India’s state-owned banks are currently reporting nightmarish quarterly earnings, but Raghuram Rajan, governor of the Reserve Bank of India (RBI), isn’t losing sleep over it just yet.
On Feb. 11, the State Bank of India, the country’s largest lender, reported a massive 62% drop in quarterly profits. Earlier in the week, Punjab National Bank, another state-owned lender, reported a 93% drop in net profits for the quarter ended Dec. 31.
An unflappable Rajan remarked that the quarterly results “have not been, to put it mildly, pretty.”
All these banks have only one thing to blame: non-performing assets (NPAs) or bad loans. NPAs are loans where the interest or principal has not been paid for more than 90 days. Rajan has set a target of March 2017 for banks to make provisions—or set aside funds—to cover the default risk of these NPAs.
Rajan explained the need for these provisions to clean up toxic balance sheets. Speaking at a banking conclave in Mumbai on Feb. 11, he said the clean-up process—or, the Asset Quality Review (AQR)—is one of the reasons for shrinking profitability.
In his speech, Rajan stressed on why the timing was right and described the gravity of the situation. He then explained the process. Here are excerpts:
On the size of stressed assets problem
There are some wild claims being made by some financial analysts about the size of the stressed asset problem. This verges on scare-mongering. Our projections are that any breach of minimum core capital requirements by a small minority of public sector banks, in the absence of any recapitalization, will be small. They will need government equity or preference share infusion since they are typically banks that will find it difficult to raise equity in the markets. A few others will need a top up of their capital to ensure they have a reasonable buffer over and above minimum capital. What the government has already explicitly committed is, in our view, enough to take care of all reasonable scenarios, and the government has committed to stand behind its banks to whatever extent needed. The RBI will provide whatever liquidity is needed, by any bank that needs it, though we do not foresee liquidity stress.
In sum, while the profitability of some banks may be impaired in the short run, the system, once cleaned, will be able to support economic growth in a sustainable and profitable way. The economic assets of our public sector banks, such as the trust they are held in by the population, their knowledgeable employees, their location and reach, and the low-cost funding they have access to, can then be fully realized.
The process of cleaning up
There are two polar approaches to loan stress. One is to apply Band-Aids to keep the loan current, and hope that time and growth will set the project back on track. Sometimes this works. But most of the time, the low growth that precipitated the stress persists. The fresh lending intended to keep the original loan current grows. Facing large and potentially unpayable debt, the promoter loses interest, does little to fix existing problems, and the project goes into further losses.
An alternative approach is to try to put the stressed project back on track rather than simply applying Band-Aids. This may require deep surgery. Existing loans may have to be written down somewhat because of the changed circumstances since they were sanctioned. If loans are written down, the promoter brings in more equity, and other stakeholders, like the tariff authorities or the local government, chip in, the project may have a strong chance of revival, and the promoter will be incentivised to try his utmost to put it back on track.
But to do deep surgery such as restructuring or writing down loans, the bank has to recognize it has a problem—classify the asset as a non-performing asset (NPAs). Think, therefore, of the NPA classification as an anesthetic that allows the bank to perform extensive necessary surgery to set the project back on its feet. If the bank wants to pretend that everything is all right with the loan, it can only apply Band-Aids—for, any more drastic action would require NPA classification.
The most plausible explanation I have is that the stressed balance sheet of public sector banks is occupying management attention and holding them back, and the only way for them to supply the economy’s need for credit, which is essential for higher economic growth, is to clean up. The silver lining message in the slower credit growth is that banks have not been lending indiscriminately in an attempt to reduce the size of stressed assets in an expanded overall balance sheet, and this bodes well for future slippages. In sum, to the question of what comes first, clean up or growth, I think the answer is unambiguously “clean up!” Indeed, this is the lesson from every other country that has faced financial stress.
Some citizens are outraged by the size of the losses that will have to eventually be absorbed and want the perpetrators to be brought to justice. Let me emphasize that all NPAs are not because of malfeasance. Indeed, most are not. Loans can go bad even if the promoter has the best intent and banks do the fullest due diligence before sanctioning. Nevertheless, where there is evidence of malfeasance by the promoter, it is extremely important that the full force of the law is brought against him, even while banks make every effort to put the project, and the workers who depend on it, back on track. This is why we have strengthened the fraud detection and monitoring mechanism, and look forward to bank support to make it effective.