Eight public sector banks (PSBs) that account for 34% of the banking system’s bad loans will face a litmus test on profitability

Eight public sector banks (PSBs) that account for 34% of the banking system’s bad loans will face a litmus test on profitability in the remainder of fiscal 2016 as they begin recognizing stressed assets and set aside money to cover the risk of default.

The Reserve Bank of India (RBI) has asked banks to clean up their books by March 2017—a process that will mean short-term pain for several banks.

At a series of meetings held in the last two months, the banking regulator took stock of asset quality across the sector and told banks to stop delaying recognition of visibly stressed assets.

This could push up bad loans for a number of banks and also lead to a jump in provisions when the third and fourth quarter earnings are reported. Most banks are still to declare earnings for the October-December period.

To be sure, some banks will fare better than others.

Bank of India, Central Bank of India, IDBI Bank Ltd, UCO Bank, United Bank of India (UBI), Dena Bank and Indian Overseas Bank (IOB) are seen as more vulnerable than others. Some 15-24% of their total loan book falls in the stressed asset category, which includes bad loans and restructured assets.

Bank of Maharashtra, whose proportion of restructured assets is not available, also has a relatively high gross non-performing assets (NPA) ratio at nearly 8%.

“Banks such as Central Bank of India, United Bank of India, and Bank of India (BoI) are more vulnerable than the others because of their low net interest income besides the exposure to large distressed groups. Bank of India is definitely vulnerable and could continue to report losses for at least two more quarters,” said Ashutosh Mishra, lead analyst-institutional equities (banks and non-bank financial companies) at Reliance Securities Ltd.

At the 39 listed banks, gross NPAs grew 26.87% to Rs.3.4 trillion for the September quarter, from Rs.2.68 trillion a year ago.

Across the banking sector, gross NPAs made up 5.1% of the loan book as of 30 September, according to RBI’s financial stability report released in December, which noted that the actual level of stressed assets (including restructured assets) was 11.3%.

As some of the restructured assets are downgraded into the bad loan category, banks will see gross NPAs rise even if overall stressed assets remain steady. The implication of this will be felt in terms of higher provisioning requirements for banks.

As per RBI rules, an account is classified as an NPA when payments are overdue for more than 90 days. Once this is done, banks need to set aside money to cover 25% of the loan amount in the first year. Assets restructured before March 2015 were attracting lower provisions of 5%.

Ashvin Parekh, managing partner, Ashvin Parekh Advisory Services LLP, said profitability will be a big challenge for public sector lenders due to the increased provisioning requirements. “Those who have been easy on provisioning will be impacted more,” said Parekh.

A number of banks considered vulnerable also have a provision coverage ratio of below 70%, which is considered to be a prudent level of provisions to maintain.

A relatively high proportion of corporate loans on the books of some of these banks could also prove to be troublesome since these loans tend to be chunky and tougher to recover than retail and small and medium enterprise loans.

For each of the eight banks mentioned above, the share of corporate loans in their total advances is over 50%.

“Banks having higher NPAs, more exposure to weak sectors such as steel would be more vulnerable. If most of the large cases have to be provided for, profits will be impacted,” said the executive director of a public sector bank seeking anonymity.

According to a 10 January report by Morgan Stanley, none of the large and highly leveraged corporate entities have been termed bad loan accounts as yet. RBI, too, in its financial stability report, pointed out that while the top 100 borrowers make up 18% of bank advances, they account for only 3% of bad loans.

“As the economy stays sluggish and collateral values are under pressure (property, commodity), we are likely to see another round of bad loan formation,” said Morgan Stanley, adding that it expects the proportion of stressed loans to rise by 8 percentage points by fiscal 2019.

Together, these concerns have pulled down banking stocks ahead of the earnings being reported.

The BSE Bankex, a measure of the performance of banking stocks, has fallen almost 11% since the start of January, compared with a 6.27% fall in the benchmark Sensex.