Life after bad debt

The year 2007 was easily the worst for US banks in a long time. The big boys like Citigroup, Bank of America and JPMorgan Chase grabbed most of the headlines for big hits in profits (from the third quarter onwards), thanks to their excesses in the credit market. But, it’s not just the megabanks that have been hit. Indeed, the pain is being felt across the industry. Profits sunk by almost a fourth in the third quarter, three banks actually went under, and the Federal Deposit Insurance Corporation (which provides insurance to depositors in failed banks) had 65 banks on its list of troubled ones (up from 47 a year ago). Analysts fear this could be just the beginning of a long-drawn bust-up in the US banking sector.

Back home, of course, the situation isn’t that alarming— not by a long way. Yet, it may just be the time for CEOs of Indian banks to take stock. For, the first signs of stress are beginning to show on their balance sheets. Levels of non-performing assets (NPAs) of banks with assets size between Rs 10,000 crore and Rs 24,000 crore (that’s 54 banks in all) have risen to nearly 1 per cent. And if there are some big names that haven’t made it to the top half of the 14th BT-KPMG Best Banks Survey, the deterioration in the quality of their assets is one big reason for the indifferent showing. The high-profile banks to lose out on the charts include ICICI Bank, Standard Chartered, Citibank, State Bank of India, Centurion Bank of Punjab and IndusInd Bank (see Bad Moon Rising?).

Bad moon rising Banks with NPAs of over 1 per cent of net advances

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Says Tarun Bhatia, Head (Corporate & Government Ratings), CRISIL, a credit rating agency: “Increasing exposure to high-risk customers and rising interest rates have been the reason for deteriorating asset quality.” As of March 2007, unsecured loans (personal loans and credit card debt) form 17 per cent of the total outstanding retail loans, compared to 6 per cent in 2004. “Following the increasing exposure to high-risk customers, we see gross NPAs in retail loans rising to 4 per cent over the next two years, from 2.7 per cent as of March 2007,” adds Bhatia.

However, there may be a quaint regulatory situation that’s contributing to an exaggerated picture of bad debt; banks that are buying bad assets for a song—in a bid to turn them around and sell them for a chunky profit—are also seeing this business of asset reconstruction being dumped into the NPA cauldron (see It’s Not That Bad). Says Bhaskar Ghose, former Managing Director & CEO, IndusInd Bank: “With ARCs (asset reconstruction companies) still not comfortable in accepting retail bad debts, most of the banks have got stuck with bad retail assets, thereby increasing the NPAs on their books.”

Rise in bad debt

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ARCs aside, there’s little doubt that bad debt is rising. With competition increasing, banks are reaching out to untapped clients, such as the self-employed and borrowers from smaller cities. This has increased their portfolio risk. Pressure on credit off-take is also compelling banks to increase their exposure to unsecured loans in a bid to increase yields. (As on January 4, 2008, non-food credit by scheduled commercial banks had moderated to 22.2 per cent, or Rs 3,82,155 crore, from 31.9 per cent, or Rs 4,16,418 crore, a year ago.)

A slowdown in housing loans, too, has forced banks to push riskier (but higher-yielding) unsecured debt. Avers Rakesh Jha, Deputy CFO, ICICI Bank: “It’s been a conscious decision to increase our exposure to unsecured loans in line with market trends. It’s a high-risk high-reward segment where yields range from 16-20 per cent, much higher than those with other bank loans.”

It’s not that bad Should distressed assets bought by banks be reported as NPAs?

