By Invitation. Profit blips don’t mean a banking crisis

As expected, banks have posted massive declines in profits and even unprecedented losses, confirming our worst fears. While the problem has been around, this time it has impacted even the biggies — SBI and ICICI Bank.

While both the RBI and the Government are allaying fears of any deep-rooted problem, calling the exercise (banks were directed by the RBI to recognise certain assets as bad loans in the December and the March quarter) necessary to get the system going again, there are a few issues that need highlighting.

First, the problem is being viewed as a ‘crisis’, from the narrow perspective of profitability and market valuations.

As this writer has been arguing, for a financial intermediary, it is liquidity and not profitability that is critical; lending per se is a fragile business with wafer-thin margins that quickly turn negative if bad debts shoot up.

This is clear when we look at the results of banks for the nine-month period ending December 2015.

We need to worry more about liquidity and asset-liability mismatches than temporary impairments in profits. The liquidity deficit of the banking system is now in the open, caused by bad debts and made worse by declining deposit growth. But markets go by profits and asset values and therefore reward and punish them solely on these scores.

Unfortunately, neither the published cash flow statement nor the liquidity ratios in the annual reports reveal enough about the impact of bad loans.

Secondly, the greater fallout of the crisis is on credibility — of regulators, of the lending business and of accounting.

Financial institutions are a different breed, unlike conventional business where it is easier to correlate income and profits with business or economic parameters. For banks, we have to only rely on what their auditors tell us. That is why the calibrated management of bad loans by banks makes us uncomfortable, as it is hard to judge the extent to which their reported income, profits and asset values are overstated.

Many of the banks have warned that worse is to follow in the coming quarters. There is a pithy aphorism about accounting that rings true here — profit is an opinion, cash is a fact.

With over 75 per cent of the NPAs (non-performing assets) contributed by public sector banks, over whom the RBI exercises significant control, it could have cracked the whip much earlier and smoothened the scaling down process.

The RBI has nominee directors on the boards of these banks, it conducts regular inspections and is privy to a large amount of operational data.

To be fair, the RBI had given them a long rope — asset sales to SRCs, debt restructuring, strategic debt conversion, special schemes for infrastructure sector and so on; but as it turned out, these were not successful and only served to postpone the inevitable, which is probably why the RBI decided to bite the bullet now.

Finally, going by all the reactions, it looks like we believe that this ‘take a bath’ accounting is all that is needed to get banks raring to start lending again.

This is simplistic because the deep-rooted factors that led to the accumulation of NPAs remain — poor credit appraisal and governance issues, the eternal problem of finding long-term finance sources for core and infrastructure sectors (remember that just five sectors contribute to over half the total NPAs), the absence of an effective mechanism to deal with bad loans and the lack of a vibrant secondary debt market, to name a few.

Unless we address these issues quickly, mere accounting clean-up will only amount to resetting the meter. Moreover, private corporate investment is muted and credit off-take is unlikely to go up significantly; neither are banks now keen on wholesale credit and are growing their retail portfolios massively as a risk reduction strategy (that retail NPAs of banks are also rising is another story).

Both the RBI and the Government have their tasks cut out — the former needs to ensure that banks sharpen credit appraisal and risk management practices and improve governance, while the government needs to not only provide the much needed capital but, more importantly, the necessary autonomy to ensure that banks function on sound commercial lines.

The writer is an independent consultant