Is Banking Meltdown on Asset quality concerns  Justified?

Recent meltdown of bank stocks in Indian bourses is heavily debated as an opportunity for the long term investors to enter the segment or worse is still to come.

The one most important negative is NPA and biggest positive is large Bond portfolio of banks having potential to earn huge profit for banks when interest rates start falling in line with rates in advanced countries.

NPAs beyond a certain level are a cause of serious concern. High NPAs disturb recycling of lent funds affecting credit growth. NPAs also affect profitability by requiring provisioning, which means a large part of the profits needs to be kept aside as provision against bad loans. Therefore, the problem of NPAs is the concern of the lenders, borrowers, investors and the policy makers.

The level of stressed asset in the banking system has crossed 13% of loan portfolio. As on 31-03-2015 , stressed assets of public sector banks alone was 7.12 Lac crores. Further, another 3-4 % is hidden in the books by way of mainly working capital limits and loans put on innovative ever greening exercises.

Today’s level of stress in the loan books of banks is partly the making of the banks and the regulator and the government and partly the effect of economic slowdown and global factors. Regulator forbearance in various forms as short term and short sighted solution is the major factor for today’s bad shape of Banks added to political and corporate part of the game.

Of course the intent of the government and regulator was good. It was with the intension to provide some time for the banks to manage the raising NPAs on account of global factors and economic slowdown. But then, the human instinct is to use (misuse?)  every opportunity for the perceived personal gain. Corporates and banks joined in exploiting the schemes like CDR, ARC, OTS etc.,

1.       The stigma of NPA and resultant provisioning is driving away banks from classifying the account as NPA and as a result banks are resorting to ever greening and do not initiate recovery measures.

2.       The top most contributors to the mess is restructuring including CDR. Business entities and Banks join hands to misuse this route to restructure /reschedule the repayment without carrying out a proper viability study and borrowers use this to extract all benefits from Banks. The sacrifice is only by banks. The corporate structure of these banks is a contributing factor as no one has personal interest /commitment to ensure safety of Bank funds. CDR is a major curse for banks, banks have taken shelter under this and regulator facilitated this.

3.       Nexus between Unscrupulous borrowers and corrupt/self-serving bank officials is another major contributor to NPA.

4.       Asset sale to asset reconstruction companies (ARC)   is another major weapon in the armor of banks to hide NPA and reduce provisioning requirement to manage P&L and B/S of the bank. In asset sale the purchaser pays just 5% cash and balance 95 % in the form of security Receipt (SR). This 5% down payment  more than gets compensated by 1.5% to 2.5% fee they get paid per year for next 6-8 years.   SRs are valued at underlying collateral value ( which is highly inflated or non existing) and not on the record of recovery, thus are shown as standard asset of very high value in the books of banks where as these are junk bonds. The ARC has no incentive to recover as stake is very small and ARC hardly has knowledge about the assets/borrower to ensure better recovery. Banks avoid provisioning, show NPA as standard asset. Thus, almost entire ARC sale amount must be treated as NPA or should be valued based on record of recovery. By not mandating this RBI has facilitated this kind of accounting jugglery.

5.       OTS is another highly misused weapon in the banks and has brought in lot of corruption.

6.       Compensation structure of bank officials /executives at some banks and promotion and other perks based on short term (quarter on quarter) performance, is another cause of this misery. Sanctions /restructuring made with holidays commensurate with remaining service of the concerned executive/CEO so that account cannot become NPA during his tenure.

7.       There is serious lacunae in appraisal, post sanction follow up and identifying the stress at early level and working closely with the borrower. Banks have not trained their officials and executives on these lines. We manage NPAs and stress on quarter-to –quarter basis. Main focus is how to avoid NPA this quarter. This attitude is the main reason behind todays mess.

Rating agency, another player in this game has further contributed to the mess. Ratings are purchased by the companies. Only past performance is looked into. Additionally, Same companies assign research /consulting activity  to rating agency to get favorable rating, affecting the independence of such agencies. Why government/regulator is not prohibiting any other assignment by these or their sister/related concerns to rating agency. Highly rated companies have gone bad within months of rating confirmation. Basel supports rating by fixing lesser capital requirement, but no guidelines to make them accountable.

 Auditors are let scot free when such magnitude of frauds are happening in the books of corporates.

RBI is very strict when it comes to small issues at smaller banks and to safeguard it’s interest or to hide it’s inefficiencies, good at imposing fines on the banks. Why RBI is not accountable for these kinds of policies which have led to this pathetic condition of banks, especially PSUs. Where is the accountability for regulator?

High value frauds are happening right under the nose of RBI. Each large fraud amounting to few thousands of crores and PSU banks are the consortium leaders with 10-15 leading banks part of this. How that none of these banks nor RBI is able identify the fraud till reaching such huge proportion? RBI gets all the info of large borrowers from each of these banks. In depth study during annual financial inspection (AFI) of Banks.  Are they not accountable for not putting in place a suitable mechanism to detect these frauds? Or has  their mechanism failed? Why Government has no will to have severe action against such fraudsters and they are merrily enjoying spending a small portion of this loot to finance their lawyers bills  and banks neither have the will nor the ability to book the culprits.

Policy making and monitoring functions of RBI must be separated. Independent review of the functioning of the regulator is required, may be by CAG. There should be an appellate authority in the system that can be approached by aggrieved party for support. RBI officers must be brought from banks through lateral recruitment to ensure they understand practical banking, especially for inspection of Banks.

Under the leadership of Mr. Raghuram  Rajan and also actions from finance ministry under BJP are in the process of bringing in some improvement in this direction. However, How far these actions will go,   one has to watch and see,given the level of influence this business and industry lobby has on government.  Banks must be made healthy and their exploitation by corporate/business class must be stopped. Who will bell the cat?

One possible solution being discussed was, Creating a NPA Bank ( Bad Bank)  to transfer all high value fraud/ NPA accounts. Such bank should have sweeping powers to take action and overtake management and sell the company and stringent laws to book the defaulters and fraudsters. Must be headed by a strong banker with impeccable integrity and high stature. They may be allowed to issue bonds on the basis of such underlying assets to banks and valuation of such asset can be on the basis of recovery performance or market driven.

Further, First year after SR based ARC sale, the SRs are to be treated as NPA and to be upgraded based on recovery performance as if this is fresh loan. This will reduce faulty asset sales and lead to better recovery for banks.

Ever greening should be viewed seriously by regulator. Forensic audit of all high value NPA accounts under the supervision of RBI and prohibiting such promoters from accessing the public finance. High value frauds in private banks also should be brought under CBI.

5:25 scheme is also a breather, but then we must watch and see how much it will be used and misused. 15% down payment for ARC sale is a very welcome move from RBI . All kind of dispensations from RBI must stop.

PSU banks share prices will be a serious concern for them in raising fresh capital from market. Shares of major PSUs are below Book value , clear indication of market concern about quality of asset and disclosure level/transparency of the financials.  How will the public confidence be restored? As of now only hope is possible south ward journey of interest rates bringing them windfall treasury gains.

Hope, the Government and RBI together address the vows of banks and bring them back on track. History repeats. Banks will bounce back again and patient investors will be rewarded by banking sector in the long run as finance is the life blood of any economy and banks are the arteries for flow.

It is time to start creeping investment into  stocks of reasonably well managed  PSU banking stocks.

Regards,

Sathya