Bad Loan Clean-Up: It Ain’t Over Till It’s Over

It’s been a bad (financial) year for banks. Actually it’s been two bad years. As they prepare to close the books on financial year 2016-17, most bankers are probably hoping that the worst is over. But they may also secretly know that it’s not.

After a period of stabilization, corporate credit quality is starting to look shaky again. Two separate studies over the past month, one released by the Reserve Bank of India (RBI) and another by Credit Suisse, show that the level of corporate stress remains high and has even worsened in pockets. Both suggest that there has been scant improvement in the ability of stressed firms to repay their loans.

For banks, this means two things. One, non performing assets (NPAs) may continue to pile up. Two, existing bad loans will prove tough to recover, leading to a surge of provisioning needs over the next year.

Before we get to that, a summary of what the data is telling us.

On Thursday, the RBI released its quarterly study of 2,784 non-government non-financial listed firms. The study showed that the aggregate interest coverage ratio (ICR) of these firms declined from 3.8 times to 2.9 times. It also fell marginally below the level seen in the third quarter last year when the corporate credit crisis was thought to be at its peak. The deterioration was across the manufacturing and services sectors, showed the RBI data.

The data came as a surprise to rating industry executives that BloombergQuint spoke to, most of whom believe that corporate credit quality, while not improving, is stable.

Is the data point an anomaly then?

No, says Ashish Gupta, head of research at Credit Suisse which has tracked the build-up of the corporate debt crisis in India since 2012. Gupta points to the findings published in the February edition of the brokerage’s Corporate Health Tracker.

Credit Suisse’s study of 3,700 companies with an aggregate debt of $520 billion threw up the following results:

• Earnings Before Interest and Tax (EBIT) declined 4 percent quarter-on-quarter while interest costs increased 4 percent. This pushed the interest cover down to 2.2 times in the third quarter from 2.4 times in the second quarter.
• The performance of stressed firms was worse than that of the broader set of companies. Companies with an interest coverage ratio of less than one, saw earnings before interest, tax, depreciation and amortisation (EBITDA) drop by 10 percent while sales fell by 15 percent. This indicates weak firms are getting weaker.
• The quantum of debt with companies having interest coverage less than one for the past eight consecutive quarters increased to Rs 7.1 lakh crore in the third quarter from Rs 5.7 lakh crore in the previous quarter. Partly because existing companies in the category added more debt and partly because many telecom companies saw their ratios deteriorate to less than one. In all, this means that a larger quantum of debt is sitting with weak companies.
• Power, telecom, and steel continue to be large contributors to the stress. While steel has seen marginal improvement, power and telecom have not.

The reason the continued deterioration in corporate credit quality is unsettling is because of its implications for the banking sector.

Since the December 2015 ended quarter, banks have been cleaning up their books following the asset quality review (AQR). This process has involved reclassifying stressed loans as NPAs, provisioning for them and eventually finding a resolution for these assets. It was assumed that the first phase is over while the second and third are work in progress.

If corporate credit quality is indeed deteriorating, the first implication is that reported NPAs will continue to rise. In fact, rating agency Fitch said in a note in February 2017, that it expects the stressed-asset ratio to rise over the next financial year from the 12.3 percent recorded at the end of September 2016.

‘A Wall Of Provisioning Ahead’

The second implication is that there may be little hope of banks being able to upgrade sub-standard assets organically, which would then require them to set aside more provisions against these assets. Because under existing regulations, the longer an asset remains sub-standard or doubtful, the higher the provisioning requirement.

Credit Suisse cautioned that there is a ‘wall of provisioning ahead’ and estimates that the additional provisioning needs next year (financial year 2017 - 2018) could be as high as Rs 86,000 crore.

Saswata Guha, director of financial institutions at Fitch Ratings shares that view and expects provisioning to remain high over the next financial year. He adds that as the banking sector migrates to the new International Financial Reporting Standards based Indian Accounting Standards (Ind-AS) by 2018, banks may also need to provision for assets where they see palpable deterioration even if they aren’t NPAs yet. If corporate credit quality weakens from current levels, these provisioning needs, outside the current NPA bucket, could also rise.

Credit Suisse, in its report, also pointed out that assets that have been parked under the Strategic Debt Restructuring scheme (SDR) may also need to be provisioned for if banks fail to find a buyer at the end of the stipulated 18 months.

“While the declared SDR of banks adds up to Rs 70,000 crore as of December 31, 2016, based on the list of companies where SDR has been announced, it amounts to Rs 2.4 lakh crore, of which almost 50 percent are standard,” said the report.

Given the rising complexity of the bad loan scenario, both Credit Suisse and Fitch are of the view that a bad bank like solution has now become essential for the banking sector.

The creation of a bad bank could accelerate the resolution of stressed assets even though it would be logistically difficult to implement, said Fitch in its February note. Given the quantum of problem loans and complexity involved in resolving these problem loans, the creation of bad banks can significantly simplify the process, said Credit Suisse.

Also Read: Steep Drop In Debt Servicing Ability Of Indian Firms