Let’s not mince any words here. Indian banking sector is facing a crisis (NPAs + Stressed Assets) of epic proportions.

The current crisis may or may not be an opportunity. But before reaching any conclusion, let’s try to understand what really led to the mess which PSU banks find themselves in.

For years, PSU banks lent aggressively to showcase their ever-increasing assets (loan) portfolio. Unfortunately, very little attention was paid to the quality of assets and probability of repayment. Since quality of borrowers was not good, some borrowers started skipping payments and some even failed to repay the loans completely. And we are talking about large multi-crore loans here.

These failures and chances of future loan defaults (bad loans), required banks to make provisions. But since making provisions meant having lesser money to lend to new borrowers and also reduced profits, banks kept postponing NPA recognition and this led to the buildup of stress in the banking system.

To the uninformed, it might seem odd to make provisions before actual losses. But making provisions is justified. If the losses from stressed assets materialize, banks wouldn’t suddenly declare huge losses – as they can set off those losses against the provisions already made.

In its periodic asset quality review, RBI decided to tackle the problem upfront. It set a deadline of March 2017 for all banks to clean up their balance sheets and recognize all stressed assets.

The message from RBI was clear – deal with the problem now instead of postponing and worsening it.

Since the size of unrecognized stressed assets was huge and deadlines were nearing, banks were virtually arm-twisted to set aside massive amounts of money as provisions. Now making provisions reduces profits. So when banks started this exercise from Sep-Dec 2015 quarter onwards, it obviously reflected in their results. Profits of most PSU banks were wiped out entirely!

As of end of March 2016, size of NPAs stood at an eye-popping Rs 6 lac crores (Source – Capitalline database*). Large provisioning have led to 15 of 27 banks posting net losses in fiscal 2016.

Recognizing the scale of problem at hand, investors shunned PSU banks shares and many fell by almost 50% in matter of months (till January 2016). Since then, stocks have recovered somewhat due to general uptrend in market.

Now comes the question – are all bad loans recognized and provided for?

The answer is not an easy one.

Some banks have been honest enough to say that there is still pain left in the system. And going forward, they would further provide for more stressed assets. Others are claiming that they have already done what was required. But whatever is being said cannot be taken at its face value. It’s best to expect that NPA figures will be revised upwards in near future. So better brace for that scenario.

Government recognizes the importance of having a stable banking sector and hence, had announced a comprehensive reforms program named ‘Indradhanush’ last year. Though the program dealt with 7 different aspects of banking like management appointments, establishment of Bank Board Bureau, governance reforms, etc., the 2 main aspects from the context of NPA crisis were capitalization and de-stressing of bank-books.

The de-stressing is already underway via provisions.

Regarding recapitalization, the original plan was to infuse Rs 1.8 lac crore in PSU banks by 2018-19. The government had committed to infuse Rs 70,000 crore of this. Rest Rs 1.1 lac crore would have to be managed by banks through markets (Source: Government/RBI announcements).

In August 2015, the government had announced that it will follow the below schedule for infusing capital:

FY 2015-16: Rs 25,000 crore
FY 2016-17: Rs 25,000 crore
FY 2017-18: Rs 10,000 crore
FY 2018-19: Rs 10,000 crore

(Source: Government/RBI announcements)

More or less, the government is delivering on this schedule. But many sector experts feel that government’s estimates of capital requirement are not correct. In light of worsening of the problem, the government might have to revise its contribution upwards. Just few days back, the finance minister (on sidelines of a conference) indicated that the government will not hesitate to exceed its contribution, if there is a need.

Though there is no agreement between experts’ and government’s estimates, the RBI and government have assured full support to all banks.

Another point to note is that not all stressed assets turn into bad loans (NPA).If the losses don’t materialize, the banks can write-back provisioning to profits.

In recent times, there have been a slew of RBI initiatives to help banks recover the money they have lent. Some of these like Strategic Debt Restructuring (SDR), 5/25 Program, increased sale of bad assets to ARC, etc. are expected to lower the impact of bad loans somewhat. Then there is growing discussion to merge some of the weaker banks with stronger ones and monetize non-core assets to bring in more capital to strengthen the banks.

All in all, the government and RBI do seem to be working in tandem to address this crisis. Even history tells that whenever Indian banks have faced a crisis, government has left no stone unturned to protect this sector from failing. This is the reason why failures in Indian banking are much lower than what have been in developed nations.

So having said that, it is wrong to paint all PSU banks with the same brush. Once the book-cleanup exercise is over, there is no doubt that most PSU banks will be much stronger than what they are now. And once that happens, market valuations too will improve to come in line with improved business.

* – via http://www.firstpost.com/business/rs-600000-crore-npas-over-90-with-psbs-is-the-bad-loan-story-turning-scary-2822560.html