All you wanted to know about...bad loan divergence

Many of us are in the habit of pushing away a hard task for a later date, in the hope that it will become easier with time. That is precisely what banks seem to have been doing with their bad loans, hiding them in the complex jumble of numbers that make up their books of account, in the hope that the bad loans could turn good with passage of time.

But the RBI is not having any of that. It has asked banks to come clean about the true state of affairs. While this is hurting banks’ earnings and the investor sentiment, this clean-up could hopefully help over the long run.

What is it?

The RBI in a circular last year on ‘Disclosure in the Notes to Accounts to the Financial Statements – Divergence in Asset Classification and Provisioning’, had stated that there have been instances of material divergences in banks’ asset classification and provisioning from the RBI norms, thereby leading to the published financial statements not depicting a true and fair view of the financial position.

The RBI had also laid down specific conditions when disclosures have to be made — the mandated provisioning by the RBI exceeded 15 per cent of published profit after tax for the period under question or additional gross NPA identified by the RBI exceeded 15 per cent of the published figure.

As if on cue, since the issue of the circular, banks have been disclosing sharp bad loan divergences from their reported numbers for two consecutive fiscals (FY16 and FY17).

For instance, Axis Bank reported ₹6,087 crore as gross non-performing assets (GNPAs) in FY16. As assessed by the RBI, the GNPAs were ₹15,565 crore — implying a sharp divergence of ₹9,478 crore. The bank has gone on to report another ₹4,867 crore of divergences pertaining to FY17. YES Bank reported a divergence of over ₹6,000 crore for FY17.

SBI reported bad loan divergence of a whopping ₹23,239 crore in FY17.

Why is it important?

Over the last two to three years, the RBI has single-mindedly focussed on cleaning up banks’ balance sheets.

First came the asset quality review, or AQR, in 2015, that mostly impacted public sector banks.

A chunk of the slippages emerged from the so-called restructured accounts — wherein the original terms and conditions of loans are relaxed to provide a breather to borrowers facing financial stress.

The flushing out of the rot in banks’ books through AQR proved inadequate as banks, continued to witness sharp slippages.

The central bank’s annual risk-based supervision leading to disclosure of huge divergences by banks, has become another key parameter die-hard investors and analysts need to watch out for.

Why should I care?

‘NPAs’, ‘AQR’, divergence, et al are not just high-flying banking jargon. Each has far-reaching implications on the financial health of your bank.

When a borrower defaults in his payments, banks are required to set aside a portion of their earnings as provisions towards these loans to provide a buffer in case of future losses. A sharp rise in NPAs can hence erode a bank’s profits.

Sharp divergences spell doom when banks carry insufficient capital to absorb sudden losses on account of increase in bad loan provisioning. Since much of banks’ activities are funded by deposits, and have to be repaid at a future date, it is imperative that a bank carries sufficient amount of capital to remain viable.

Bottomline

The next time your bank reports bad loan divergences, sit up and take note.

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