Banking: Long road to recovery

After a slowdown that has stretched for a little over three years, there are signs of a pick-up. When talk of green shoots surfaces, it signals that investors should begin scouting for sectors that are well-placed to play the recovery theme.

Banking is one such sector that is directly linked to the fortunes of the economy. With about a third of weightage in the Sensex, banks and financials’ have led the performance of the market across cycles.

But this time around, despite all the optimism, bank lending is unlikely to revive in a hurry. Public sector banks constitute more than 70 per cent of the total loans in the banking system. For any meaningful recovery, it is imperative that lending in these banks gathers pace, quickly. But weak capital base, large pile of stressed assets, elevated concentration of debt and high leverage are likely to hold back credit growth for State-owned banks. Investors can trim their exposure to the sector and stick to banks that have shown resilience and are better placed to ride out the weakness.

The state of the economy and bank credit growth is a typical chicken and egg situation. Fresh investments cannot come about unless banks provide the necessary funding, and bank credit growth cannot ramp up until the economy chugs down the revival path.

Credit growth has been closely linked to the pace of economic growth, as data suggests. Through most of 2007 and 2008, for instance, robust growth in GDP fuelled strong credit demand. Bank credit back then grew a healthy 25-30 per cent year-on-year.

As GDP growth fell, credit growth too slipped to 13-14 per cent levels in 2013 and 2014, after growing over 20 per cent annually since 2005. On an average, credit growth has been 2.5 to 3 times the real GDP growth (old series). The long spell of economic slowdown has dragged credit growth down to 10 per cent levels in 2014-15.

Hence, only a pick-up in economic activity can spur lending.

So at what rate will the economy grow in 2015-16? Thanks to the new series of GDP data released by the Central Statistical Office (CSO) a couple of months ago, there are varied estimates doing the rounds. According to the CSO and government, which look at GDP at market prices, growth is pegged at 8-8.5 per cent for 2015-16. The RBI, on the other hand, considers gross value added (GVA) at basic price as a more appropriate indicator and estimates the economy to grow at 7.6 per cent.

While all estimates point to an improvement in economic growth, the banking sector is unlikely to see a substantial increase in lending. Here’s why.

In relation to the new series, bank credit has ranged between 1.4 and 2 times the growth in GVA at basic prices. Based on the growth estimates put out by the government and the RBI, bank credit growth can claw back to 12-13 per cent in 2015-16, but the heady days of over 18 per cent growth are unlikely to come back soon.

Two, in the last year or two, lending has grown at a slower pace in relation to the growth in the broader economy. Bank credit has grown by a smaller multiple to the growth in GDP than in the past, owing to weak credit offtake in public sector banks. In the boom period before the 2008 financial crisis, both private and State-owned banks grew their loan books at a similar multiple to the GDP growth.

But in the last three years, PSU banks have grown at a far slower pace (5-10 percentage points lower than private banks), because of their huge exposure to the corporate segment — 40-50 per cent of lending is to large corporates. With a number of large projects stalled, corporates are in no hurry to put up new capacities. Credit growth of PSU banks plummeted to 7 per cent in 2014-15.

As public sector banks still constitute nearly three-fourths of loans in the banking system, a weak credit offtake can drag the performance of the entire sector.

Lower than expected growth in GDP can make matters worse. The CSO recently marked down the growth estimates for 2014-15 from 7.5 per cent to 7.2 per cent. If the growth for the economy slips below 7.6 per cent in 2015-16, then overall bank credit growth could languish at 11-12 per cent for another year.

Rather than betting on stocks that can gain from a possible recovery, it is best to stick with ones that have shown resilience and beaten the industry growth in the last two years. These stocks are better placed to ride out the weakness and ramp up their lending when the economy revives.

Most private banks fit the bill. In 2014-15, private banks’ loan books grew a robust 18 per cent, beating the industry by a wide margin. This was thanks to the healthy growth in retail loans which form 40-50 per cent of their portfolio. (see table 1)

HDFC Bank, Axis Bank, IndusInd, Kotak Mahindra Bank, YES Bank, Lakshmi Vilas Bank, Federal Bank, and DCB Bank have grown their loans at a healthy clip. Within the PSU pack, SBI is the only player which has a healthy exposure (20 per cent) to retail. But the bank grew its loan book by a modest 7.2 per cent in 2014-15 and is likely to lag the growth in some of the large private banks.

Weak balance sheets, particularly of PSU banks, can impede funding of new projects. Even if the investment cycle revives, banks may not be in a position to fund the growth this time around. Bad loans have shot up from 2.7 per cent levels four years ago to 4.6 per cent of loans in 2014-15. Public sector banks, which are the biggest contributors to stressed assets, have seen both their bad loans and restructured assets rise. For many public sector banks, the total stressed loans (bad loans and restructured) are way above 13 per cent, while their core capital ratio (Tier I) is below 8 per cent. They are already stretching themselves thin on capital.

Based on data as of March 2015, stressed assets (for listed players) in the banking sector are about ₹4.4 lakh crore (bad loans + 30 per cent of restructured assets). Provisions made for bad loans and restructured assets are about ₹1.6 lakh crore.

Even if we assume that banks are able to recover 30 per cent of stressed assets, the provisions fall short by ₹1.4 lakh crore. This is close to a fifth of the total capital of banks.

