The stand-alone credit profiles and ratings of some Indian state-run banks could come under pressure as their asset quality, capital and earnings deteriorate further, Amit Pandey, primary credit analyst at Standard and Poor’s (S&P’s) in Singapore, said in an interview.
Public sector banks (PSBs) need ₹ 2.3 trillion of capital, more than three times the ₹ 70,000 crore promised by the government over 2016-19, Pandey said.
How do you see India’s economic recovery in FY17? What are the constraints and risks?
We expect India’s economy to build on the recovery in fiscal 2017 led by public capital expenditure and urban consumption. However, poor export performance stemming from tepid global demand, anaemic private sector capital spending due to low capacity utilization, and weak rural demand due to two successive sub-par monsoons constrain any sharp ramp-up in economic growth, especially in industrial production.
Policy responses to boost demand have their own limitations, given macroeconomic stability imperatives. So, while the Union government increased allocation for public capital spending for fiscals 2016 and 2017, it lowered its overall deficit target to 3.5% of GDP (gross domestic product) for fiscal 2017, from 4.1% in fiscal 2015.
The Reserve Bank of India (RBI), the central bank, cut policy rates by 125 basis points (bps) in 2015. However, they remain higher than the lows in earlier recovery cycles, given the RBI’s stance to maintain positive real rates in the economy. Heightened uncertainty on global growth prospects led by China, the US interest rate cycle, and capital flows remain the key downside risks that can cause external volatility.
Is India facing a major problem with bad loans?
India’s banking system is suffering from the debt burden of some stressed corporate sectors. Tepid domestic industrial activity, the corporate sector’s subdued profitability, and high leverage in certain pockets continue to be worrisome. Some corporate sectors continue to face low capacity utilization, after the high capital expenditure of the past few years amid moderate demand. They include infrastructure and iron and steel, and contribute to a sizeable portion of Indian banks’ stressed assets.
We estimate that Indian banks’ ratio of stressed assets—gross NPLs (non-performing loans) plus standard restructured advances—to total loans could increase to 11.5-13% by the end of fiscal 2017. We expect the standard restructured loan ratio to decline. This is because this restructuring flexibility ended in April 2015, some restructured loans to SEBs (state electricity boards) may be replaced by state government bonds, and some restructured loans will slip into NPLs.
How do you see loan growth in Indian banking sector in fiscal 2017?
We expect loan growth in India’s banking sector to be 11-13% in fiscal 2017. Companies are the key users of bank credit. The industry and services sectors together account for 65% of bank loans, followed by retail at 21% and agriculture 13%. We anticipate that corporate capital spending will be weak, given low capacity utilization and high leverage. However, we expect some improvement in total loan growth, given an increase in nominal GDP growth and opportunities in sectors such as renewable energy and road infrastructure. We believe growth in retail loans will continue to outpace that in corporate loans, in line with the trend over the past two years. Several factors support retail loan growth. Home mortgages—about 9% of GDP—and vehicle penetration rates are low, interest rates have been falling, and banks are focusing on the retail segment because of its stable asset quality and the slowdown in corporate credit demand.
How do you expect the profitability of the sector to shape up?
Banks have cut base lending rates by 50-80 basis points (bps) in the past few quarters following policy rate cuts, which should result in lower net interest margins (NIMs) over the next two to three quarters. We anticipate that NIMs of banks with higher bad loans will compress more because of interest reversals on non-performing loans. Indian banks’ credit costs will remain high in FY17, especially for corporate lenders with weak provision coverage because of under-provisioning on existing gross NPLs, weak corporate performance, continuing slippages of standard restructured loans into the non-performing category, RBI’s review of banks’ asset quality, and higher provisioning on strategic debt restructuring (SDR) loans—banks are using the RBI’s SDR scheme to take over stressed companies by converting a part of the debt to equity.
RBI recently asked banks to provide at least 15% for residual SDR loans and for potential depreciation in value of equity shares acquired of such companies. We expect the overall industry return on assets to reduce to 0.5-0.6% in fiscal 2017 from 0.8% in fiscal 2015.
How big a challenge is capitalization for public sector banks?
