Evergreening by private sector banks
The banks have a potential incentive to evergreen assets so that provisions do not dent profitability
In its March quarter results, ICICI Bank Ltd reported a 76% drop in profit following a substantial increase in provisions. This ‘big bath’ in earnings that has occurred in a bellwether for Indian private sector banks calls into question the quality of board oversight, especially with respect to evergreening of loans. Given such a precipitous drop in the earnings, I suspect that evergreening of loans may have been happening in some private sector banks.
Because the large increase in provisions now is actually an outcome of bad loans that may have been made in the past and which may have been evergreened, let us examine a puzzle using the reported numbers as of December 2013. Note that we need to look at past numbers to understand the puzzle, which was highlighted in chapter 7 of the P.J. Nayak committee report.
As the first chart confirms, as of December 2013, stressed assets in public sector banks had reached alarming proportions, but not in private sector banks. On the contrary, gross non-performing assets as a percentage of loan assets in private sector banks declined in December 2013 when compared to March 2013.
Compare these numbers to what was happening in the macroeconomy. By 2013, the rate of economic growth had been slowing for nearly three years. Moreover, with nominal interest rates having been quite high during that period, borrowers took loans at high interest rates. The extremely high leverage of corporates that we witness now started accumulating from 2010 onwards. Several asset-heavy businesses, which had borrowed liberally from both private and public sector banks, faced cash flows that were inadequate to support repayments to banks. Combined with the impasse in infrastructure projects, the number of stressed borrowers burgeoned.
Now, let us analyse whether there was indeed any difference in the portfolios of borrowers of public and private sector banks. To see whether this was the case, examine the overall portfolio of stressed borrowers as of December 2013 for both public and private sector banks. For this purpose, we use the Altman Z-score, which has been a popular method to demarcate between strong, weak and stressed companies. We use the CMIE Prowess database on firms that banks lend to and collate that information to the bank-level to obtain the corporate portfolios of public and private sector banks. The second chart indicates that as of December 2013, 18.4% of borrowers in public sector banks were Altman-stressed, while 18.6% of borrowers in private banks were Altman-stressed. It also shows that there was little difference in the portfolio of stressed borrowers of private and public sector banks. In fact, statistical tests confirm that the two distributions were identical.
Based on borrower fundamentals, as of December 2013, there was no difference in the portfolio of stressed borrowers of public and private sector banks. Yet, there were substantial differences in the reported stressed asset numbers. Which of the two represented the true picture? The large provisioning reported by ICICI Bank suggests that the former was more likely. Therefore, it is quite likely that private sector banks were hiding their stress through possible evergreening of loans.
Why would public sector banks report more truthfully their stressed asset position when compared to private sector banks? Incentives! In private sector banks, senior management is incentivized on the basis of bank profitability. Also, the compensation paid out to senior management—through stock options—is in substantial measure contingent on the stock price of the bank. There is a potential incentive to evergreen assets in order that provisions do not make a dent in profitability. This incentive is the strongest in the new private sector banks, where a significant proportion of compensation could accrue through encashing stock options.
What do we do now? Going forward, board oversight is critically needed on the quality of the loan asset portfolio, as under-reporting NPAs and other stressed assets sensitively influence the integrity of financial reporting. Clearly, all bank boards need to be sensitive to this. However, private sector bank boards need to be particularly vigilant. Successive lines of defence are the bank CEO, bank audit committee, bank board, bank auditors and the Reserve Bank of India (RBI) supervisors.
RBI supervisors need to carefully examine if evergreening indeed did occur—and if so, was it wilful? Did sections of the senior management of the bank support these practices? After all, evergreening of large accounts cannot occur without the support of the senior management. Necessary penalties must be levied if a particular bank is found guilty of such misgovernance. Penalties should be targeted at the prime beneficiaries of evergreening. The measures would include the cancellation, in part or full, of unvested stock options, and the claw-back by the bank, in part or full, of monetary bonuses. The existence of any wilful and significant evergreening suggests that the board and the audit committee had also not been adequately vigilant, and it therefore appears desirable that the chairman of the audit committee be asked to step down from the board.
Krishnamurthy Subramanian is associate professor of finance at Indian School of Business and a board member at Bandhan Bank and NIBM. He was a member and director of research of the P.J. Nayak committee.
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Business NewsOpinionEvergreening by private sector banks
First Published:18 May 2016, 03:41 AM IST
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