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Mumbai: At one Indian bank—Central Bank of India—bad loans exceeded 6% of total advances in the quarter ended 30 June. At six more banks, four of which are majority-owned by the government, gross non-performing assets (NPAs) were above 5% of advances. Gross NPAs of five other banks, all of them in the public sector, made up more than 4% of their loan books in June.

After setting aside money to cover the risk of default, net NPAs of Dhanlaxmi Bank Ltd were in excess of 4% in June and those of seven others more than 3%. Net NPAs of State Bank of India and Punjab National Bank, two of India’s largest lenders, were close to 3%.

The rising tide of bad loans is a manifestation of severe stress in the 80 trillion ($1.26 trillion) banking industry, largely owned by the government, as the economy grows at a slower pace. And with economic indicators offering no signs of relief, things can only get worse before they take a turn for the better.

The numbers make sombre reading. Wholesale-price inflation accelerated to 5.79% in July and may not drop below that level in the rest of the year while consumer-price inflation remains high, at 9.64% in July. The rupee has depreciated 14.5% against the dollar in the current fiscal after losing 6.27% last year and about 12.4% in fiscal 2012.

In the year ended 31 March, the economy grew 5% after expanding 6.7% in the previous year. The pace isn’t likely to pick up in the current year although the Reserve of India (RBI) has forecast 5.5% growth.

Spending cuts helped curb the fiscal deficit to 4.9% of gross domestic product in fiscal 2013, compared with 5.8% in the previous year, but the gains are fragile and the depreciating rupee will have an impact on both inflation and the fiscal gap as the cost of subsidies will increase.

A high current account deficit, which reached 4.8% of gross domestic product (GDP) in the last fiscal, has added to the vulnerability of the economy, dented investors’ sentiment and shaken banks’ confidence in extending loans to companies. Aggregate credit portfolio of banks shrank by 0.4% in the first three months of the current fiscal. For state-run banks, the decline was 1.5%.

RBI deputy governor K.C. Chakrabarty admits Indian banks are under stress, particularly the public sector lenders, but says the situation isn’t alarming.

Chakrabarty cites precedents—back in March 1994, gross NPAs at Indian banks made up as much as 19.07% of total advances. For the next seven years, until March 2001, they remained in double digits as a percentage of the total loan book.

“If the banks could survive that phase, they would definitely come out of the current crisis, too, particularly when they are adequately capitalized," Chakrabarty argues.

Indeed, the situation may not be quite as alarming as in the past and the banking system, more robust than it was in the 1990s, can perhaps overcome the stress, but it’s undeniable that Indian banks are facing one of their toughest tests ever.

For Indian companies, slower economic growth and consumer spending has dovetailed with high borrowing costs. On top of that, many investment projects have been stalled because of delays in securing regulatory approvals and completing land acquisition.

That has hurt companies’ cash flows and made it hard to service debt, leading to the pile-up of bad loans.

In the June quarter alone, gross NPAs in the banking system increased by 12.02% to 2.06 trillion and made up 3.85% of the total advances. The gross NPA ratio was 3.23% in March. This means that in the space of one quarter, it rose by 0.62 percentage point—a big jump by any yardstick. The net NPA figures for the period are not immediately available.

Rating company Standard and Poor’s (S&P’s) expects bad loans to swell to 3.9% by the end of this fiscal and to 4.4% by fiscal 2015.

Since March 2009, when the gross NPA ratio was 2.28%, it has been growing progressively every year, barring fiscal 2011 when both gross and net NPA ratios dropped.

The soured assets in isolation do not reveal the gravity of the problem. They need to be seen along with restructured debts—loans that the banks recast by declaring a moratorium on repayments, stretching the loan tenure, trimming the interest rate and, in some cases, taking a haircut, or reducing the amount repayable to creditors.

The combination of gross NPAs and restructured assets in March was 9.25% of total advances. For new private banks that came into existence in the 1990s and 2000s, and foreign banks, the figure is one-third the industry average while for public sector banks, they are in double-digits.

Indian banks have cumulatively restructured more than 2.5 trillion of loans under a corporate debt restructuring (CDR) mechanism introduced in 2005. Overall, 2.5 trillion worth of bad loans have been restructured on this platform.

In the three months ended 30 June, banks restructured the debt of 12 companies, totalling 20,000 crore. In 2012-13, banks restructured 75,000 crore of loans on the CDR platform, nearly double what they did in 2011-12. Banks restructure loans bilaterally, too, outside the CDR platform, and together the quantum of restructured loans in the industry could be as much as 4.25 trillion.

According to S&P, Indian banks had restructured 5.7% of their aggregate loan balances as of 31 March. The rating company expects restructuring to remain high in the next two years.

Another way of assessing the deterioration in the quality of assets is to look at the accretion of fresh NPAs or the so-called slippages. In March 2013, the ratio of such slippages was 2.72%, up from 2.05% in March 2011. The combination of fresh slippages and fresh restructured advances as a percentage of total advances in March was 5.91%, more than double the level in March 2011—2.86%.

