Monday, October 3, 2016

Bank Recap: Where has the money gone?


Holding on to public sector bank stocks has cost investors dear. Over the last five years — between 2010-2011 and 2015-16 — a whopping ₹1,37,000 crore has been wiped out of PSU banks’ market capitalisation. The Centre’s reluctance to let go of its majority stake in these banks has led to an eye-watering ₹68,000 crore of erosion in its wealth held in 21 public sector banks (PSBs), where its stakes range between 53 and 85 per cent.
That’s not all. The Centre has also been infusing capital into PSU banks year after year. In the last five years, even as the market value of PSU banks plummeted, the Centre infused over ₹85000 crore in these banks. Mostly, the infusion has been need-based, made in banks that are in dire need of capital to grow and meet their regulatory requirements. But despite the Centre’s largesse, PSU banks have seen a consistent fall in earnings owing to weak credit growth, stressed margins and a sharp rise in bad loan provisioning over the last two to three years.
Is the government throwing taxpayers’ good money after bad? We study banks’ balance sheets to look at key figures that help assess where, and how efficiently, the capital has been deployed.
Funding growth?

We all know that a bank relies heavily on large amounts of deposits for its lending activity. Nonetheless it is the amount of capital that a bank has which decides its wherewithal to lend. This is because, while much of the bank’s activities are funded by deposits and other borrowings, these have to be repaid at a future date. Hence a financially sound bank needs a large buffer of capital to withstand shocks from loss on account of defaults by its borrowers.

So, has the Centre’s capital infusion helped banks grow their loans?
Not quite. The overall loan growth for all PSU banks put together was a meagre 2 per cent in 2015-16, even as the Centre infused around ₹20,000 crore during the year. The trend has been no different in the past couple of years. Over the last three years, PSU banks’ loan book has grown by just about 5 per cent annually, even as their private counterparts recorded a healthy 20 per cent growth.
SBI, India’s largest lender, has been on the top of the pecking order, receiving a little over ₹10,000 crore by way of infusion over the last three years (between 2013-14 and 2015-16). The bank delivered an annual loan growth of about 10 per cent during this period. And this is amongst the best growth numbers within the PSU bank space. IDBI Bank, which received the most funds after SBI — to the tune of around ₹4,000 crore in the last three years — saw a meagre 4.5 per cent growth in loans during this period.
But there were a few other banks which, despite receiving a higher share of the ‘infusion’ pie, actually saw their loan book shrink in the last three years. Bank of Baroda, Bank of India and Indian Overseas Bank reported a fall in loans during this period, despite receiving over ₹3,000 crore by way of infusion. Some of these banks have received funds from the Centre even this fiscal (2016-17).
To a large extent, PSU banks’ weak credit off-take is understandable. Credit growth, being linked to the pace of economic growth, has taken a hard knock in the past couple of years. PSU banks have particularly faced the brunt because of their huge exposure to the corporate segment — 40-50 per cent of lending is to large corporates.
But the government infusing over ₹40,000 crore into PSBs over the last three years, begs the question: where have PSBs deployed these funds if not for growing their loan book?
Behold the losses

A key aspect of a bank’s capital is its ability to absorb losses in the normal course of operations, something that has been put to test to the fullest by state-owned banks in recent times. The sorry state of affairs at PSBs owing to the sharp rise in delinquencies is well known. The asset quality review by the RBI that forced banks to take it on the chin and provide additionally for certain loans has also been well documented. But digging into banks’ annual reports deeper reveals that PSBs have only just managed to stay above the water in the past year and the Centre’s funds have gone mostly to fund banks’ losses on account of huge loan defaults.

Bad loan provisioning for most PSU banks doubled (even trebled in some cases) in 2015-16, eroding earnings. What has made matters worse is that the core earnings of most of these banks have fallen grossly short of the requirement for bad loan provisioning. For instance, IDBI Bank saw its bad loans provisioning more than double to ₹3,500 crore in 2015-16. Including write-offs, the provisions were a steep ₹8,800 crore. But the bank only managed to deliver a core net interest income (interest earned on assets less interest paid on deposits and borrowings) of about ₹6,000 crore in 2015-16. Quite understandably, the bank slipped into huge losses which, in turn, were carried over to the bank’s balance sheet, eating into its reserves, and hence, capital.
Indian Overseas Bank’s core net interest income was flat in 2015-16, while provisions for NPAs doubled to about ₹7,300 crore. The bank’s operating profit of ₹2,885 crore for the year could hardly absorb the incremental provisioning, and the bank ended the year with a loss of around ₹2,900 crore.
Bank of India ended the year with a loss of ₹6,000 crore as provisions for bad loans of about ₹14,000 crore were more than double the bank’s operating profit for the year. For UCO Bank, its net interest income fell by 12 per cent, even as bad loan provisioning trebled in 2015-16, leaving it saddled with a loss of ₹2,799 crore. Allahabad Bank, too, saw its core income shrink, but provisioning nearly treble, leading to losses.
The list runs endless on banks delivering weak core earnings and passing the baton of absorbing losses to their capital. While it is true that over the past two years, the prolonged slowdown in the economy has presented banks with even more challenges, a consistent fall in core income, margins and sharp rise in defaults over the last couple of years point to a more structural issue.
We know that PSU banks have large exposures to the corporate segment, when compared to their private sector peers who have a robust retail loan portfolio. This, to some extent, explains the healthier performance of the latter in recent years. However the unbridled growth in loans, post the 2008 financial crisis and the lapse in prudential norms have clearly aggravated the problem for state-owned banks. It is likely that the Centre’s capital infusion will continue to fund these banks’ losses rather than growth for some time to come.
What will happen if the tap runs dry one day, is anybody’s guess!
More concerns

