have defaulted on loans over the last few years, the non performing assets of banks, particularly public sector banks have gone up.
As on March 31, 2013, the gross non performing assets (NPAs) or simply put the bad loans, of public sector banks, had stood at 3.63% of the total advances. Latest data from the finance ministry show that the bad loans of public sector banks as on September 30, 2014, stood at 5.32% of the total advances. The absolute number was at Rs 2,43,043 crore. During the same period the bad loans of private sector banks was more or less constant at 1.8% of total advances. Interestingly, public sector banks accounted for over 90% of bad loans in 2013-2014 (i.e. between April 1, 2013 and March 31, 2014).
All these points have several repercussions. The first is that banks need to charge a higher rate of interest in order to compensate for the higher credit risk (or simply put the risk of the borrower defaulting on the loan) they are taking on. As Rajan said in the speech “The promoter who misuses the system ensures that banks then charge a premium for business loans. The average interest rate on loans to the power sector today is 13.7% even while the policy rate is 8%. The difference, also known as the credit risk premium, of 5.7% is largely compensation banks demand for the risk of default and non-payment.”
Simply put, those who default in effect ensure that those who repay have to pay a higher rate of interest. The irony is that banks give out home loans to individuals at 10-11%. This shows that lending to individuals is a better credit risk for them than lending to infrastructure companies.
As Rajan put it “Even comparing the rate on the power sector loan with the average rate available on the home loan of 10.7%, it is obvious that even good power sector firms are paying much more than the average household because of bank worries about whether they will recover loans.”
Also, a report in the Business Standard today suggests that the RBI is “mulling action in terms of limiting loan-sanctioning powers of banks with stressed asset ratios.”
The stressed asset ratio is the sum of gross non performing assets plus restructured loans divided by the total assets held by the Indian banking system. The borrower has either stopped to repay this 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.
The
Business Standard report carries a list of 14 public sector banks that have a stressed asset ratio of 12% or more. Central Bank of India has the highest stressed asset ratio of 20.49%, followed by the United Bank of India at 19.7%.
If the RBI decides to limit the loan-sanctioning power of these banks, it will do so in the backdrop of the finance minister Arun Jaitley asking banks to lend more. A few days back Jaitley said “We have asked banks to go out there and lend without any fear. They should do proper appraisals of projects and provide loans to infrastructure projects.” Like in almost everything else, he was following the tradition set by his predecessor P Chidambaram.
The stressed assets of many public sector banks did not cross 12% because they did not carry out proper project appraisals. It crossed such high levels because the banks were forced to lend to crony capitalists close to the political dispensation of the day i.e. leaders of the previous United Progressive Alliance (UPA).
Take the case of GMR Infra. For the period of three months ending September 30, 2014, the company paid a total interest of Rs 845.04 crore on its debt. Its operating profit was Rs 101.14 crore. The company had a total debt of Rs 39,187.45 crore as on March 31, 2014. What this clearly tells us is that the company is not earning enough to pay the interest that it has to, on the total debt that it has managed to accumulate.
This is true about many other companies as well particularly in the infrastructure sector, which is dominated from crony capitalists. These companies borrowed much more than they should have been allowed to in the first place. Also, many promoters got away without putting much of their own money in the business.
As Rajan said “The reason so many projects are in trouble today is because they were structured up front with too little equity, sometimes borrowed by the promoter from elsewhere. And some promoters find ways to take out the equity as soon as the project gets going, so there really is no cushion when bad times hit.” This could not have happened without the tacit support of the political dispensation of the day.
And this perhaps led Rajan to quip that India is “a country where we have many sick companies but no “sick” promoters.” “In India, too many large borrowers insist on their divine right to stay in control despite their unwillingness to put in new money. The firm and its many workers, as well as past bank loans, are the hostages in this game of chicken — the promoter threatens to run the enterprise into the ground unless the government, banks, and regulators make the concessions that are necessary to keep it alive. And if the enterprise regains health, the promoter retains all the upside, forgetting the help he got from the government or the banks – after all, banks should be happy they got some of their money back!” Rajan added.
Another implication of the massive increase in bad loans for public sector banks has been that the law has become “more draconian in an attempt to force payment.” As Rajan put it “The SARFAESI (Securitization and Reconstruction of Financial Assets and Enforcement of Security Interests) Act of 2002 is, by the standards of most countries, very pro-creditor as it is written. This was probably an attempt by legislators to reduce the burden on DRTs and force promoters to pay. But its full force is felt by the small entrepreneur who does not have the wherewithal to hire expensive lawyers or move the courts, even while the influential promoter once again escapes its rigour. The small entrepreneur’s assets are repossessed quickly and sold, extinguishing many a promising business that could do with a little support from bankers.” This leads to a situation where upcoming entrepreneurs do not want to take the risk of growing bigger by taking on more loans and may choose to continue to remain small.
To conclude, Rajan’s speech at IRMA was an excellent summary of all that is wrong with the Indian banking sector. He also made suggestions on how to set it right. The promoters should not try and finance mega projects with tiny slivers of equity, he suggested. Banks needed to react quickly to borrower distress. And the government needed to set up more debt review tribunals. These are simple solutions that need political will in order to be implemented.
Arun Jaitley has been asking the RBI to cut interest rates for a while now. He has also asked banks to lend more. Nevertheless, it’s not as simple as Jaitley thinks it is. First and foremost the government needs to ensure that big borrowers cannot just get away with defaulting on loans. This in itself will have a huge impact on interest rates.
As Rajan put it “It is obvious that even good power sector firms are paying much more than the average household because of bank worries about whether they will recover loans. Reforms that lower this 300 basis point risk premium of power sector loans 
vis-a-vis home loans would have large beneficial effects on the cost of finance, perhaps as much or more than any monetary policy accommodation.”
This is something that Jaitley should be thinking about seriously in the days to come, if he wants banks to genuinely bring down lending rates.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)