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India Inc in the Centre of the Bad Loan Storm
May 18, 2017

During the financial crisis in 2008, when global financial behemoths were falling like a pack of cards, Indian banks were unscathed.

Their strong and conservative credit systems were greatly lauded at that time.

However, a few years down the line, they seemed to have lost the plot completely.

As the economic downturn gripped the country, not only did credit growth slow to multi-decade lows but souring loans that were extended to India Inc started to push banks down a deep chasm.

The state-run banks were the first to step onto the firing line. After the RBI's mandatory asset quality review in the latter half of 2015, public sector banks hamstrung with inefficiency and bureaucracy quickly fell to the mounting corporate bad loans.

On the other hand, private sector banks were in a much better position. Not only were their retail-focused operations witnessing robust credit growth, but even the loan defaults weren't too significant.

By the end of March 2016, the gross bad loans of public sector banks had shot up to 10%. At private banks, they increased marginally to 3%.

During the spiraling bad loan crisis, private banks were largely seen as safer than their troubled public sector counterparts.

The perceived safety of some of these private sector banks has turned out to be a mirage, an illusion of water created by burning sands in deserts.

This became amply clear after a recent RBI notification mandated banks to report diversion in their reported and audited NPA numbers (varied more than 15%).

Turns out Yes Bank was the most errant bank.

It reported a gross bad loan ratio of 0.76% for FY16, much lower than the 5% as per the RBI audit.

Meanwhile, the stock gained more than 70% in the twelve months of FY17.

Yes Bank defended its action claiming remedial measures have reduced the divergence in FY17.

But the fact of the matter is that Yes Bank underreported its bad loans.

Reportedly, other private sector banks also kept their bad loans under wraps.

The question now is how much can we trust these banks? They failed to be fair and transparent in disclosing bad loans, which are an important metric to judge their risk preparedness and ultimately their earnings capability.

All this while, markets were giving state-run banks the short end of the stick as most of them were left with bloated bad loans after their asset review in 2015.

However, private sector banks continued to enjoy the market's goodwill by keeping bad loans to the minimum despite registering robust growth.

Clearly, banking on the clean image of private banks had its pitfalls. The stock of Yes Bank has corrected just 10% from its peak after its bad loans came to light in FY16. But lack of transparency could go a long way in hurting the credibility and valuations of select private sector banks.

At Equitymaster, we never get carried away by the favourable dynamics of a sector. Rather, we've always followed a rigorous bottom-up approach to stock picking.

Even at the height of the bad loan crisis, we steered clear of private sector banks that were growing recklessly. After conservatively weighing risk management capability, only a few private sector banks made the cut for our large-cap recommendation service Stockselect.

In hindsight, it's easy to identify a mirage. But in the heat of the desert, only a seasoned eye can discern the deception. A bottom-up strategy is the only shield against wealth-destroying mirages.

Data Source: RBI
Note: As on 30th September 2016

This Chart Of The Day was published in The 5 Minute WrapUp - Why We Skipped This 70% Gainer

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