Asset Quality Concerns

The current financial And economic meltdown that has engulfed the world has affected almost all sectors and industries. While the magnitude varies from sector to sector, the common fallout has been the world's acceptance that all good things do come to an end.

One of the most severely affected sectors has been the banking industry. The problems faced by the banking sector has been aplenty - plummeting stock prices, credit crisis, decline in consumption, postponement of corporate capex and layoffs. And the combined effect of all of these problems has been the raised concerns over the asset quality of the Indian banking system.

Since the beginning of this decade, the asset quality of Indian banks has improved quite significantly. The gross non-performing asset (GNPA) as percentage of the gross advances had come down to a respectable 2.4 per cent (in FY2007) from mind boggling +10 per cent levels around the time of the tech bubble burst. Notably, the improvement in GNPA has been both on relative as well as absolute terms. This is despite the fact that the NPA recognition norms have been tightened. However, considering the aggressive credit growth seen in recent years, coupled with an anticipated slowdown in economic growth, asset quality concerns have raised head yet again.

Let's try and size up the threat...

The Causes

The current threat to the asset quality is thanks to an undesirable confluence between the ongoing slowdown in economic activity and the potential after-effects of high interest rates and the liquidity crunch. Over the recent past, the prime lending rates have increased significantly, in line with the Reserve Bank of India's (RBI) tight monetary policy. This in turn has resulted in a higher interest outgo on existing debt and a slowdown in capital expenditure. And in all probability, banks will have to bear the brunt of higher interest rates on their asset quality.

What started as a moderation in economic activity (due to tight monetary conditions) has snowballed into a slowdown and worldwide credit crisis that has accentuated to the domestic problems. With major economies like USA, UK and Germany officially in a recession, a global recession looks imminent as well. This has impacted the growth prospects in India despite zero direct exposure to US mortgage, contrary to the earlier expectation of marginal effect on the Indian economy. Consensus expectations point towards a significant decline in the gross domestic product (GDP) growth to 7.7 per cent in CY2008 and 6 per cent in CY2009, which is bound to affect the asset quality.

The Implications

So then, what is the size of the problem? Well, if the lending rates are any indication, the problem is quite immense. The quantum of risky loans is very high with 10 per cent of advances carrying a rate of above 15 per cent.

Approaching the asset quality threat from a sectoral perspective, it becomes evident that about 16 per cent of the total outstanding exposure (as of FY2008) is towards small and medium enterprises (SMEs), real estate, non-banking financial companies (NBFCs) and unsecured personal loans. These sectors have been hit severely by heightened-risk aversion-led liquidity crunch and macro headwinds. Housing credit, which forms 11.6 per cent, is a segment demanding attention in view of the job cuts and salary cuts announced by the corporates in the recent past as well.

The value at risk, based on our calculations, is around Rs 2,86,000 crore. This amount is the aggregate exposure to small and medium sized corporate borrowers from risky sectors, which represents 13 per cent of the total non-food credit.

The Solutions

As has traditionally been the case, many of the risky loans are restructured to ease liquidity problems. In all likelihood, banks will exercise the option of restructuring here as well, albeit on a case-to-case basis. Furthermore, the RBI has announced exceptional treatment for restructured commercial real estate exposures as part of its economic revival efforts. In addition to this, second time restructuring of exposures (other than commercial real estate, capital markets and personal/consumer loans) are eligible for exceptional treatment as well. However, one should keep in mind that while restructuring can be effective in avoiding delinquencies to an extent, it results in understatement of deterioration in asset quality. From a sectoral perspective, FY2010 is likely to be more crucial for the banking sector as the year will see advances growth tapering off with further slowdown in economic activity. Furthermore, delinquency rates will lag the turn in economic growth by three to six months. The impact of individual banks will depend on the composition of exposure to lending segments, current and targeted provisioning coverage as well as the effectiveness of restructuring and recovery mechanism.

In Conclusion

While the asset quality concerns are definitely worrisome, the capital adequacy levels of Indian banks should provide significant cushion in absorbing the losses arising from the deterioration in credit quality. A large majority of Indian banks maintain a capital adequacy ratio of above 10 per cent as at the end of FY2007. Furthermore, the leading banks have been actively raising capital (through rights issue, follow-on offer and bonds) to shore up their capital during FY2008, thereby incresing the capital adequacy ratios.

Besides the healthy cushion provided by comfortable capital adequacy position of most of the Indian banks, the easing off in g-sec yields should help mitigate the pressure of additional provisioning to an extent. For the current fiscal, the southward trend of bond yields should translate into complete/partial write-back of MTM losses incurred by the banks during Q1FY2009.

Clearly the domestic banks are much better placed than many of their emerging market (EM) peers. In fact, this has been the case since 2003. As at the end of FY2007, NPAs of Indian banks formed just 2.5 per cent of their total loans as per the World Bank's data, which is +6 per cent for banks in China, Malaysia and Thailand.

Hence, while we have been cautious on the banking stocks due to asset quality concerns, a further slide in bond yields, easing in corporate spreads and rapid rate cuts warrant easing in the extent of asset quality concerns, thereby turning their current valuation attractive. Large PSBs (Bank of India, Punjab National Bank and Union Bank) and HDFC Bank in the private sector space therefore seem attractive investments from a long-term perspective.