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Banks: Where to from here?

Dec 6, 2004

The recent report released by the Reserve Bank of India (RBI) on the Trend and Progress of Banking in India is an eye-opener in many sense. As against the common belief that public sector banks are 'elephants that cannot dance', there are some interesting facts that shows that all is not bad! We take a closer look at the non performing assets (commonly referred as NPAs) side of the banking sector and what lies ahead?The table below highlights the trend in NPAs of the banking sector with respect to its players i.e. public sector undertakings, private sector and foreign banks.

Who said PSUs are not efficient?
FY01FY02FY03FY04
Public sector banks
Gross NPAs/Advances12.4%11.1%9.4%7.8%
Net NPAs/Advances6.7%5.8%4.5%3.0%
Private sector banks
Gross NPAs/Advances8.4%9.6%8.1%5.8%
Net NPAs/Advances5.4%5.7%5.0%2.8%
Foreign banks
Gross NPAs/Advances4.6%5.3%5.4%6.8%
Net NPAs/Advances1.5%1.8%1.9%1.8%
Source: Trends and progress of banking in India

To start of with, the ratio of gross NPAs to advances has declined in the last four years for private sector and PSU banking majors. There are various reasons for the same, cyclical and structural. Firstly, demand for credit from the corporate sector has been lacklustre in the last four years (a cyclical factor). So, barring the sharp rise in retail loan portfolio of the banking sector (that has lower defaults), banks have not really witnessed any significant growth in advances to corporates in the last four years. This means that the additions to NPAs have been slower. Secondly, the passing of the Securitisation Act has strengthened the backbone of the financial sector and consequently, loan recovery rates have improved (a structural factor). Thirdly, banks themselves have become more cautious while lending loans to corporates, unlike the mid-1990s. However, what is surprising is the consistent rise in gross NPAs as a percentage of advances ratio of foreign banks over the last four years. Who said foreigners are better?

While it is evident that both the private sector and PSUs have managed to bring down Net NPAs as a percentage of advances over the last four years, the decline has been faster for PSUs (assuming that a bank had gross NPA of Rs 100 in FY04, of which it provided for Rs 20 from its profits, the Net NPA at the end of the year will be Rs 80. This explains the difference between the gross and the net NPAs). The banking sector, as a whole, was able to clean up their balance sheet in a significant way because of the sharp fall in interest rates during this period. With demand for corporates remaining lacklustre, most of the banks had parked significant sums in government securities, well above the statutory requirements. With interest rates softening, the value of the securities portfolio of banks appreciated dramatically, which in turn enabled banks to write-off NPAs at a faster rate.

As the report by RBI itself states "treasury income of the banking sector increased from Rs 95 bn in FY02 to Rs 195 bn in FY04 and constituted 32% and 37% of operating profit in the corresponding years. This in turn enabled banks to make larger loan loss provisions. Consequently, the net NPA ratio has declined from 5.5% in FY02 to 2.9% by FY04". As is evident from the table above, there is not much difference between net NPA to advances ratio between PSU and private sector banking majors!

However, the difference arises when one considers the sectoral composition of NPAs of the private sector and PSU banks. Priority sector lending, including advances to the agricultural sector, accounts for bulk of the NPAs of public sector banks (almost twice as much the private sector peers). Since most of the private sector banks are urban focused unlike PSU banks, they have an advantage. PSUs, on the other hand, have carried the burden of being government owned and therefore, have social obligations.

The sources of NPAs - Priority sector disadvantage for PSUs
(% total NPAs)Old private sectorNew private sectorPrivate sectorSBI GroupOther PSUsTotal PSUs
Agriculture6.6%2.9%4.4%16.5%13.6%14.4%
SSIs19.5%6.8%12.2%15.0%18.7%17.6%
Public sector0.2%1.1%0.7%1.5%1.1%1.2%
Non-priority sector58.9%87.5%75.3%51.5%51.1%51.2%
Others14.9%1.8%7.4%15.5%15.5%15.5%
Total100.0%100.0%100.0%100.0%100.0%100.0%
of which priority sector40.9%11.4%24.0%47.1%47.7%47.5%
Source: Trends and progress of banking in India

What to look for?

Demand for non-food credit has increased in the last one year indicating that the much awaited investment recovery is taking shape. While this could mean higher growth in advances for the banking sector as whole, not all banks have proper risk management system and technology to support this expansion. This could mean that the gross NPA to advances ratio could increase in the future.

As discussed earlier, the banking sector was able to clean up their balance sheet from robust trading profits. With interest rates expected to increase in the future, this benefit is no longer available for banks and therefore, the sustanence of the current low net NPAs to advances ratio is doubtful. Investors have to exercise caution on this front.

"To improve flow of credit to small and marginal farmers, the banks have to make efforts to increase their disbursements to small and marginal farmers to 40% of their direct advances by March 2007. All private sector banks also to formulate targets from the year 2005-06, with an annual growth rate of at least 20% to 25% of credit disbursements to agriculture" - one of the major policy developments in 2004. Since the agricultural sector is highly dependent on monsoons, risk of default exist and consequently, the return ratios of both private sector and PSUs could come under pressure. Private sector banks are faced with a new challenges on this aspect.

While de-regulation brings with it whole host of growth opportunities, we believe that valuations of banking stocks at the current juncture is on the higher side, with respect to their growth prospects in the medium-term. With the sector moving towards tighter provisioning and capital adequacy norms, we believe that only few banks have the management depth and balance sheet strength to overcome these challenges. Given this backdrop, probably, banking on better credit growth prospects alone may not be the right strategy as far as investing in bank stocks are concerned.

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