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Banks: Vending NPAs - Views on News from Equitymaster
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Banks: Vending NPAs
Sep 28, 2005

Non performing assets (NPAs) or in generic terms ‘repayment defaults’ is an operational hazard that players across the banking and financial services industry vehemently try to avoid. This is because, NPAs not only add a stigma to the bank’s repute about the quality of lending but also scares away depositors from parking their funds with the bank. An interesting find by ‘Economist’ reveals that, in India, although there have been few instances of ‘bank failures’, several have defaulted on their debt (see chart). This is because, usually, banks were bailed out by the government (read RBI) or rescued in some other way to avoid a failure. Thus, the instances of bank failures are lower as compared to bank defaults, albeit the former being artificially adjusted. However, given the sector’s gradual shift towards ‘openness’ to foreign competition (until 2009), such arbitrary favours will have to be done away with.

Over the years, the RBI has also adopted a proactive approach when it comes to tightening the ropes in terms of asset quality in the banking sector. The same has been evident in the policy initiatives taken by the apex bank in terms of enactment of the Securitisation Act and drafting guidelines for the purchase/sale of NPAs. In response to the same, the level of delinquency has registered an appreciable decline, especially in the case of PSU banks.

However, the heartening fact is that, of late, banks have also not shied away from adopting the unconventional means of offloading the NPA burden from their books. ICICI Bank has proposed to auction Rs 15 bn worth of bad assets that will reduce its net NPA to advance ratio from 2% in FY05 to 1% by FY06. Also, the likes of Kotak Bank and Centurion Bank find purchase of stressed assets a profitable business proposition, as they believe they can recover a decent premium over the price they pay for the loans.

How will the sale of NPAs help?

  • Provide liquidity: Banks are taking the direct route to selling bad loans instead of going through an asset reconstruction fund, as they can get cash upfront therein, while the ARCs (asset reconstruction companies) offer security receipts that are encashed after assets are sold. Also, the auction will offer a better price discovery mechanism. Internationally, bad loans are auctioned at a 70% to 80% discount to their value and thus, the deal proves to be profitable to the purchasing bank if it can recover a higher amount from the stressed asset.

    Given the lack of low cost deposit mobilisation, the sale of loans will also provide capital to fund the banks’ credit growth and expansion needs. The additional liquidity will ease pressure on the banks’ net interest margins that is otherwise likely to get squeezed if the banks opt for high cost deposits.

  • Reduce provisioning liability: While stressed assets not only eat into the capital (CAR) of the bank due to their higher risk weightage, banks also need to incur provisioning liability as per the RBI guidelines, depending upon the classification of the stressed asset (i.e. substandard, doubtful or loss asset). The same erodes the bank’s net profit margins. Thus, offloading the stressed assets will not only free additional capital (especially given the Basel II requirements) but also reduce their provisioning requirements.

  • Enhance asset quality: Needless to say, offloading the stressed assets will augur well in terms of asset quality of the banks (net NPA to advances), a very important parameter in judging the operational efficiency of banks.

  • Improve valuations: In distinction to companies from other sectors that are valued on the basis of forward earnings, companies across the banking sector are valued on the basis of their forward adjusted book value (i.e. book value less net NPAs). It thus goes without saying that a smaller quantum of NPAs will enhance the banks’ adjusted book values, thus calling for better valuation.

Our view
Sale of NPAs has been encouraged with a view to develop a healthy secondary market for non-performing assets where securitisation and reconstruction companies are not involved. However, the success of the same will depend on the banking entities’ strict adherence to the regulator’s guidelines regarding recording of NPAs in the books of the purchasing bank, assigning 100% risk weightage to it and provisioning for the same.

Given the possible upside to interest rate movement and the sector’s increasing exposure to high-risk assets such as credit cards and personal loans, the possibility of higher delinquency rate looms large. While banks necessarily need to hedge themselves against this potential risk, a well-developed secondary market for NPAs will also help them align their asset qualities with their risk profile without being at the mercy of the ARCs.

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