Others

Others

The Indian banking sector is in deep trouble. No, I am not referring to the 25%-50% crashes the stock prices of lenders such as DHFL,IIFL or Edelweiss or the huge liquidity crunch that threatens the operations of several lenders, forcing RBI to raise the single-borrower lending cap for NBFCs by 50% (from 10% of assets to 15%). These are, but, temporary blips in the larger scheme of things.Finance professionals use the term "Asset-Liability-Mismatch ( ALM )" for this kind a problem resulting from the divergence between the tenure of a lender's borrowings and the maturity of its loan assets. During credit-booms, this is less of a problem as liquidity needs can easily be met through short-term borrowings such as commercial papers. However, when market conditions are not favourable, liquidity is either unavailable or too expensive, thus leading to financial instability.As the panic ensuing from the IL&FS default settles down, as the USD-INR exchange rate stabilizes and lenders learn all over again (as they do every few years) that borrowing short-term (via Commercial Papers for example) and lending long-term (3 years -20 years) is not a smart thing to do, things will be back to normal as far as this problem is concerned. I say this with confidence because most NBFCs that matter have healthy books with asset quality being reasonably good, (system-wide GNPA of NBFCs stands at 5.8% according to RBI) capital ratios being healthy (Capital to Risk Weighted Assets i.e. CRAR standing at 22.9% according to RBI 's FSR report). I am equally confident about the RBI's willingness to intervene should things start to deteriorate.This discussion is neither about ALM (not to be confused with Asset-Liability-Management) nor about tick-by-tick movements- neither of which will likely affect the banking landscape significantly in the long term . This is about how the very nature of the banking system is changing rapidly and how banks face a choice i.e.- adapt or die!The credit quality situation in the banking sector is nothing short of unprecedented. At 12.3% of loans outstanding Non- Performing-Assets (bad loans) are at unsustainable levels. Deposit growth in FY 18 was paltry, coming in at 7%- the worst in atleast 10 years. Credit growth was an anaemic 10%, down from the heydays of 2011 when it was 21.5%. The banking industry (at an overall level) was unprofitable in the latest financial year, losing Rs 43,000 crores - appalling given it is the only industry in the world that can legally create money out of thin air! (I will explain how this is done later)Source - Monsoon CreditTechRBI's data shows that while Gross NPA rates have gone up steadily (from 3.9% in FY 14 to 12.3% in FY 18), credit growth has slowed significantly (from 13.9% in FY 14 to 8.2% in FY 17 before recovering slightly to 10% in FY 18). All this while, the Return on Assets (measure of how profitable the banks are) have plummeted from 0.7% to -0.3%.Lending consists primarily of three segments- Corporate lending, small business lending and consumer lending. Out of about a $1.2 trillion in loan assets (banking-system wide), consumer credit accounts for about $345 billion, small business credit for about $70 billion and corporate credit for most of the rest Corporate loans in general are seeing more stress than usual. A detailed reading of RBI data shows that sectors such as metals (46.3% NPAs) & engineering (34.4% NPAs) are in much worse shape than others such as chemicals (8.8% NPAs). However, what is concerning is that retail lending- the segment considered the safest of the lot is showing signs of stress. A CRIF study shows that roughly 10.04% of all unsecured retail loans are under stress. Small business loans ( MSME ) are also under duress with analysts putting the NPAs in this sector at about 10-11%. No matter which way you look at it, our system-wide NPAs are some of the highest in the world - even worse than those of Bangladesh, Pakistan and Botswana One explanation for the banking sector stress often cited by experts is - Demonetisation. They argue that the withdrawal of nearly Rs 15 trillion in currency led to a massive monetary shock that stressed businesses and individuals alike, creating the current banking crisis. Another explanation for the massive asset quality stress, especially in the MSME loan portfolio is that the Goods and Services Tax adversely affected the financial health of small businesses due to uncertainties involved in the transition process. A close look at the NPA data paints a very different picture.While it is not my contention that demonetization & GST had no effect on the NPA problem, the banking system had a clear problem even before either event, with overall Gross NPA rate of 9.4% in September 2016 (before both Demonetization and GST). Indeed, overall banking GNPA did go from 7.9% in FY 16 to 9.6% in FY 17 and then again to 12.3% in FY 18. So, while it is entirely plausible that GST, Demonetization and RBI's new prudential norms exacerbated an existing problem, the data simply doesn't support the explanation that the bad-loan crisis is due to any of these factors.BCG data shows that historically, PSU banks such as State Bank of India cornered most of the market when it comes to deposits & loans (the core business of banks). However, those days seem to be gone with privately owned banks & NBFCs now accounting for 76% of incremental lending (new loans made this year) and 60% of incremental deposits! No wonder PSU banks now only account for 64% of all outstanding loans, down from 71.6% in FY 15- a fall of 760 bps in just 3 years. All of this suggests that agile privately-owned banks & NBFCs are snatching market-share rapidly from what many commentators see as bureaucratically run, conservative PSU Banks.Source - Monsoon CrediTechWhile the common man usually tends to think of PSU banks as heavily process-oriented and conservative, the fact is that their asset quality is in far worse shape than their private peers. Compared to the industry average of 12.3% GNPA rate, PSU banks have a GNPA rate of 15.6% while their private peers are doing much better with a GNPA rate of 4% (4.4% including restructured advances). What is also interesting is that there is a huge divergence between the asset quality at different private banks. For example, HDFC Bank reported pristine asset quality (a mere 1.3% GNPA) in sharp contrast to the likes of ICICI Bank and Axis Bank which reported GNPA rates of 8.84% and 6.77%.However, what is clear as day is the fact that Private banks and NBFCs - with reasonable asset quality and a healthy capital cushion (reflected by their CRARs) are best positioned to take away market share from the PSU banks which simply do not have the capital cushion required to absorb the massive of bad-loans on their balance sheets. The market understands this fact. No wonder all PSU banks combined account for less than 30% of the market capitalization of the private banks (combined) despite accounting for nearly twice the advances outstanding as their private peers.The fact is that 19 of the 21 PSU banks in India reported losses in FY 18 while virtually all private banks & large NBFCs reported profits, although there was a fall in overall profitability. A large part of this can be explained by the stark differences in asset quality. The math is simple- if you are earning 4%-6% interest spread (difference between your lending rate and your cost of borrowing) on an average loan but end up having 12.3% of all your loans under water, you are going to lose a lot of money. (The spreads vary depending on the loan product) This is exactly what is happening.No wonder, the banking industry as a whole lost Rs 43,700 crore in FY 18. The question to address is - why is this happening and what can be done about it? Those are questions we will take up in the next article in this series.Ashwini Anand, CFA is the Founder of Monsoon CreditTech, a machine learning company that works with some of India's premier lenders to help them make better credit decisions leading to lower delinquency rates, higher approval rates and better portfolio profitability.