Why the worst may not be over for banking stocks

If 2015 was a sombre year for the Indian stock market, then 2016 has started off on a catastrophic note. With about a third of the weightage in the Sensex, banks and financials have led the fall in recent weeks. Banking stocks have been falling like a pack of cards, led by their weak performance in the latest December quarter.

What has added to banks’ bad loan woes is the RBI’s intensive asset quality review (AQR), as part of its cleaning-up exercise of banks’ stressed assets. It has asked banks to declare certain accounts as bad loans, even if these loans are not delinquent.

Bad loans that have shot up to 4.6 per cent in 2014-15 from 2.7 per cent of four-year ago levels, have been a growing cause for concern. Public sector banks, which are the biggest contributors to stressed assets, have seen both their bad loans and restructured assets rise.

Earlier, CRISIL had estimated bad loans to rise to around ₹5.3 lakh crore or 6.3 per cent of total advances by March 2016. But this was before the severe downturn in commodity prices and the RBI’s asset quality review. Going by the amount of bad loans declared by banks in the latest December quarter, the overall stress in the banking system can be far worse.

For instance, Axis Bank added about ₹1,000 crore to bad loans on account of AQR, while ICICI Bank added ₹4,000-odd crore. Public sector banks have taken it harder on the chin. Punjab National Bank, the third-largest PSU bank, added over ₹5,000 crore due to AQR. SBI, India’s largest bank, has added about ₹20,000 crore of fresh bad loans in the December quarter, more than thrice that it added in the previous quarter.

Sharp and sudden spike in bad loans have increased banks’ provisioning for bad loans, impacting earnings substantially.

The RBI’s intent is to have clean and fully provisioned bank balance sheets by March 2017. Fear of sudden spikes in bad loan provisioning in the coming quarters has turned investors jittery. But the apex bank’s Governor in an effort to quell these concerns, on Thursday, stated that the AQR was done to ensure that banks were taking proactive steps to clean up their balance sheets to support economic growth. Once the clean-up is done, Indian banks will be restored to health, he assured.

But there are several risks to this optimistic view.

The Governor points that the additional provisioning under AQR has been made to absorb likely losses. These can be written back if these losses do not occur. While this can be a possibility over the next year, as the economy gradually recovers, there are various other factors that can play a spoilsport. Many PSU banks were under-provided for stressed assets even before the AQR was brought in to force.

PSU banks maintain far lower provision coverage (extent to which a bank sets aside funds to cover loan losses). Based on the data as on March 2015 (for listed players), the shortfall in provisions is almost 30 per cent of PSBs’ net worth.

In the past, the real worry has been the large amount of loans that have been restructured on the pretext of extending a ‘lifeline’ to businesses. The RBI closed this window last year. But it allowed banks to restructure loans under Strategic Debt Restructuring and the 5:25 scheme instead. These loans, not classified as bad loans carry only a marginal provision. PNB, for instance, has about ₹14,000 crore worth loans restructured under these two schemes, for which it has made about 2-3 per cent provision (against 15 per cent made for bad loans).

This throws open the possibility of sharp increase in provisioning in future, if losses arise on these accounts. The RBI has indicated its comfort on the commitment of the Centre to infuse capital in PSBs. But there is already a debate on whether the ₹70,000 crore of capital infusion earmarked over the next four years will be sufficient. Add to this is the concern that in the past capital infusion has hurt the interest of investors. Infusion at an abysmal price, leads to increase in equity base and dilution in book value, thus undermining market prices.

So, should you stock up on PSB stocks that are trading at 0.3-0.5 times book value? Not quite. Valuations based on banks’ book value can be misleading. This is because, if we adjust the book value for the entire bad loans and 30 per cent of restructured assets, PSU banks will trade close to their book value (adjusted) or more.

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