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Why India’s bad loan problem is really bad

LiveMint logoLiveMint 12-06-2017 Tamal Bandyopadhyay

Last week, Spain’s largest lender Banco Santander SA announced taking over struggling Banco Popular Espanol SA for a symbolic value of €1. Santander also plans a €7 billion ($7.88 billion) rights issue to infuse capital and provide for the bad loans of Popular, the country’s sixth biggest bank.

The European authorities, led by the European Central Bank, were behind the rescue act. Popular had been struggling under the burden of €37 billion of bad loans in the real estate sector but Santander feels that this deal will accelerate its growth and profit from 2019. Analysts also see an opportunity for Santander in Popular’s small and medium-sized corporate loan portfolio; besides, Santander can also sell off Popular’s property assets.

The sale, which was stitched at the speed of light, did not impact stock markets. In fact, bank stocks rose in Europe last Wednesday after it was announced at 0430 GMT in Brussels by the Single Resolution Board, an agency formed by the European Union to wind down sick banks. 

Indeed, there are differences between the state of affairs in Popular and some of the state-owned Indian banks (Popular was facing a run on its deposits), but is the Santander-Popular deal something which can be emulated in India? Corporate assets have soured for many government-owned banks but they have their pockets of strength—retail loans, relatively low-cost savings and current accounts, non-core assets, a vast branch network.

How do we solve the bad loan problems? There are two distinct trends before us: Spain believes in swift action, while Italy allows the problem to fester for years. Should we go the Spain way or continue with our band-aid approach? It will be interesting to hear what India’s finance minister Arun Jaitley says when he meets the heads of public sector banks and financial institutions later on Monday to review their performance.

The new ordinance gives the Reserve Bank of India (RBI) powers to force banks to sort out issues in a time-bound manner by forming multiple oversight committees and encourages banks to take haircuts. Besides, RBI can now move the insolvency court against the bank defaulter on its own. However, it does not say how the holes in banks’ balance sheets will be filled in the aftermath of the cleanup drive.

Meanwhile, it may not be a bad idea to ask two key questions and seek the answers.

How did the Indian banking system get into the mess?

There have been multiple reasons behind this. The popular way of looking at this is the state-owned banks are inefficient—they do not have the expertise in credit appraisal and monitoring of loans. This could be an over-simplification of the real causes behind the pile of bad loans. Indeed, in relative terms, private banks are better off but in those sectors where both private and public banks have taken exposures, both have almost equally suffered. The private banks have much less bad assets because they have not given loans to certain sectors/corporate groups.

Why did the public sector banks take exposures to those sectors where private banks fear to tread? In some cases such as infrastructure, there was subtle and not-so-subtle nudge by the government, the majority owner of these banks. Besides, most of these banks also have a herd mentality. Once one bank gives a loan to one particular sector, others follow it almost blindly in search of balance sheet growth.

In the aftermath of the collapse of iconic US investment bank Lehman Brothers Holdings Inc. in September 2008, growth collapsed in the world, but India was almost insulated from that with the government unveiling massive economic stimulus programmes. RBI cut its policy rates to a historic low and flooded the market with liquidity and banks gave loans indiscriminately. The “boom” lasted for a few quarters but the “bust” that followed has been continuing for years. Most banks misread the economic scenario.

Also, post-Lehman collapse, the deposit growth for private banks slowed while the government-owned banks were flooded with money and that, in many cases, led to misallocation of capital.

How bad is the bad loan scene?

Well, it depends on through which prism do we want to look at it. Going by rating agency Icra Ltd’s latest analysis, gross bad loans of Indian banks in March 2007 has been 9.5% of their loan portfolio. After setting aside money, or making provisions, the net bad loans are 5.5%.

This is one way of looking at the problem but it does not tell us the real story. One needs to add to this the loans that have been restructured under different schemes and the many large accounts which are extremely vulnerable as the borrowers are over-leveraged and not in a position to service the loans regularly. If we add all these, then the total stressed assets could be close to 16% of bank loans.

Again, this does not reveal the full picture. We also need to add to these the loans that have been written off. Unlike in other parts of the world, in India, written off loans are taken out from banks’ balance sheets but they are parked in the branches of banks and as and when part of those loans are recovered, they add to banks’ profits. By taking them off from the banks’ balance sheets, an optical illusion of lower bad loans (in percentage terms) is created. If we add the written off loans to the pile, the overall stressed assets could be as much as 20% of banks’ loan assets.

Banks’ exposure to large corporations and infrastructure sector has been most affected. In this segment, bad loans could be as much as 35-40% while the retail loans are in fine health.

It’s needless to say that the private banks are much better off than the state-owned banks. For instance, in March 2007, public sector banks’ gross bad loans have been 11.4% versus private banks’ 4.2%; their net bad loans at 6.7% are more than three times the net bad loans of private banks.

Finally, bad loans as a percentage of overall loan portfolios of banks do not explain the enormity of the problem. We need to look at the bad loans against the backdrop of the net worth or capital and reserves of the banks. In March 2017, for the industry, it’s close to 50% and for private banks, around 13%. However, the average bad loans of the government-owned banks are 75.53% of their net worth; for many, they have exceeded their net worth. This is why both RBI and the government are worried. We need to address the problem now; there is no time to lose.

 Tamal Bandyopadhyay, consulting editor at Mint, is adviser to Bandhan Bank. He is also the author of A Bank for the Buck, Sahara: The Untold Story and Bandhan: The Making of a Bank.

His Twitter handle is @tamalbandyo.

Respond to this column at tamal.b@livemint.com.

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