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Are Indian banks ready for crisis part II?
At a time when the global economy is heading towards another financial crisis, perhaps even worse than the one that hit the world in 2008, Indian banks are grappling with issues like moderating credit growth, rising slippage ratio and mounting credit cost. Can they weather the rising storm?
Issue Date - 19/01/2012
Indian banks, the dominant financial intermediaries in the country, have evolved dramatically over the last few years. And it is evident from several parameters, including credit growth, profit margins, and trend in gross non-performing assets (NPAs). While the annual rate of credit growth clocked 23% during the last five years, profitability (average return on net worth) was maintained at around 15% during the same period. Even gross NPAs fell from 3.3% as on March 31, 2006 to 2.3% as on March 31, 2011. Good internal capital generation, reasonably active capital markets, and governmental support also locked up better capitalisation for most banks during the period, with overall capital adequacy touching 14% as on March 31, 2011. At the same time, high levels of public deposits ensured that most banks had a comfortable liquidity profile, so much so that they even weathered the 2008 global financial comfortably. So far, so good.

But, as the global environment turns grim and the Indian economy too starts feeling the pinch (India’s real GDP moderated for the third consecutive quarter, rising 7.7% yoy in Q2 2011, down from a 7.8% yoy rise in Q1 2011), India’s so-far-insulated banking system is about to face several challenges in the near future, which include increase in interest rates on saving deposits, a tighter monetary policy, a large government deficit and implementation of Basel III norms. In fact, the biggest problem is that with higher interest rates, companies, particularly SMEs, and individuals are finding it difficult to repay loan instalments. This adds to the bad loans or non-performing assets (NPAs) of lenders. As per Moody’s, for all Indian financial institutions NPAs as a percentage of total assets stand at around 2.3% at present, relatively higher when compared with Chinese, Taiwanese and Australian banks, which have non-performing loans estimated at around 2% of total lending.

Further, the spill-over from restructuring window, which RBI opened in FY2008-09, is not over yet. To recall, in December 2008, the RBI had allowed a second time restructuring of corporate advances and a one-time restructuring of commercial real estate advances. As a part of this exercise, banks had allowed deferment of principal repayment to eligible borrowers by 6-12 months. And it’s because of this process that the restructured advances accounted for about 4% of scheduled commercial banks’ (SCBs) total advances as on March 31, 2011. In fact, for PSBs, restructured advances were higher at 4.5% in March 2011 because of their higher lending to the corporate sector, while for private banks, such advances were lower at around 1% of their credit portfolio. Interestingly, while some of these restructured accounts have already slipped into the NPA category over the last two years (in the range of 8-20% for various banks), with the operating environment further deteriorating, the slippages from restructured advances could continue into FY2011-12 as well.

Even IDBI Capital, the investment banking and securities arm of IDBI Bank, factors a stress case assumption of 25% increase in restructured assets and 15% delinquencies from those restructured assets apart from high normal slippages going forward. This is above the historical trend of 80-85% success in restructured assets and 10-15% slippage in those restructured assets. And the bad news doesn’t end here. After factoring in increases in slippages ratio, credit cost and reduced margins, IDBI Capital estimates 11.7% CAGR in profit after tax (PAT) for PSBs and 15.3% CAGR in private sector banks during FY2011-13, the lowest over the last five years.

No doubt, to absorb any shocks from rising bad loans, the government is providing financial support to banks. For instance, during FY2010-11, the government had infused Rs.165 billion in PSBs to improve their Tier 1 capital to 8% and take up its stake in the PSBs to at least 58%. After this, the Tier 1 capital of most of the PSBs has improved. Therefore, these banks (apart from SBI) may not require significant Tier 1 capital in the short term. In case they do, the government has budgeted for Rs.60 billion for them in FY2011-12. But then, how long can PSBs rely on continued government support given the country’s large government debt burden (India’s budget deficit could widen to 5.8% of GDP in FY2012 as against the govt. target of 4.8%)? They definitely need to set aside more cash to ensure that bad loans don’t grow; i.e. they are in a position to write off bad loans as and when required.

At an aggregate level, Indian banks fare well against the Basel III requirement for capital. However, some may appear inferior on comparison. For instance, nine banks had Tier 1 capital of less than 8.5% as on March 31, 2011. Considering the stricter deductions from Tier 1 and the fact that some of the existing perpetual debt (around Rs.250 billion) would become ineligible for inclusion under Tier 1, some banks may need to infuse core capital in the near future. Additional capital may also be required to support a growth rate that exceeds the internal capital generation rate, which is likely.

Another factor that might further erode the profitability of Indian banks in the near future is the rising cost of deposits. The reason is simple. In recent periods, the spread between the savings bank (SB) deposit and term deposit rates has widened significantly. This is thanks to RBI, which in May 2011, raised the SB deposit interest rate from 3.5% to 4.0%. At the systemic level, SB deposits are estimated to account for 22-23% of total bank deposits (as of March 31, 2011). Thus, even a slight increase of 0.5% in interest rate on SB deposits could raise the cost of deposits by around 13 basis points (bps) at the systemic level. If banks do not pass on this additional cost to borrowers, their net interest margins (NIMs) could be diluted by 10 bps. This translates into a dent of 100 bps on the return on equity. Overall, the impact on NIMs for various banks ranges from 5 to 15 bps, which even if not very significant per se, would certainly add to the pressures on profitability of banks.

So, what’s the way out? As far as the immediate measures are concerned, the only thing that Indian banks need to ensure is that they have adequate capital to support short term growth. Although a temporary slack in credit growth and adjustment in the lending rate may lead to a dip in the NIM of Indian banks in the first half of FY2011-12, the situation is likely to recover in H2 FY2011-12.


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