Decoding the bad loan trend of banks: There's more than meets the eye

Most of the government-run banks that reported earnings in the June quarter have shown an increase in their bad loan level, notably Punjab National Bank, Allahabad Bank and Indian Bank.

Bankers play down the problem saying most of the stressed assets have been reported already and the addition of sticky loans will not be significant going ahead since the pace of incremental slippages has come down.

Besides, they hope that an expected economic revival will help erase the sticky assets in the banking system.

Would this mean that there is a genuine improvement in the health of Indian companies and relief for banks? A closer look at the trend will show that there may be more than meets the eye.

Behind the sale of bad loans

For one, a significant portion of the bad loans have been sold to Asset Reconstruction Companies (ARCs) until March, especially from the books of public sector banks, which has significantly eased the burden on the books of these banks, helping them show lower bad loan numbers and, in turn, boost the profit.

About Rs 10,000 crore worth of loans were sold to ARCs from about 22 public sector banks in the fiscal year ended 2014, according to analysts at Care Ratings. The comparative figure in the previous financial year was just about Rs 500 crore.

Banks rushed to sell bad assets in such large quantum last year because of a new set of RBI rules that set in from April, which required banks to make 5 percent of provisions on every new loan they restructure, instead of 2 percent earlier.

That means for every Rs 100 loan a bank restructures, it needs to set aside Rs 5 as provision amount, instead of Rs 2 before.

This will have huge impacts on the profitability of banks.

Banks rushed to sell bad assets before March for this reason, even though they will have to take a small hit on these loans since ARCs will buy such loans at a discount.

Now, sale of bad assets to a bank is only transferring the problem and not a permanent resolution.

From a lender, the loan is transferred to a specialist in bad loan management, which issues security receipts that are shown as investments on banks’ balance sheet.

But ultimately, only when the ARC is able to recover loans and pays to the bank is the asset actually resolved.

Assuming that the assets sold were part of the banks’ books, the gross NPA ratios of banks would have gone up by 30 basis points (bps). One bps is one hundredth of a percentage point.

Also, selling bad loans to ARCs doesn’t necessarily mean that the issue is resolved - neither for the bank nor for the troubled company.

“They (the bad loans sold to ARCs) can come back as ARCs give banks security receipts and not cash,” said Vaibhav Agrawal, vice-president research at Angel Broking.

“If eventual recovery is not made, then such receipts have to be provided for by banks. The key here is that if the economy revives, then it is not going to be a material issue,” Agrawal said.

Behind the loan recast

Second, a lot will depend on the performance of the restructured loan portfolio of banks.

In the last one year, banks have restructured a large number of loan accounts, which would have actually turned bad loans otherwise. Banks have recast loans more aggressively towards the end of March, due to the increased provisioning for restructure loans since April.

According to the data on the corporate debt restructuring (CDR) cell, about Rs 3.48 lakh crore of loans were outstanding under the mechanism until end June, out of which Rs 2.51 lakh crore are currently being restructured. That’s not all. Banks also do bilateral loan recasts, which would make the combined figure of the restructured assets in the Indian banking system anywhere between Rs 5-6 lakh crore, or 9.8 percent of total bank loans.

Here again, the economic recovery will play a crucial role, along with fast clearances for several infrastructure projects that are stuck will decide whether these loans can turn good or bad.

In the absence of an economic boost and timely removal of structural bottlenecks, there is a clear danger of bad loans emerging from the restructured loan pile. Analysts put such risky loans as 25-35 percent of total restructured loans.

One of the key poll promises of Modi is that his government will fast-track clearances for projects. If the promises do not get converted to action, a lot of these rejigged loans can eventually become bad.

The current huge pile of bad loans in the Indian banking system has been built due to slew of factors, ranging from economic slowdown, slow-decision making by key government machinery - both at central and state level - and years of careless lending by banks to expand their loan book and due to influence of interested parties (read government, in the case of state-run banks and powerful industrialists, in the case of both public and private banks).

Till end-March alone, the total gross non-performing assets of 40-listed banks in India stood at Rs 2.5 lakh crore - an amount equal to the estimated capital requirement of India’s state-run banks to meet the Basel-III norms over the next five years.

More than the reported numbers, dealing with the hidden bad loans may be more critical for banks.

The problem of bad loans may have roots deeper than it appears.