Jaimin Bhatt If the likes of Kotak bank and Standard Chartered Bank have taken a hit in this year’s Best Banks’ rankings, their apparent inferior quality of assets has plenty to do with that dull showing. However, it’s not as if their bad debt is out of control. Rather, these banks are in the business of buying up distressed assets cheap, revamping them and selling them at a smart profit. Only problem? The Reserve Bank wants such assets to be reported as NPAs. Says Jaimin Bhatt, Group CFO, Kotak Bank: “Thanks to RBI norms, a lot of the distressed assets we buy are reported as NPAs.” As per the guidelines laid by Reserve Bank of India, any purchase of distressed assets that has been on the books of the seller for less than two years will be considered as NPA on day one of purchase. For assets older than two years, the buyer has to recover at least 10 per cent of the total value in the first year and complete the total recovery within three years of purchase; else the asset will automatically turn into an NPA. “Resistance of the borrower to recognise change in ownership and the necessary court process delays recovery in the first year, thereby classifying these assets as NPAs,” adds Bhatt. Kotak, today, has a portfolio of 200-250 distressed assets bought at Rs 600 crore, and valued today at some Rs 10,000 crore. Standard Chartered Bank is the other bank in India that has bought distressed assets on its balance sheet. Stanchart has bought distressed assets worth around Rs 250 crore in the past two years since it started this activity. Says Anurag Adlakha, CFO (India & South Asia), Standard Chartered Bank: “We purchase NPAs from other banks, with the aim of turning them around and realising gains.” That may explain an NPA to net advances ratio of 1.43 per cent. However, even if you take out the asset reconstruction business, Stanchart’s NPAs are still high, at 0.92 per cent.

This is due to a lower growth in the housing mortgage loans. In the past two years, the unsecured loans on the books of ICICI Bank (ranked #9 in BT-KPMG Survey) have surged from 7 per cent in March 2005 to 15-16 per cent in March 2007. This has also increased the NPAs of the bank to 1.4 per cent (of net advances) in the first nine months ended December 2007, up from 1.02 per cent in March 2007.

Clearly, the mouth-watering yields in unsecured loans are seducing bankers, many of whom are looking for ways to mitigate the risk that comes along with such debt. Axis Bank (#5) is one such bank that’s increasing its exposure to this loan segment, even as it seeks to minimise defaults. Says P.J. Nayak, Chairman & Managing Director, Axis Bank: “We only deal in large-ticket loans and with people who have a track record with the bank.

The problem arises mainly in the small-ticket segment.” A prudent NPA level of 0.42 per cent may be one reason why Axis Bank can afford to test the waters of riskier loans.

Not every other bank believes in or is in a position to be as adventurous. Central Bank of India (#34) has slowdown its exposure to unsecured loans. Says H.A. Daruwalla, Chairperson & Managing Director, Central Bank of India: “Due to defaults in personal loans, we have rebalanced our portfolio with a focus on small & medium enterprises and retail credit, which are backed by collateral. In addition to this, we have ramped up our recovery efforts, which have resulted in our NPAs coming down.” For Central Bank, NPAs for the nine months since March 2007 have come down to 1.22 per cent from 1.70 per cent.

Gross NPAs on the rise

However, with delinquencies across all retail asset categories rising, CRISIL expects gross NPAs to surge further in 2008-09. Gross NPAs in housing loans, car and commercial vehicle loans are expected to rise to 2.7 per cent (2.2 per cent in March 2007), 3 per cent (2.3 per cent) and 5.5 per cent (4 per cent), respectively. “The rupee appreciation and a slowdown in the business cycle will impact corporate lending to companies in sectors like textiles, auto and sugar, putting further pressure on rising NPAs,” says R.K. Bansal, CFO, IDBI Bank.

Compounding the banks’ woes is the self-imposed clampdown on recovery, thanks to recent controversies related to strong-arm tactics being used by banks on borrowers.

Yet, the good news is that Indian banks compare well on a regional basis on the NPA front (see Better Than the Rest). But, then again, the crisis in the West is a warning signal for banks to clean up their acts.


As Ritesh Maheshwari, Senior Director (Financial Institutions Rating), S&P Asia, points out: “Bad decisions are taken during good times and when the going gets tough problems start to emerge. Rising exposures to unsecured loans as well as a slowdown in corporate loans and in housing loans will put some stress on the balance sheets of Indian banks. But, it’s not a doomsday situation.”