PSU banks maintain a far lower provision coverage ratio (cumulative provisions/ gross non-performing assets) — a measure that indicates the extent to which a bank has set aside funds to cover loan losses. If we consider PSU banks alone, then the shortfall in provisions is almost 30 per cent of their net worth.

Over ₹4 lakh crore of loans have been restructured in the last three years. More than a third of this has slipped into bad loans. The RBI’s latest Financial Stability report estimates bad loans to rise to 5.9 per cent of total loans by March 2016 under a severe stress scenario. At 13 per cent loan growth, this could mean a ₹1.4 lakh crore increase in bad loans.

Banks that have high stressed assets are likely to conserve their capital for meeting provisioning and regulatory Basel III requirements. (see chart 1) With the window for restructuring closed from April 2015, banks that have a higher tendency to restructure assets in the past will see a sharp increase in provisioning.

In the boom years of 2008 and 2010, Indian corporates betting on the continued growth in the economy put out aggressive capex plans and took on huge amounts of debt to fund their growth. But as large projects in the core sectors such as mining, power and infrastructure stalled for want of approvals and raw materials, companies could no longer generate cash flows and service their debt.

In the last five years, the debt of BSE 500 companies has risen about 20 per cent annually. But the increase in debt is not the only concern. In India, debt is concentrated in a few leveraged companies. Of the total debt for BSE 500 companies, the top 10 account for a third and top 20 companies half of the total debt.

About 40 per cent of total debt is owned by companies with debt-equity of more than three. Companies which are less solvent also form a large share of the total debt. About a fifth of debt is owned by companies that have interest cover of less than one.

Large banks in India carry high concentration risk. Within the PSU pack, in SBI, for instance, the share of the 20 largest borrowers in total loans was about 15 per cent in 2014-15. SBI’s share in overall bank lending is over a fifth. Similarly, PNB’s lending to the 20 largest borrowers is 15 per cent of its total loans, and that of Syndicate Bank, IOB, and United Bank is in the 13-17 per cent range. Central Bank has more than a fifth of its loans extended to such borrowers.

Within the private bank space, barring ICICI Bank in which the share of large borrowers in total loans is about 16 per cent, the others’ share is in the 10-13 per cent range.

High debt concentration throws up two risks for the sector. One, given the lacklustre performance of the corporate sector, defaults by large companies can result in huge losses for the banking system. This is particularly worrisome in PSU banks which already have a large pile of stressed assets. Private banks, on the other hand, have a much stronger balance sheet to withstand large defaults.

The second risk emanates from the fact that banks may not be able to extend loans to over-leveraged companies, to fund the next leg of growth in the economy. The RBI is now set to tighten banks’ exposure to a single or group of connected borrowers. The new norms, which will come into effect from 2019, will require Indian banks to substantially cut back their exposure to group companies, which under the current norms can go up to 55 per cent of the bank’s capital. According to the new framework, banks’ exposure to both single and group of companies should not exceed 25 per cent of their Tier I capital.

High debt concentration can hence, act as a stumbling block to increase lending aggressively in case of weak banks.

It is best to avoid stocks that have high debt concentration, large stressed assets and low capital base. Most PSU banks fall under this category. Punjab & Sind Bank, Central Bank, Vijaya Bank, United Bank, Syndicate Bank, Dena Bank, PNB and IOB have their 20 largest borrowers accounting for 15-26 per cent of total loans. Most of these banks also have a large concentration of bad loans. The top four’s non-performing assets (NPAs) account for about 13-20 per cent of their total gross NPAs (see chart 2).

It is usually insufficient to gauge the performance of a bank by the size of its balance sheet alone. It is more important to see how the banks’ assets have been financed. Banks that use more of their own capital to fund their assets in relation to their borrowed funds (deposits) are said to have high leverage.

Excessive leverage by banks came to light at the height of the global financial crisis, when many banks undertook aggressive lending without raising additional capital. The RBI in January this year, under the Basel III regulatory framework, revised its guidelines on the leverage ratio for banks coming into effect from April 1, 2015. The leverage ratio is defined as their capital measure divided by their exposure measure, with this ratio expressed as a percentage.

Capital measure for the leverage ratio is the Tier-1 capital and exposure measure is the sum of on-balance sheet exposures; derivative exposures; securities financing transaction exposures; and off-balance sheet items.

As a simplistic approach, let us look at the total bank leverage (ratio of assets to capital) for Indian banks. Most PSU banks have a high leverage of around 17 times. But the return on equity does not justify the risk. ROEs range from as low as 3 per cent to 13 per cent for PSU banks. Most large private sector banks, on the other hand, have low leverage of 9-12 times but have high ROE of 17-20 per cent. The problem with high leverage is that it magnifies profits when returns are healthy but it also blows up the losses in case of abysmal returns. With limited scope of improvement in earnings in PSU banks, at least over the next year or so, existing high leverage will inhibit lending, more so as the RBI sets limit of minimum leverage according to the rules laid out by the Basel Committee by 2017.

Investors should stick with banks that have a strong return profile and low leverage. Most private banks, such as YES Bank, HDFC Bank, CUB, Axis Bank, IndusInd Bank, ICICI Bank and Kotak Bank have a strong return on equity on relatively lower leverage. In the PSU basket, SBI is better placed than the rest of the players. (see chart 3)