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Why the Indian banking sector will continue to face problems

Looking at the performance of the BSE Bank index, lately it seems like the investors have already answered the question. 

The graph below shows that the bank Index has been hit pretty hard. 

The banking and the non-banking sectors have seen some tough times in the recent past. Even before the COVID-19 pandemic they were constantly in the news for all the wrong reasons. Rising NPAs, increasing levels of provisions, the Yes bank and the PMC bank issues etc. to name a few. Most of it was mainly because the Indian economy had been bad for some time now. And banks are directly linked to a country’s economic growth. And what makes them more vulnerable is that they are connected to every sector as they are the primary source of capital. So, if the power companies suffer, so do banks. If the real-estate sector goes down, so do banks. And so on & so forth.

banking graph

In these pandemic hit times too, it’s likely that their problems will continue. 

In fact banking as a sector could be the last to recover. 

Mainly because:

  1. Level of Bad debts likely to worsen going forward

Experts believe that the level of NPAs should double owing to the economic impact of the pandemic. Which frankly is to be expected in a bad economy.

But as mentioned before the banking system was already in a tough spot. With rising levels of NPAs (bad debts) and provisions, their performance had been poor off late. And now a depressing economy will only add to those woes and worsen the situation.

Even the stimulus package poses a strong risk to their balance sheet. The government has asked banks to offer loans to troubled MSMEs (Micro, Small and Medium Enterprises). Which according to banks were already underperforming: ‘the stressed MSMEs have not been working for the last two months and have not been generating any cash flow. The manager who sanctions the loans will have to face harassment if the loans turn NPAs’.

But the government will have to step in and save the day. They will need to infuse more capital into the banking system and might even have to rescue some small failing banks. Which they have done several times before by means of mergers and acquisitions.

Global Trust Bank was taken over by Oriental Bank of Commerce. 

The RBI had nudged ICICI Bank to take over Bank of Rajasthan. 

The latest Yes Bank case, where three large banks were asked to help revive it.

  1. Ratings downgrades by Fitch and other agencies

Fitch, the ratings agency also believes the same and has therefore downgraded their ratings for the Indian banking system. They have sighted that the virus outbreak will ‘worsen Indian banks already weak operating conditions.’ In view of this they have downgraded the ‘viability rating’ of the top banks of the country: SBI, Axis Bank, ICICI Bank and Bank of Baroda. 

They believe that banks will suffer more but not to the point of failure. And if there is a chance this were to happen the government will intervene. 

A little-known fact that isn’t mentioned often is that the Government maintains a list of systematically important banks. Banks which are integral to the economy. And if these banks start to drown, then the Government will jump in to save them. As it will be far more economical to save these banks than to deal with the credit crisis that can arise from the failure of such banks.

  1. Increasing NPAs will require more provisions to be made

Banks are already increasing their levels of provision in anticipation of the bad debts (NPAs) that are to come. And for that they will need more capital. Some of the top banks (Kotak Mahindra and Axis bank) have already announced fund raising plans. And truth be told the larger banks are better placed in terms of capital adequacy. It’s the smaller ones that are at risk.

So, if things get out of hand banks will need more help from the Government. 

  1. Continued operational interference due to measures for containing the virus

The containment measures are likely to continue for some time now. Especially in the larger cities where banking plays an important role. This increases one of the most major risks a bank faces- operational risks.

Operation risk is loss due to errors made by its people, processes or systems. Even though technology has transformed the way we bank, a lot of Indians still prefer the old school method of banking. Furthermore, there are still a lot of processes that need human interaction. All of which can result in an increased level of operational risk. 

Furthermore, as time passes the number of cases amongst bank employees (interacting directly with customers) are rising leading to branches being shut temporarily. 

But there is still light at the end of the tunnel

Yes, the banking industry will suffer going forward. But they will not reach a point of complete failure. Especially the larger banks. Thanks to the various norms that have been put into place by the Government. These include the BASEL III norms that were implemented ensuring the banks have enough capital (capital adequacy) to deal with issues (like the one now). 

So, if we look at some of the top banks their Capital Adequacy Ratio (CAR) meet the BASEL III norms. Which indicates that they have a fairly well-capitalised balance sheet and are well-positioned to handle the crisis. But the same cannot be said about Small and PSU banks. They are still at risk.

 March 2019

Axis bank

ICICI

SBI

HDFC Bank

Kotak

IndusInd

Bank of India

Capital Adequacy Ratio (CAR)

15.80

16.90

12.90

17.10

17.90

14.20

14.20

Another positive can be a change in the way we bank. Due to the pandemic people have been forced to turn away from cash to digital mode of payments. If this trend persists it could benefit banks over the long-term and change the face of retail banking completely.

Furthermore, the regulatory body (RBI and government) and the banks seem to be on the same page for now. Which is to help people recover from the economic crisis. And the banks will be playing a very big role in this. So far, they have been instrumental in transferring money from the Government to the people. And now they have to offer loans and help people with their repayment processes under the revised terms issued by the Government.

But it remains to be seen how long the banks can abide by them. It’s possible that they might agree to it now. But as the situation worsens they will have to choose between helping people or saving themselves.