How good are our banks?

Tamal Bandyopadhyay :Livemint : Sun, Aug 18 2013. 03 03 PM IST

The banking industry is showing signs of severe stress due to deterioration in quality of assets and growing NPAs

Gross bad assets of at least one bank—Central Bank of India—exceeded 6% of its advances in the June quarter. For another six banks, four of which are majority owned by the government, they are above 5% of loans. Gross bad assets of five more banks, all of them are in the public sector, in June have been more than 4% of their loan books. After setting aside money for bad loans, net non-performing assets (NPAs) of one bank in June have been in excess of 4% and that of seven banks over 3%. Net NPAs of the State Bank of India and Punjab National Bank, India’s largest and second largest lenders, have been close to 3%. India’s Rs.80 trillion banking industry is showing signs of severe stress as Asia’s third largest economy is slowing for a variety of reasons.

In the June quarter, gross NPAs in the banking system grew by 12.02% to Rs.2.06 trillion and formed 3.85% of the industry’s advances. I don’t have the net NPA figures but even gross NPAs are a good indicator of the banking system’s health. It was 3.23% in March. Since March 2009, when gross NPA was 2.28%, it has been growing progressively every year barring fiscal year 2011, when both gross and net NPA ratios dropped. Between March 2009 and March 2013, net NPA of the banking system has risen from 1.06% to 1.56%. In the June quarter, it has risen further.

The bad assets in isolation do not reveal the gravity of the problem. They need to be seen along with restructured assets. The combination of gross NPAs and restructured assets in March 2013 has been 9.25%.

The deterioration in quality of assets can be assessed looking at the accretion of fresh NPAs, or the so-called slippages. In March, this ratio has been 2.72%, up from 2.05% in March 2011. The combination of fresh slippages and fresh restructured advances as a percentage of total advances in March 2013 has been 5.91%, more than double of what we had seen in March 2011—2.86%.

In each of these categories, the public sector banks are the worst affected. Their counterparts in private sector are in a far better shape. This tells us certain unpleasant truths about our public sector banks that account for around 70% of the industry—poor credit risk assessment, disbursal of loans and supervision.

Things can get worse for a couple reasons:

One, with the sharp depreciation in local currency, Indian corporations’ ability to repay foreign loans will be dented. They have exposure to foreign currency borrowing to the tune of $170 billion and between 30% and 60% of that has been hedged. The hit will be on the unhedged portion and there will be impact on companies’ balance sheets. Naturally, these companies will find it difficult to repay bank loans.

Two, though the overseas advances by Indian banks’ foreign branches rose by 15.03% in March, their bad assets grew by at least 43%. Gross NPAs in overseas loans have grown from 1.41% in March 2012 to 1.76% in March 2013 but they will swell as the borrowers are mostly Indian companies. How will they service loans taken from foreign branches of Indian banks when they are finding it difficult to service domestic loans?

As if these are not enough, there are problems in banks’ investment portfolio too. With sudden tightness in liquidity, bond yields have been on the rise. Prices and yields move in opposite directions. Till about a week ago, the impact was mostly on the shorter end and the yield on 91-day treasury bills was trading close to three percentage points higher than the 10-year bond yield but now the spillover effect has caught on.

On Friday, the benchmark 10-year bond yield ended at 8.895%, almost at its three-year high. Since 22 May, when US Federal Reserve chief Ben Bernanke first hinted at bringing to close monetary easing that led to the flight of money from equities and debt, the 10-year benchmark yield has risen 173 basis points (bps), from 7.167% to 8.895%. One bps is a hundredth of a percentage point.

The banks will have to make good the depreciation in their bond portfolio by setting aside money. Hardening of yield by 100 bps on banks bond portfolio which is not shielded from the depreciation—the bonds kept in the so-called available for sale (AFS) and held for trading (HFT) categories—is close toRs.30,000 crore. The banks do not take hit on the bonds that are part of held to maturity (HTM) basket even after their value depreciates. Bond yields dropped in April and the first half of May and, eager to take advantage of the falling yields, public sector banks increased the size of their tradable portfolio from 29% of their bond portfolio in March to over 34% in June. That has exposed them to interest rate risk and depreciation loss.

A Reserve Bank of India (RBI) calculation puts the depreciation figure for the public sector banks atRs.21,500 crore, based on their bond portfolio in June. Since then, yields have risen further.

The gross NPAs of Indian banks in March 1994 were 19.07% and for the next seven years, till March 2001, they remained in double-digits. If the banks could survive that phase, they would definitely come out of the current crisis too. But at what cost? They will have to set aside money both for rising bad assets and depreciation in their bond portfolio. This will hit profitability. As profits erode, they will need to infuse fresh capital if they want to expand assets. Under the global Basel III norms, that came into play in April, they would need Rs.5 trillion capital in next five years. Unless there is a dramatic recovery in quality of assets, they would need more.

Tamal Bandyopadhyay keeps a close eye on everything banking from his perch as Mint’s deputy managing editor in Mumbai. He is also the author of A Bank for the Buck, a book on HDFC Bank.