It might not be intuitive to the casual observer, but India has had the mother of all credit cycles over the last five years. Nominal gross domestic product growth was about 14% a year in the last five years, while bank credit grew by 28%.
To put this into perspective, household debt in the US, the hotbed of current problems, grew by less than 10% a year in the same period, albeit on a much bigger base. It’s obvious that a health check on the banks is called for.
That the credit cycle in India has turned as well is not a secret. Gross non-performing loans, or NPLs, in every major bank are seeing an uptrend. For example, at ICICI Bank Ltd these have risen from 2.1% of loans at the end of fiscal 2007 to 3.4% at the end of fiscal 2008, and now stand at 4.1%. The question is whether the trend will reverse soon or get worse, and what the banks are doing to cope with the turn in the credit quality.
Third-party originated consumer loans, loans to small and medium enterprises that are now struggling with liquidity issues, an unnecessary stampede into unsecured microlending, government-inspired pro-growth lending and so on, will all come home to roost over the next year or two.
We pointed out in early September that the Indian economy was likely to slow dramatically and that few people were recognizing that possibility. The slowdown is now an accepted fact, but the banks are yet to take the kind of actions they should as credit losses mount.
Specifically, building up loan loss reserves, taking the charge-offs that are necessary without trying to delay these into the future and slowing loan growth. The first is an age-old issue with Indian banks, the second more a cyclical awakening that’s yet to hit managements and the third issue seemingly recognized by private banks is not being allowed to take effect at the public sector banks. The government’s insistence that the state banks keep the growth in lending going, even as the economy has turned and credit quality weakens, is ludicrous.
A word here about recent Reserve Bank of India, or RBI, initiatives is necessary. RBI’s recent orders to try and free up bank capital fly in the face of what every central bank globally is trying to do—shore up its banks’ capital.
RBI recently allowed banks to restructure non-performing mortgage loans and allowed a second round of restructuring of already restructured loans that have gone bad all over again. Loans being restructured are not classified as NPLs.
We are yet to see a successful loan workout programme with delinquent borrowers anywhere in the world, so there’s absolutely no reason to believe that it will work in India. A large part of these restructured loans are likely go bad in the next fiscal; this has the potential of creating severe problems—candidates for seeing their NPLs rise by 50% or more are quite a few; Axis Bank Ltd is likely to be the biggest victim.
Indian banks have never been inclined towards healthy loan loss reserves; a look at past economic cycles is fruitless since gross NPLs had tended to be extremely high then. However, a comparison with global peers is certainly a shocker.
Behemoth State Bank of India’s loan loss reserves were 47% of its gross NPLs at the end of fiscal 2007. The ratio did not budge at the end of 2008 fiscal and currently stands at a still paltry 48%. As much as 50% NPL coverage is the norm with most banks.
In the meanwhile, all the large global banks have been bulking up their loan loss reserves—JPMorgan Chase and Co.’s reserves stand at 260% of NPLs, even a capital-strapped Citigroup Inc. is running at 130%.
There also seems to be a disinclination to write off the loans that are uncollectible either by hiding behind restructuring or otherwise. An appropriate level of charge-offs themselves will deplete loan loss reserves substantially. ICICI Bank’s net charge-offs were only 12% on its NPLs in the last fiscal.
Charge-offs for unsecured lending will have to be substantially higher than what we are seeing. At the same time, declining asset values will mean that collecting on secured lending won’t prove easy either. Charge-off rates at global banks are close to outstanding NPLs.
Be it charge-offs or NPLs, most would argue the credit cycle in India won’t be as harsh as the developed world. We may not necessarily agree, but banks showing no inclination to build up their NPL coverage ratios is worrisome either way.
Most of the large Indian banks have tier I ratios—a measure of a bank’s core capital—of 10-12% currently. Unlike the December quarter, banks are not going to have treasury gains to fall back on in the future, which would mean that earnings and, hence, core capital grows slower than assets.
With an uptick in NPLs, recognition of accumulated charge-offs and some build-up in NPL coverage ratios, it is not inconceivable at all that the 10-12% tier I ratios move closer to 8-10%. If that happens, the large US banks after the initial recapitalization efforts will look better capitalized than the apparently strong Indian banks.
Rajeshree Varangaonkar and Bharat Indurkar have day jobs with US-based hedge funds. They write every other Thursday. Send your comments to firstname.lastname@example.org