20 entities (and not groups) as a percentage of equity. If it exceeds 200%, it is a red flag. This report was almost prophetic. Come March 2012, some of the large borrowers with hefty debt from banks turned NPLs. This has dealt a blow to the capital adequacy ratios of some banks. The potential risk from this situation could be quite worrisome and bank managements really need to work on methods to alleviate this risk given its lethal power to sink the banks.
Given India’s imperfect regulatory regime, ascertaining LGD or the time to recovery is next to impossible. India ranks a poor 121 in the World Bank scoring model on insolvency resolution.
If we consider entire reported restructured loans as NPLs from FY2007 onwards, the banking system will still continue to report healthy pre-provision operating profit (PPOP). But this time around, the magnitude is high. However, if we look at the past track record, the restructured loans have shown a recovery of about 85% in the last decade or so. Even if the assumption is 70% recovery with 10% restructured loans, the NPL increment over 2-3 years is still 3%.
Given the above background on different classes of NPLs and restructured loans, it will be necessary to run a stress test to see whether what is said above does bear fruit.
India Ratings has carried out a second round of stress test with three critical assumptions.
l CET-1 (common equity tier-1) downward adjustment: Reported CET-1 of each bank was reduced for (a) upper tier II, (b) perpetuals, (c) fully providing for pension liability, and (d) increased specific loan loss coverage ratio to 60%. The impact has been quite astounding for some of the large banks. In case of one of the largest public sector banks, the CET-1 reported stands at 9.8% but under stress case assumptions for CET-1 it reduces to 7.5% even before imposing NPLs.
l Reduced PPOP: PPOP reduced between 5-20% for each bank depending on CASA level. Lower CASA meant a 20% reduction in PPOP from March 2013 level.
l NPLs at 15%: The NPLs included approximately 10% from cyclicals and 3%