Mumbai: The Reserve Bank of India (RBI) has downgraded the country’s largest lender State Bank of India (SBI) following an inspection of the bank’s books for the fiscal year ended March 2009.

The rating, based on the six parameters known as CAMELS (capital, asset quality, management, earnings, liquidity, and systems and controls), has been brought down by one notch, from B to B-, but this will not make any material difference to SBI as the regulator gets into action and starts closely monitoring a commercial bank only when its rating is down to C or lower.

The CAMELS rating of a bank is highly confidential and neither the bank nor the regulator ever discloses it. A bank never uses its rating for publicity even if it gets an A, and similarly RBI doesn’t make it known even if it’s very low as that affects public confidence in the lender and risks a run on deposits.

Close look: Typically, banks are inspected annually, but SBI undergoes the inspection once in two years. Madhu Kapparath/Mint

The bank clarified its position on non-performing assets (NPAs) as well as capital and vehemently contested the observations of the report on corporate governance.

SBI chairman O.P. Bhatt declined to comment on the issue, citing confidentiality.

An email sent to the RBI spokesperson did not elicit any response till press time.

“Classification of assets at times is a perception issue and it can differ," said a senior banker who is not associated with SBI.

“The balance sheet is audited by auditors appointed by the regulator and cleared by the bank’s board of which an RBI nominee is a member. Besides, there is a time gap between when the balance sheet is signed and the RBI inspection team checks the books, and things can change in this period," said an SBI executive, who did not want to be named.

When a borrower is not able to service a loan for one quarter or 90 days, technically it becomes an NPA. There are three types of NPAs—sub-standard, doubtful and loss assets. While a bank needs to fully provide for a loss asset where chances of recovery are nil, the quantum of provision for sub-standard and doubtful assets depends on many things, including collateral against such loans.

According to the inspection, SBI had not classified about Rs2,000 crore of assets as NPAs. Had it done so, it would have been required to make higher provisions and to that extent its net profit would have fallen.

The SBI executive said around Rs300 crore of this has already been recovered and that part of it was subsequently shown as NPAs. Once an asset is an NPA, a bank does not earn any interest on it and on top of that is required to provide for it.

Similarly, the RBI inspection team found that the bank had not set aside money for certain assets for which it should have and as a result of this its capital remained inflated. For instance, it had not provided for credit derivative swaps (CDS) in its overseas books. A CDS is a derivative used to offset risks in debt markets. It allows creditors to insure themselves against the possibility that a borrower might default.

SBI had not made any provision for such CDS as there was no price erosion. “Indian corporations are involved in such deals and there is absolutely no problem. Since they are not traded in the secondary market, there is no price discovery. How do we make any provision? Our global auditors also didn’t insist on this," said the SBI official.

Another case of under-provisioning, according to RBI, was the bank’s guarantee given to an auto finance firm for the securitization of loans. The guarantee was given to enhance the rating for a pool of securitized assets. Going by RBI norms, a bank needs to have a capital-to-asset ratio of 100% for such a credit-enhancement guarantee. In other words, for Rs100 worth of guarantees, it needs to set aside 100 instead of Rs9, which is the normal capital-to-asset ratio.

SBI’s capital adequacy ratio was 12.97% for the year and had it followed the right norms for provisioning, it would still have been 12%, more than the minium requirement of 9%.

Change in portfolios

There has been a series of exchanges between RBI and SBI in the past two years on the alleged corporate governance violation. According to the regulator, Bhatt, the bank’s chairman, changed the portfolio of one of the managing directors (MDs) and made himself the sole decision maker for practically all administrative and business functions.

In the past, two MDs of the bank used to head the national banking group and the corporate banking group. In the new regime, one of them was made MD and chief credit and risk officer while the other has been heading associate banks and subsidiaries. The State Bank of India Act, 1955, lays down the powers of the chairman and the two MDs, and the bank’s board is empowered to specify the duties and the responsibilities of its MD, RBI argued, saying the board was not kept informed about the change in the portfolios of the MDs.

Bhatt has strongly defended his actions, saying the SBI Act does not specify that the board will allocate the roles and responsibilities to the MDs. “The MD was given the position of the head of the bank’s apex level credit committee as well as head of risk, both of which are not only the most important roles in any bank, but also in terms of global best practices, are occupied by senior most officers reporting either to the CEO (chief executive officer) or the board or both," Bhatt had written to the regulator.

In his communication with RBI, he also said that since there is no provision in the Act on duties and responsibilities of the MDs, there is a board-approved policy that authorizes the chairman to allocate duties to MDs and deputy managing directors (DMDs).

According to Bhatt, the MDs are members of all committees of the board as well as the bank that run the organization. The RBI nominee on the board, a deputy governor, was all along in the know of the development, he said.

Unlike other banks where executive directors report to the chairman, in SBI, both MDs and DMDs who form the central management committee that runs the bank, directly report to the chairman. “Their portfolios are interchangeable," said the SBI official quoted earlier in the story.

S.K. Bhattacharya, MD and chief credit and risk officer, retired in October.

Residual issues

According to the SBI official, many of the issues raised by the RBI inspection team were resolved earlier and the residual issues have been sorted out in the September quarter. The bank’s consolidated net profit dropped 22.51% in the September quarter as provisions rose three times, with bad loans worth Rs4,412 crore added in the quarter.

A Mumbai-based analyst of a foreign brokerage said his community looks for quality of assets and margins while taking investment calls for any bank. “We don’t give much importance to the CAMELS rating as it is never made public, but if the regulator is concerned about the quality of assets of any bank, then we will be worried," he said.

The CAMELS rating, introduced in late 1990s, is modelled on the US Federal Reserve’s CAMEL with an additional focus on the last letter—systems and controls. Within CAMELS, the maximum weightage is given to capital and asset quality.

“Only on two parameters—management, and systems and controls—some amount of subjectivity can creep in, but all other parameters are objective," said a former central banker who was associated with the supervision of banks.

For instance, the capital adequacy ratio needs to be 9% or more and net NPAs should not be more than 3% of loans. Similarly, the return on assets in a bank should not be less than 0.25%.

SBI’s capital adequacy ratio in 2009 was 12.97%, net NPAs 1.79% and return on assets 1.04%.

The scale of the US Fed’s CAMEL rating is 1-5; in India the CAMELS scale runs from A to E. Once a bank’s rating is down to C, the central bank starts monitoring it closely, and E, the lowest grade, is the trigger for so-called prompt corrective action. Once this occurs, RBI restricts the concerned bank’s activities and keeps it under close vigil till its health is improved. No bank currently enjoys an A rating.

The ratings are never publicly disclosed, but communicated to the concerned banks.

Typically, banks are inspected annually but the country’s largest bank undergoes this once in two years. SBI and its associate banks account for close to one-fourth of the banking assets in India.

Bhatt, whose term as chairman will come to an end in March, has been one of the most dynamic CEOs the bank has seen in its recent history. Under his stewardship, the bank regained part of its lost market share.

SBI dropped 1.2% on Thursday to close at Rs3,174.85 on the Bombay Stock Exchange even as the bourse’s benchmark index, the Sensex, lost 1.37%. Since January, SBI has gained 40% against the Sensex’s rise of 18% and the sectoral Bankex index’s increase of 45.43%.