In each of these categories, public sector banks—they account for around 70% of banking assets—are the worst hit and their private-sector counterparts and foreign banks are in a relatively better shape.

The numbers serve to expose the poor credit risk assessment systems at public sector banks and the poor quality of the loan disbursal and supervision systems.

From here on, things can turn for the worse because of a couple of reasons:

For one thing, the sharp depreciation of the rupee will hurt the ability of Indian corporate borrowers to repay foreign loans that add up to around $170 billion. Borrowers who haven’t hedged their foreign loan exposure will be hit particularly hard. These companies will surely find it difficult to repay bank loans.

Two, although overseas advances by Indian banks’ foreign branches had risen by 15.03% in March 2013 from a year earlier, their bad assets increased by at least 43%. Gross NPAs among overseas loans rose from 1.41% in March 2012 to 1.76% in March 2013 and they will swell further as the borrowers are mostly Indian companies. How will these companies service loans taken from the foreign branches of Indian banks when they are finding it difficult to service their domestic loans?

As if the asset-quality issues are not enough, there are problems in banks’ investment portfolios, too. In a bid to curb the runaway depreciation of the rupee, RBI has taken a slew of measures to drain liquidity from the system and make money more expensive. The objective of the central bank was to discourage speculation on the local currency. The first set of measures was announced on 15 July.

With the sudden tightness in liquidity, bond yields have been on the rise. Prices and yields move in opposite directions. Until about a week ago, the impact was mostly on the shorter end and the yield on 91-day treasury bills was over 3 percentage points higher than the 10-year bond yield. Now long-term bond yields have started rising.

On Tuesday, 20 August, the benchmark 10-year bond yield ose as much as 9.49%, the highest since September 2001.

Since 22 May, when US Federal Reserve chairman Ben Bernanke first spoke about the possibility of unwinding the Fed’s monetary stimulus programme, the 10-year benchmark yield has risen 233 basis points (bps)—from 7.16% to 9.49%. One basis point is one-hundredth of a percentage point.

The banks will have to set aside money to cover the depreciation in the value of their bond portfolio. In accounting parlance, this is called mark-to-market (MTM) or valuing a financial asset in accordance with their market value and not the price at which they were bought.

Going by an RBI estimate, the impact of the hardening of yields by every 100 basis points on the portion of bond portfolios not shielded from depreciation is close to 30,000 crore.

Banks do not take a hit on bonds that they hold until maturity.

Bond yields dropped in April and in the first half of May, and eager to take advantage of the falling yields, public sector banks increased the size of their tradable portfolio from close to 29% of their overall bond portfolio in March to over 34% in June. That has exposed them to interest rate risk and depreciation loss.

RBI estimates the depreciation figure for the public sector banks at 21,500 crore, based on their bond portfolio in June. Since then, yields have risen further. In fact, since June-end, the yield on the benchmark 10-year bond has risen some 200 basis points.

Subsequently, the difference between the yield on 91-day treasury bills and 10-year paper has shrunk from about 315 basis points to 245 basis points even though the yield curve continues to remain inverted. With the rise in bond yields, across maturities, the impact on the entire banking industry at this time is expected to be around 60,000 crore.

This is roughly about 6% of Indian banks’ total capital base. In other words, 6% of capital will be eroded by setting aside money to cover the depreciation loss.

Only once in the past did Indian banks face this kind of sudden spurt in yield—in January 1998 when RBI raised its bank rate and repo rate by two percentage points each and increased by half a percentage point to 10.5% the portion of deposits that banks must hold with the central bank, to protect the rupee from the East Asian currency contagion.

Setting aside money to cover the risk of default on bad loans and the depreciation of their bond holdings will erode the profitability of Indian banks. They will also have to set aside more money to cover restructured loans. From June, they would need to set aside money equal to 5% of new restructured loans. Loans that have already been recast will entail 5% provisioning in phases over the next three years by March 2016. Banks will also need money to take care of wage increases. The last industry-wide wage pact, which offered 800,000 bank employees in the public sector and most private and foreign banks a 17.5% wage increase, expired in October 2012.

And under international banking norms that came into play in April, India’s banks would need 5 trillion of capital in the next five years. Out of this, 1.75 trillion should come in the form of equity capital and 3.25 trillion as non-equity capital.

All this means banks will need to replenish their capital base—a tough task in the current environment. For the record, the government has budgeted 14,000 crore for capital infusion in public sector banks in fiscal 2014. In June, the capital adequacy ratio of Indian banks was 13.5% out of which 10.05% was tier-I or core capital, consisting of equity and reserves. For the public sector banks, the figures were lower—11.96% and 8.66%, respectively. Capital adequacy is an indicator of banks’ financial strength expressed as the ratio of capital to risk-weighted assets. India’s banks may well survive the crisis. To find the wherewithal to grow and flourish may be tougher.

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