Make investors feel they matter

The last two to three years have been challenging for the banking sector. A prolonged slowdown has impacted the investment cycle and corporates have reduced new outlays in the last few years, taking a toll on bank lending. Weak earnings have reduced the ability of companies to service their debt, leading to a sharp rise in loan defaults for banks. While the situation is grim, these are challenges that banks must face, being in the business of lending.

For investors in banking stocks, what has made matters worse is not poor performance alone, but a slew of measures undertaken by the Reserve Bank of India in a bid to clean up balance sheets and prep the pitch for the next leg of lending, as Governor Raghuram Rajan reiterates time and again.

However, measures such as the RBI’s diktat on lending rates and the review of stressed accounts have made it impossible for investors to gauge the performance of banks and take a long-term view on the prospects of investment. In the last two years, the frequency with which the RBI has brought in new regulations has increased manifold, leading to a great deal of uncertainty in banks’ earnings.

A look at the listed universe reveals that growth in banks’ core net interest income slipped to a modest 7-odd per cent in the nine months ended December 2015, after nearly 10 per cent growth in FY15. Banks’ earnings that managed a growth of about 8 per cent in FY15 have fallen by 34 per cent in the nine months ended December 2015. Public sector banks have been the worst-hit, with earnings shrinking by 79 per cent during this period.

It is true that the slow pace of growth in the broader economy is to be blamed to some extent. But much of what has also plagued the sector is due to the RBI’s micromanagement of loan pricing and asset quality decisions. This is evident in the sharp underperformance of some banks in the December and March quarters, led by a tight squeeze on margins and lumpy increases in bad loan provisioning.

Let’s start with the transmission of rate cuts. Through 2015, as the RBI embarked on its rate easing exercise, banks were constantly brought under trial by the regulator and India Inc for not doing the needful. This only hurt banks’ performances. Consider the transmission of rate cuts in the past. Between September 2008 and September 2009, for instance, the RBI slashed the repo rate by 425 basis points.

But borrowers had to make do with a mere 120-basis point cut in lending rates. Between March 2012 and June 2013, when repo rate fell by 125 basis points, only a fifth of this rate cut was passed on to borrowers.

But in 2015, as the RBI lowered its repo rate by 125 basis points, banks lowered their benchmark lending rates by 50-60 basis points — nearly half the RBI’s rate cut. This is way above the level of transmission seen in the past.

But the RBI, still finding such cuts inadequate, decided to overhaul the base rate system. While the new marginal cost-based lending rates (MCLR) may, to some extent, force the banks’ hand to reduce lending rates, it does little to bolster investor confidence. Banks have to work harder to keep their margins intact and manage asset-liability mismatches. The interest rate risk in the banking book (IRRBB), as disclosed under the Basel requirement by Indian banks, can be used to gauge the impact on earnings on account of holding assets and liabilities across different maturity or repricing dates.

For instance, Axis Bank in its 2014-15 annual report states that for every 200 basis points fall in interest rates, its earnings (NII) will fall by about ₹2,000 crore. For every 100 basis points fall in interest rates, ICICI Bank’s NII will fall by ₹822 crore. For SBI, every 100-basis points fall in rates will reduce earnings by ₹6,882 crore, about 12 per cent of its 2014-15 net interest income. The interest rate risk to net interest income for Indian private and PSBs varies from about 2 per cent to 9 per cent.

In a bid to ensure quick transmission, the RBI has failed to take cognisance of the fact that one of the main reasons for slower transmission has always been that banks rely significantly on longer term deposits, and only about 50-60 per cent of banks’ funding gets repriced with every rate action by the RBI. How then can they transmit more benefit to borrowers than they actually reap on their own cost of funds?

Banks also cannot follow a harmonised pattern and cut rates uniformly, as every bank’s assessment of risk may be different. Some may have to keep higher spreads to factor in higher risk of lending.

For investors, such restrictive credit pricing mechanisms are no doubt unsettling as they cannot bet on banks taking sound commercial decisions to safeguard their margins.

Under the RBI’s recent asset quality review, banks were asked to make provisioning for loans extended to 150-odd companies, even if these loans were not delinquent. Few private lenders who were thus far able to contain slippages have seen their bad loans spike and earnings plunge. Given the stress in the overall system, the RBI may have considered it prudent to review stressed accounts and ensure that all banks made necessary provisions to cover losses — an argument very few can challenge. But what has been lacking in the whole exercise is transparency.

If investors need to gauge the real impact of such an exercise and re-adjust their view on specific stocks, it is only fair that the details of such a review — companies in the list, reason for putting them under the watch list and possible additions or deletions to the list — are made public. How else does one put a number to future earnings?

Playing the good cop-bad cop routine has also not helped much. The RBI recently relaxing the provision for loans to certain companies in the March quarter, under its so-called ‘asset quality review’, is a case in point. Even as investors revised their earnings expectations, the RBI knocked off 20 companies from the AQR list. This left investors in the lurch, particularly as news reports (no notification or announcement by the RBI per se) flowed in just ahead of the March quarter results.

While one can argue that many of the RBI’s actions are to safeguard depositors’ interest, these measures seem more like quick-fix solutions; they do not offer a sustainable solution. For instance, the lackadaisical performance of state-owned banks has clearly been due to a lapse in prudential norms. What is needed is to hasten reforms to materially improve governance in these banks rather than impose restrictions on all banks. The focus of the Centre and the regulator should be to operationalise the recently constituted Bank Board Bureau (BBB).

The government reducing its stake in PSBs would be the first step. This brings us to the issue at hand of creating a conducive environment for investors.

Only if there is a change in the governance structure and confidence that profitability can improve, will investor appetite be rekindled. Ad hoc or opaque policies from the RBI do not help. After all, investors cannot be left feeling that they have to walk on eggshells, while investing in bank stocks.