How the Public Sector Banks are in clear and present danger

These are exigent circumstances for Indian Public Sector Banks (PSBs). An old saying is apt at this juncture - bad breeds bad. In the eventuality of a financial meltdown, the kind India has witnessed thrice over the last 25 years - the balance of payments crisis when we had to pledge our gold in 1991; the east Asian contagion in 1997; and the mother of all twisters - the collapse of iconic investment banks in the US which sparked a global financial crisis - it was always the domestic banking system which acted as the tip of the spear that held the wild animals at bay.

The spear itself is weak and those defending it emasculated. On Saturday, a vigilant government announced that it will soon infuse Rs 6,990 crore in nine public sector banks including the SBI, Bank of Baroda (BoB) and Punjab National Bank (PNB) for enhancing their capital and meeting global risk norms. This is the first tranche of capital infusion for which the government had allocated Rs 11,200 cr in the Budget for 2014-15. But this is minuscule when you look at the gargantuan size of the virus and the rate at which it is spreading.

Among the beneficiaries, the largest public sector lender SBI leads the pack with a capitalisation of Rs 2,970 crore, followed by BoB, Rs 1,260 crore, PNB, Rs 870 crore, and Canara Bank with Rs 570 crore. The capital infusion has been decided based on the performance of the bank. The better the performance and the efficiency, the higher will be the infusion.

The second parameter that has been used is the return on equity (ROE) for these banks for the last financial year. Public sector banks require equity capital of Rs 2.4 lakh crore by 2018 to meet norms on capital adequacy. The government has infused Rs 58,600 crore between 2011 to 2014 in the state-owned banks.

Balance Sheet

The bigger problem lies with the PSU bank balance sheets which are riddled with holes. The third quarter 2014-2015 results released by Indian banks so far indicate continued pressure on financial performance due to weak credit demand (impacting both growth and net interest margins) and higher-than-expected pressure on asset quality.

These headwinds are unlikely to abate easily in the medium term, as: *Loan book growth would struggle (as a large segment of borrowers are battling with high leverage and low utilisation of capacity). *Banks would find it difficult to protect their margins in an easing monetary cycle, with a vigilant regulator ensuring the base rate mechanism is effectively used for monetary transmission. *Credit costs will remain high due to a higher rate of failed restructuring and ageing of stressed assets accumulated in recent years.

The valuations of Indian banks, despite a correction last week, remain punchy and closer to historical peaks. Brokerages and analysts will argue that they are universally sellers on all PSU banks, due to little clarity on institutionalised reform at these banks and a continued sharp deterioration in their financial performance. The third quarter financial year 2014-15 (Q3FY15) results for banks released so far indicate continued stress on banks' asset quality in a muted growth environment. Analysis of the Q3FY15 results shows no revival in loan growth. Loan growth for PSU banks is particularly weak at 9 per cent YoY as at end-Q3FY15 versus 16.7 per cent as at end-Q3FY14. There also has been no easing in asset quality stress. Compared with an average loan growth of 15 per cent YoY in the last four quarters, average growth in stressed assets (gross Non Performing Assets + standard restructured) has been at 24 per cent YoY. In Q3FY15, stressed assets grew by 26 per cent YoY versus loan growth of 13.7 per cent YoY. As a result, stressed assets as a percentage of loans rose sharply to 7.4 per cent of loans versus 7.1 per cent at end-Q2FY15 and 6.7 per cent at end-Q3FY14.

Falling Assets

This is scary, for stressed assets are growing at twice the level of loans. Weak credit demand from corporate borrowers (highly leveraged with under-utilised capacity), margin pressure (accentuated by the base rate mechanism) in an easing rate cycle and elevated credit costs (due to failing restructuring and increasing provision requirement on rising stock of stressed assets) would be key challenges for Indian banks over FY15-17E. Trends in Q3FY15, so far, indicate no alleviation in any of these concerns.

At the very kernel of the falling asset quality is cronyism. Here are a couple of examples. Last year, Bhushan Steel, makers of top-ofthe-line auto grade steel, want their credit limit enhanced. What do they do? They fork out a Rs 50 lakh bribe to the chairman and managing director of a public sector bank - Syndicate Bank. The CBI, listening in on phone intercepts, decides to move in and snare both the CMD S K Jain and Neeraj Singhal, vice chairman and MD of Bhushan Steel.

Almost in parallel, it decides to file a PE against IDBI Bank for giving a Rs 950 crore loan to Kingfisher Airlines many years ago. Ruthless expansion using bank balance sheets has been the credo of India's corporate sector. With no stringent bankruptcy laws, and only debt recast models using the debt recovery tribunal vehicle, industrialists and businessmen have roiled PSB profit and loss accounts. Governance and transparency issues have dogged PSBs because of their opacity when it comes to loan disbursal and sanction. An element of arbitrariness has crept into these disbursals, more so if finance ministry mandarins are backing the loan seeker.

The entire credit process food chain is fraught with massive translucence. NPAs in public sector banks, which have systematically been used as a means to redistribute public wealth to canny industrialists and businessmen, have gone up to Rs 245, 809 crore as of March 31, 2014.

Grinding Halt

The best part is that as the economy has decelerated more or less to a grinding halt, bank NPAs have gone through the roof - up 36 per cent from Rs 1,83,854 crore in 2012-13 to Rs 2,45,809 crore in 2013-14. Gross NPA ratio therefore is up from 3.42 per cent in 2012-13 to 4.03 per cent in 2013-14. In 2014, the RBI managed to recover Rs 33,486 crore up from Rs 19,832 crore in 2013. A multitude of promoters are constantly on the make, using a variety of means to get loans from PSBs, perceived to be low-hanging fruit. Lucre is used as the lubricant, as we have seen in the Bhushan Steel and Prakash Industries cases.

Stressed loans - growing faster than loans and asset quality - may continue for at least four more quarters, and cauterising this wound will be difficult. The risks to PSU bank balance sheets are worrisome as seen with third quarter results where profits are falling off the cliff. Mercifully, these banks come with the backing of a sovereign guarantee and hence are perceived to be safe, but think of how they can imperil the financial system as they bloat out of control.