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Alice Continues in Wonderland

With most people pinning their hopes to rate cuts, which will augur well for the banking sector, the inside truth of the sector is overlooked

Over the past few weeks, the narrative in equity markets has focused on investing in public sector banks. The investment argument pivots almost completely on the widely expected drop in policy rates over next several months. This will lower funding costs, deliver marked-to-market gains on government security portfolios of banks and, in some cases, even increase the net interest margins (NIMs). So why did the RBI have to change the accounting guidelines for project loans for banks in December? The macro picture diverges dramatically from the micro.

Public sector banks - largely bankrupt
If public sector banks (PSBs) were not owned by the Government of India - in other words by us, the taxpayers - they would have long ago shut down. The graphic below shows that after a whole decade, we are back to a situation where declared net non-performing loans (NPLs) and 're-structured' assets (euphemism for loans that would become NPLs if loan conditions are not relaxed) exceed the net worth of public sector banks. Take a moment to think about this. Cumulatively, public sector banks are bankrupt and are operating only because we continue to leave our money with them as deposits.

Impaired assets - only part of the picture
In a report post Q2FY15 results Credit Suisse looked at a sample of 3,700 listed companies. Taking the interest cover of less than one as a criterion (which means that the earnings before interest and tax are insufficient to cover interest costs revealed in the financial statements), it found that of the top 200 corporates that were stressed, only 30 per cent of the loans had been recognised as 'stressed' by lenders, with banks preferring to carry remaining 70 per cent as standard assets in their books.

When we combine this with the figures above, it is clear that banks (especially state-owned ones) are in a precarious situation. Not only are they bankrupt as per their own admission, they are still presenting financial accounts that are 'coloured', to use a mild word.

If performance is poor, change the measure
The Reserve Bank is the ruling lord of the credit world. It sets policy interest rates, supervises banking operations and determines what sectors banks can lend to and the risk weightage attached to such lending. It presided over the steady deterioration of bank balance sheets over the past few years. Interestingly, the RBI is also a regulator that can authorise changes in the way banks report their financials! A more blatant conflict of interest is difficult to find. An example of this conflict is evident in the recent changes the RBI has mandated in treating stressed assets. It has relaxed rules regarding 'refinancing' of projects after they are commissioned.

The new norms allow:

  • Creation of a new loan amortisation schedule for existing loans by refinancing after the borrower commences commercial operations. This is not to be treated as 'restructured assets'.
  • Refinancing by the same lenders is possible every five-seven years. This was earlier called 'ever-greening'. Earlier guidelines required that at least 25 per cent of loans be taken up by new lenders. This is not the case any more.
  • If refinancing is on terms that lead to an NPV loss on the loan, it is no longer required to classify it as restructured.
  • Restructured loans can be again be refinanced. Earlier, repeated restructuring would lead to the loans being classified as NPL.

In addition, since 'refinancing' is simply lending, there is no requirement to report it separately. In other words, with a wave of the proverbial magic wand, the RBI has erased all the bad loans in the books of banks. Banks can now continue to advance money to repay old interest and principal without these showing up as money not likely to be returned by borrowers.

Vanishing NPLs
As per the new norms, one research report has estimated that over 66 per cent of unrecognised NPLs and over half of restructured loans will be eligible for refinancing. Banks can now live in denial with respect to bad loans. Distressingly, these will now not need to be reported and the 'optical' health of the banking system will become significantly better.

Does this mean that investors should shun public sector banks? Quite the contrary. As mentioned at the start of this note, macro factors favour public sector banks. A cyclical uptick in the economy will likely allow some stressed corporates to repay their borrowings and return to health. Ironically, best near-term equity performance may come from banks that have the worst balance sheets. However, do remember when you look at a bank's balance sheet hereon that there is no truer statement than 'beauty lies in the eyes of the beholder'.

Anand Tandon is an independent analyst.

This column appeared in the February 2015 issue of Wealth Insight.