Indian public sector banks have sizeable capital needs to support growth and meet Basel III requirements, which kicked in on 1 April 2013, and will gradually increase until 2019. Most Indian public sector banks will have to rely on external capital infusion, given their reduced ability to generate internal capital, largely because of the pressure on asset quality. Their ratio of pre-provision income to average assets has fallen substantially, leading to losses in some cases after considering credit costs. The government had promised to infuse ₹ 0.7 trillion ( ₹ 70,000 crore) into these banks over 2016-19 last year, with ₹ 250 billion ( ₹ 25,000 crore) allocated for fiscal 2017. We had estimated the banks’ capital needs at ₹ 2.3 trillion, including provisions for stressed assets.
Hence, in our view, allocated amount won’t be sufficient to fully resolve the banks’ looming capital shortfall. In view of the potential shortfall in capital, India’s public sector banks will need to continue to explore other funding options. Alternative channels include additional tier-1 issuance, and funding from insurance companies or equity capital markets. The banks may also look to divest their stakes in other companies to support capital. However, given their low profitability and sizeable dilution risks, most public sector banks in India trade in the equity market at a discount to their book values. We believe that this is unlikely to change unless these banks make significant progress in resolving asset quality, profitability, and governance issues. Their access to equity markets is therefore likely to be limited in the near term. RBI has recently allowed banks to include some more items as part of common equity tier-I (CET1) —45% of revaluation reserves arising from change in carrying amount of bank’s property; 75% of foreign currency translation reserves; and deferred tax assets arising due to timing difference up to 10% of bank’s CET1. We estimate that these relaxations will boost the tier-I ratio of the rated public sector banks by 30-90 basis points. Banks may further recognize revaluation reserves based on the current market value of their properties. However, these steps are likely to help only marginally. Increased capital infusion by the government will be the most important source for shoring up capitalization of public sector banks.
Finance minister Arun Jaitley recently said the government will set up an expert group to examine consolidation of PSBs and consider allowing them to issue employee stock options (ESOPs). How do you see the impact of these measures?
The government’s ambitious plan to strengthen the performance and governance of the public sector banks is positive, in our opinion. Yet, the plan will take time to implement, and success will depend upon execution. The government is focusing on improving the selection of board members and top management. The plan also envisages higher empowerment for banks while increasing accountability and offering incentives for good performance at the banks. The key performance indicator (KPI) framework for banks includes capital efficiency, business diversification, asset quality management and financial inclusion. The performance bonuses of the heads of banks may be linked to KPIs. The government may also introduce employee stock ownership plans. We think the polarization of the market in favour of stronger banks would gain momentum as Basel III capital norms are implemented. Public sector banks with lower capitalization and internal generation of capital could become takeover targets, resulting in consolidation in the banking sector, though over the medium to long term only. The initial process may start with the bank board bureau—a body that will help banks to develop strategies and improve governance—getting operational.
How about private sector banks?
Private sector banks are likely to continue to gain market share because of their stronger retail franchise and capital position. However, we anticipate that the non-performing loan ratios of banks with high exposure to companies in sectors facing difficulties will continue to rise, even among private sector lenders. We believe the leading private sector banks we rate are better placed than their public sector peers to meet Basel III capital requirements. These private banks benefit from better capitalization, higher internal capital generation and greater investor appetite because of their stronger profitability. Each of the rated private banks has pre-provision operating income to assets of more 3% as compared to 1-1.5% for rated public sector banks except SBI (State Bank of India). We anticipate that some private sector banks will increase unsecured lending such as personal loans and credit card loans to improve profitability. Banks are also targeting loans to small businesses, partly through loans against property.
Which banks are the most vulnerable, and why?
We believe the worsening trend in asset quality of banks will continue, especially for corporate lenders. Banks with large corporate loan portfolios and a backlog of provisions are the most vulnerable, from an asset quality perspective. The stand-alone credit profiles and ratings on some Indian public sector banks could come under pressure as their asset quality, capital and earnings continue to deteriorate, more so if the government’s capital infusion remains moderate. The tier-I capital levels of some public sector banks are already close to the regulatory minimum requirement of 7% for December 2015—under Basel III regulations, the requirement of tier-I capital, including the capital conservation buffer, rose to 7.625% for March 2016. Banks could face multiple-notch downgrades if their capital breaches the minimum regulatory requirement. Hence, the government’s capital infusion and extraordinary support to PSBs will be a key rating factor.
How are the other banking systems likely to fare in Asia? What are the key risks?
Asia-Pacific banks are in for a choppy ride, with vulnerable asset quality, slowing loan demand and weakening profitability. Those are all results of a sluggish regional economy that’s straining corporate and consumer borrowers, while a commodity rout hurts corporate borrowers, and fears of slowing economic growth in China.