When stimulant becomes depressant for banks
Editor’s note: Are market rallies ignoring the ground realities? Perhaps not. But are investors too optimistic about recovery? Maybe yes. This dilemma is unlikely to end soon. As you know, banks are considered the pancreas of an economy. And the cornovirus pandemic has not only attacked the respiratory system of many susceptible people but has also struck the pancreas of the global economy. India has been no exception to this phenomenon.
This is the part-1 of our special coverage on the economic impact of coronavirus pandemic on the banking industry. In the part-2, we will discuss how Indian banks are likely to perform under strenuous conditions. To take advantage of market volatility, you must do your homework right.
Bailouts and bankruptcies are two sides of the same coin—failure. And fortunately (or unfortunately), the decision of saving a company or letting it rest in peace doesn’t depend on viability and sustainability; it’s almost entirely based on how big the impact would be. The bigger the social, financial, economic and political impact, the greater would be the chances of getting a bailout.
Last month, the US government offered a USD 25 billion bailout package to the airline industry; comprising grants, low-interest loans and warrants allowing the treasury to purchase stake in airline companies. This was an attempt to provide payroll support to the crashing airline industry. American Airlines received USD 5.8 billion (of the USD 25 billion bailout package) of which USD 4 billion came in the form of grants. Any company accepting the payroll support can’t announce any major layoffs or pay-cuts until September this year and it can’t pay dividend or buy back shares through September 2021.
An independent investigation done by Forbes has made startling claims. A report titled Inside the USD 2.5 trillion debt binge that has taken S&P 500 titans including Boeing and AT&T from bluechips to near junk reveals that out of 455 of S&P 500 companies (which excludes banks and cash rich companies) on an average, companies acquired a dollar of debt for every dollar of revenue earned over the past one decade.
Since March this year, at least 60 corporations have filed bankruptcies and the list is increasing with every single passing day. The five-year average of yearly borrowings by the corporations in the US has been USD 1.3 trillion. However, companies have borrowed nearly USD 1 trillion in just first five months of 2020—including the likes of Boeing, Oracle and AT&T which have collectively borrowed close to USD 58 billion.
Clearly, the next few quarters will be crucial for the US’ banking industry. If that’s the case with the world’s largest economy which has the privilege to print the world’s reserve currency, it’s crucial to see where the Indian banking system stands on this backdrop.
At the grassroots level, the picture looks grim but these tough times may also offer some excellent opportunities to banks that have been doing their business judiciously and managing risks well.
Let’s do in-depth analysis of India’s banking system.
Stimulus package and monetary support…
As far as India’s stimulus package is concerned, there’s neither any bailout so far nor has there been anything paid in the form of grants. The government has taken measures to ease the liquidity situation in the economy but unfortunately that’s not helping either. Banks have become extremely risk averse, and rightly so. They are happy to park Rs 7-8 lakh crore in reverse repos but aren’t lending.
The government recently instructed the banking officials of Public Sector Banks (PSBs) to lend without bothering about 3Cs— Central Bureau of Investigation (CBI), Central Vigilance Commission (CVC) and Comptroller and Audit General (CAG). As part of the economic stimulus package, the government has announced 100% guarantees to loans extended to MSMEs worth Rs 3 lakh crore.
Autonomy of these institutions? That could be a topic of discussion some other day.
But why does the government have to send such extreme messages to bank officials?
It’s a clear indication that neither the government nor banks are willing to take on the risk of default straight away. Although loans are backed by 100% sovereign guarantees, defaults would first reflect on the balance sheets of banks as Non-Performing Assets (NPAs), and would have to go through the standard procedure of asset classification. That’s the major pain point of banks.
Moreover, the government not only deferred the Insolvency and Bankruptcy Code (IBC) for one year but also increased the threshold required to invoke the law to Rs 1 crore, from Rs 1 lakh required earlier to offer immunity to MSMEs hit by the coronavirus pandemic.
The loans that are expected to be disbursed automatically to eligible borrowers won’t have any interest rate subvention—unlike corporations get in the US.
The government needs to decide whether or not it is wise to insist that PSBs lend (when they are not willing to lend for fundamental reasons) and then spend crores of Rupees on recapitalizing them. PSBs still have a dominant share of approximately 59%.
Instead of that, the option of slashing policy rates (in the hope of better transmission) has been sought out.
Who’s benefiting from the falling policy rates? Banks aren’t keen on lending and have also been reluctant to pass on the benefits of rate cuts to their borrowers to the fullest. But when it comes to deposits, the policy rate transmission is quite seamless.
Reason? The cost of NPAs is high and someone has to bear it.
The government initially offered a moratorium of 3 months to begin with and extended it further for 3 months.
On top of that, RBI issued three crucial directives
- Accounts which were standard on March 01, 2020 and have been granted moratorium, shall exclude the moratorium period for the 90-day NPA recognition norm.
- In respect of accounts which were classified as Special Mentioned Accounts (SMA) 02 and subsequently opted for moratorium, banks shall make at least 5% provision for the quarter ended on March 31, 2020 and another 5% in the quarter ending on June 30, 2020.
- Banks shall not pay dividend from profits relating to the FY20 until further instructions.
These three directives, when read together, suggest that RBI has been preparing Indian banks for handling greater distress in future. Now it remains to be seen, how well-prepared Indian banks are.
To understand the implications better, you may now want to know the standard NPA-recognition process flow.
NPA is a loan account whereon the payment of interest or principal or both has been due for a continuous period of more than 90 days. Further, to identify the level of stress RBI has directed banks to maintain 3-layer classification based on the tenure of non-payment—known as Special Mention Accounts (SMA)
Under normal circumstances, many accounts classified as SMAs don’t reach to the level of NPAs because borrowers manage to source funds to remain in the standard bucket. Under current circumstances, not only could they find it difficult to source money but if they have opted for a moratorium, banks may not know about their latest credit behaviour until September. The NPA recognition will kick in only in December.
- Suppose an account was standard on February 29, 2020 (just before the moratorium 1.0 was announced)
- The borrower opted for moratorium 1.0 as well as moratorium 2.0
- It means, the account will remain standard and will be classified under the “regular” bucket. If the borrower fails to pay for 90 days, starting from September 01, 2020, only then the asset would be recognized as NPA
Credit environment in India wasn’t encouraging even before the coronavirus pandemic broke out. Instances such as IL&FS and DHFL which were considered one-offs didn’t happen in isolation.
Is India going to witness another NPA cycle?
To answer this question, we must know the level of stress in the pre-pandemic time, among other things.
Industry experts believe, the level of stressed assets in the Indian banking system just before the pandemic broke out was higher than the levels seen in September 2019. If you are an equity investor and hold any banking stock in your portfolio it’s imperative for you to understand the present macroeconomic environment as well as the industry-level state of affairs.
Efficiency of management and buoyancy in risk management will decide which banks emerge as winners in the post-pandemic era. Part-2 of this special coverage will address that topic.
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We do not have any financial interest of any nature in the company. We do not individually or collectively hold 1% or more of the securities of the company. We do not have any other material conflict of interest in the company. We do not act as a market maker in securities of the company. We do not have any directorships or other material relationships with the company. We do not have any personal interests in the securities of the company. We do not have any past significant relationships with the company such as Investment Banking or other advisory assignments or intermediary relationships. We are not responsible for the risk associated with the investment/disinvestment decision made on the basis of this blog article.