The issue of funds being frittered away to make good the losses incurred by banks owing (a great extent) to their own shoddy lending practices and weak risk managements system, does not stop there. A look at banks’ balance sheets also reveals that many banks have been borrowing aggressively from the central bank or through the market via bonds.

Banks resort to borrowings for multiple reasons. One of them could be to fund aggressive growth in loans. But the credit-deposit ratio for many banks is low — below 75 per cent (close to 25 per cent of deposits have to be kept aside as cash and liquid assets), indicating ample funds for lending if need be.
But since the lending activity has been sedate, banks’ borrowings appear to have been driven by other reasons such as meeting large commitments or funding asset-liability mismatches (when deposits and loans do not come up for payment at the same time). Sometimes banks structurally do not have a stable deposit base, i.e. they rely on flighty deposits such as short-term wholesale funding rather than more stable funding sources. These banks can run high ALM mismatches by design and hence, more often than not, have to depend on borrowings.
A bank’s ability to meet its depositors’ payments can also be thrown off track if there are sudden large defaults on loans. In this case its loans (less NPAs), cash reserves and investments may not be enough to meet the depositors’ needs. The sharp rise in loan defaults over the last one year or so can also explain why some banks have resorted to additional borrowings. PSU banks have also been raising funds by issuing Basel-III compliant bonds to meet the regulatory requirement, which is included in borrowings.
There were quite a few PSU banks that saw a sharp increase in borrowings in 2015-16, even as their loan growth remained sluggish. Many of these banks also witnessed a much muted growth in deposits, indicating loss of market share to private players. UCO Bank, for instance, saw a steep 68 per cent increase in borrowings in 2015-16 even as its credit deposit ratio was a low 60 per cent. The bank’s loan book, in fact, shrank by 14.5 per cent during the year. But its bad loans doubled, forming 15.4 per cent of loans and its Tier I capital stood at 7.6 per cent, just about meeting the regulatory requirement in 2015-16.
Dena Bank, too, saw borrowings shoot up by 82 per cent in 2015-16. While its advances grew by a modest 4 per cent, bad loans doubled. IOB, Vijaya Bank and Indian Bank, too, saw their borrowings jump by 30-50 per cent even as loan growth remained muted.
Managing risk

It is evident that most of the Centre’s funds (and banks’ funds too) has been deployed by banks to fund losses rather than grow their loan book in the past year or so. This has left many banks with lower capital ratios; a few just about meeting their regulatory requirement. Caught in the vicious cycle, the Centre will have to bail out these banks yet again to protect depositors’ interest.

What makes matters worse is that a few banks still have higher exposures to riskier assets, that tend to drain more capital.
Presently regulations require Indian banks to have total capital amounting to 9.625 per cent of their risk-weighted assets. This is to make sure that the amount of capital that a bank holds is pegged to the profile of its borrowers. The RBI assigns different ‘risk weights’ to different types of loans based on the possible defaults for each category. Loans to the Central government have a zero per cent risk weight while exposure to commercial real estate has a 100 per cent weight. Personal loans and credit cards carry a 125 per cent risk weight, so do capital market exposures. Exposure to corporates rated below BBB carries a 150 per cent weight. Hence the riskier a bank’s portfolio, the higher will be its risk weighted assets and the amount of capital it needs to maintain.
Banks can, therefore, conserve capital to a large extent by lowering the risk in their lending.
Banks, in their annual reports, disclose a break-up of their exposure across three risk buckets — below 100 per cent risk weight, 100 per cent risk weight and more than 100 per cent risk weight. A few banks carry a higher proportion of risky assets, which will continue to be a drain on their capital. Indian Bank has about a fourth of exposures carrying more than 100 per cent risk weights. Andhra Bank and OBC are other banks that have 20-30 per cent of their exposures in the most risky bucket.
Implications for investors 

The above analysis brings to light several weak links in the performance of public sector banks. Muted loan growth, higher exposure to large corporates, weak margins, and large loan defaults have eroded their capital.

Some of these issues are linked to the state of the economy and hence with a gradual revival in investment activity, earnings could improve. But much of what is ailing these banks is structural, and can be remedied only by improving the governance in public sector banks. Some of these issues are under way with the constitution of an independent Bank Boards Bureau, but are long-drawn.
In the near term, most banks still have to grapple with low capital ratios, weak core earnings and asset quality. Many PSU banks still maintain low provision coverage of 45-55 per cent (the extent to which a bank sets aside funds to cover loan losses). If possible slippages from restructured assets are considered, the cover would be even lower.
Also, even if the Centre does continue to support these banks, infusion at an abysmal price will lead to dilution in book value, further undermining market prices.

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