State Bank of India Needs Bad-Loan Cleanup to Vindicate Bulls

(Bloomberg Gadfly) -- The 2.1 trillion rupee ($32 billion) government bailout of Indian lenders will obviously benefit the biggest of them all: State Bank of India. But will it make a large enough difference to vindicate bullish investors?

SBI's results on Friday offer some clues. Net income of 15.8 billion rupees for the September quarter missed consensus estimates by 40 percent. The lender's shares climbed as much as 7.9 percent after the announcement: When it comes to beleaguered Indian banks, it's balance sheets rather than profit-and-loss accounts that investors scrutinize. At almost 10 percent of advances, nonperforming assets remain stubbornly high. But the good news was the 167 billion rupees in provisions, 38 percent more than in the June quarter.

This is where a capital injection from the government would help. To see how, start with the 1.9 trillion rupees of soured loans on the lender's books -- a figure that doesn't even include the many lumpy corporate assets like Reliance Communications Ltd., whose fate hangs by a slender thread. SBI's 882 billion rupee loan-loss cover has expanded by 30 percent over the past year. Making the cushion another 30 percent thicker -- raising it to 1.15 trillion rupees -- would mean finding an extra 260 billion rupees in pre-provision profit.

Can fresh equity help fill this gap? Among the dozen banks represented on a National Stock Exchange index of government-controlled lenders, SBI alone has two-fifths of total assets. Assume the bank gets 500 billion rupees of new capital over two years, a little less than a quarter of what New Delhi has promised for all lenders.  SBI has a Tier 1 common equity ratio of slightly more than 10 percent. So it should be able to use the resources to expand its risk-weighted assets by 5 trillion rupees, adding to an existing 23 trillion rupee pile by 2019.

Assume also that the bank is able to earn net interest of around 4 percent on risk-weighted assets, a tad higher than its current level of profitability. The 5 trillion rupees in extra assets would yield pre-provision profit of 200 billion rupees annually. At that rate, not only would the hole in the balance sheet be filled in two years, the bank would be generating capital to produce future growth. 

Reality won't be nearly as smooth as these back-of-the-envelope calculations. For one thing, SBI's 52 percent cost-to-income ratio eats into a big chunk of profit from lending. Besides, competition for good lending opportunities is extremely high, which isn't a surprise considering loan growth for the Indian banking system is at a multi-decade low.

Still, shareholders who pushed SBI stock up almost 28 percent when the recapitalization plan was announced last month aren't being unrealistic. With aggressive cost control, and a little bit of luck, it's possible for the bank to climb out of the hole it has dug itself. But to do that, it badly needs to get in front of its bad-loan problem.

The latest bump in provisioning shows the cleanup has at least begun.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Andy Mukherjee is a Bloomberg Gadfly columnist covering industrial companies and financial services. He previously was a columnist for Reuters Breakingviews. He has also worked for the Straits Times, ET NOW and Bloomberg News.

1. Not all of it would come from a special bailout bond or from New Delhi's budgetary resources; banks are expected to raise their own funds as well. 

To contact the author of this story: Andy Mukherjee in Hong Kong at amukherjee@bloomberg.net.

To contact the editor responsible for this story: Matthew Brooker at mbrooker1@bloomberg.net.

©2017 Bloomberg L.P.