Banks not displaying signs of stress in their loan book despite the central bank hiking repo rate by 250 basis points since last May could be one of the reasons
By Dr Seela Subba Rao
Reserve Bank of India Governor Shaktikanta Das addressing the directors of bank boards recently hit out strongly against ‘smart accounting methods’ to conceal stress and bloat financial performance. The Governor further added that it is the joint responsibility of the chairman of the board as well as the directors to ensure corporate governance and not allow any gaps in governance, with the potential to cause some degree of volatility in the banks.
He advised banks to be more cautious in the pursuit of their growth strategies, pricing and portfolio composition. He further reiterated that the boards of the banks and audit committees should check the propensity to show good profits through smart accounting and window dressing before their approval of the financial statements of the banks.
Financial Health
The financial results of the banking sector have been truly outstanding in the fourth quarter of FY23. Profit after tax at the aggregate level of scheduled commercial banks was around 51%. Other parameters of the banking sector were also robust. Gross NPA (non-performing asset) ratio has halved since the peak in fiscal 2020-21 to 4.7% for public sector banks and 2% for private sector banks, provisions for loan are quite healthy across banks.
Various factors such as the reopening of the economy after the pandemic ebbed and the surge in demand for credit have aided banks to some extent. Scheduled commercial banks reported a robust credit growth of 15.4% in FY23 compared with 9.7% in FY22. The growth was powered by personal loans, and loans to the services sector and agriculture & allied activities. The margins of the banking sector improved with net interest income growing 28% in the last quarter of FY23, largely due to the slower transmission of RBI’s rate hikes to bank deposits. Adequate liquidity and reduced NPA aided profitability too.
Public sector banks have come a long way from a total loss of Rs 85,390 crore in 2017-18 to a profit of Rs 1,04,649 crore in 2022-23. The market leader, State Bank of India, declared an annual profit of Rs 50,232 cr in 2022-23, a 59% rise over the previous year. Similarly, for the full year, the net profit of private sector banks rose to Rs 1,17,000 crore in FY23 from Rs 94,046 cr in FY 22 registering an increase of 23.3%, according to data compiled by the BS Research Bureau for 14 listed private sector banks.
Casting Aspersions
Despite the stellar growth in the fourth quarter of FY23, the RBI cast aspersions on the performance of the banks. In fact, there are certain solid reasons for Das’ assumptions and aspirations. Firstly, the banks are not displaying signs of stress in their loan book despite the central bank hiking the repo rate by 250 basis points since last May 2022.
Secondly, segments such as unsecured personal loans, credit card loans and MSME loans which are more vulnerable registered a higher credit growth compared with other categories since the pandemic. Borrowers in these segments would typically struggle with their repayment obligations in a rising rate cycle. Thirdly, during the inspection of these banks, the RBI noticed certain instances wherein banks were adopting innovative ways to conceal the real status of stressed loans.
For example, good borrowers being persuaded to enter into structured deals with a stressed borrower to conceal the stress, use of internal or office accounts to adjust the borrower’s repayment obligations, renewal of loans or disbursement of new/additional loan to the stressed borrower or related entities closer to the repayment date of the earlier loans. The central bank has come across cases where one method of evergreening, after being pointed out by the inspection team, was replaced by another method.
As per extant instructions, commercial banks need to ensure that the balance sheet and profit & loss account reflect the true and fair picture of their financial position. Further, banks need to avoid short-provisioning, misclassification of NPAs, under-reporting/incorrect computation of exposure/risk weight, incorrect capitalisation of interest on NPAs, deliberate inflation of assets and liabilities at the end of the financial year, and subsequent reversal immediately in the next financial year. Perhaps, there are some apprehensions about the violation of these instructions by them.
The Prescription
Needless to mention, the RBI should take necessary steps against banks if they are using methods such as entering into structured deals with a stressed borrower to conceal the bad loan, using the internal accounts to adjust the borrower’s repayment obligations and disbursing new loans closer to the repayment date. These practices pose a threat to the bank’s sustainability and its true health status may not be reflected in its balance sheet and profit & loss account.
During the on-site inspections of the head offices and select branches of the banks, the inspection teams need to undertake the scrutiny of the banks’ financial statements meticulously and check whether they had resorted to any techniques of window dressing. Basically, the means of check of window dressing comprise certain grey areas such as verification and valuation of assets, verification of provisions for NPAs, and verification of capital and revenue items of expenditure.
A distinction between capital and reserve items is very important from the point of view of calculating the correct profit or loss of a bank. Window dressing can be done by shifting any capital expenditure item from the balance sheet to the income & expenditure statement, showing it as revenue expenditure. This lowers the profits and vice versa. A check is also required to determine whether the revenue item is deferred revenue. A check is also required to determine whether the revenue item is deferred revenue.
Over-aggressive growth, under-pricing or over-pricing of products both on the credit and deposits sides, concentration, or lack of adequate diversification in deposit/credit portfolios can expose banks to higher risks and vulnerabilities. The Indian banking sector should take note of recent turbulence in the American banking sector. Bank boards as well as audit committees should be cautious about basic aspects such as asset-liability mismatch, excessive focus on the bottom line and market capitalisation.
If the RBI is indeed aware that such unethical practices are being followed, it would be best to end these through stern directions to banks, in the interest of all stakeholders. If warranted, appropriate penal actions against banks in terms of the provision of the Banking Regulations Act, 1949, may be considered.
There is a need for an integrated system of regulation and supervision of various banks, financial institutions and other institutions of financial services in India.
The Board for Financial Supervision, constituted in 1994, as a committee of the Central Board of Directors of the RBI accountable for consolidated supervision of commercial banks, development financial institutions through their Department of Supervision may be further strengthened.