Cycle of stressed assets in public banks is over now: JP Morgan

JP Morgan believes that the non-performing loan (NPL) cycle for Indian banks is over. In a report by the firm, it says that recognition of stressed assets is likely to come down in coming quarters. Speaking to CNBC-TV18, Harsh Wardhan Modi of JP Morgan says that while resolutions take long time, recognition is the first step towards resolving the issue. “Peak of NPLs is already there,” he says adding that NPLs seen a 650 basis points uptick in the past.Capital adequacy as well as deteriorating market share is still a challenge for public banks, but the regulators are stepping in to help them. Modi sees earnings visibility for non-banking finance companies (NBFCs) for next 2-3 years, especially the housing finance companies. Below is the verbatim transcript of Harsh Wardhan Modi’s interview to Latha Venkatesh, and Anuj Singhal on CNBC-TV18.Latha: Is the worst of the non-performing loan (NPL) cycle over? A: We believe so. One of the key defining factors of peak of any NPL cycle is when the banks start recognising and admitting that there is an issue. The fact that asset quality review (AQR) forced banks to start recognising NPLs and call spade and spade, we believe it is a turning point and we feel it across Asia. A big chunk of emerging ASEAN banks are still under NPL cycle. In North Asia, Chinese banks are still grappling with recognition of NPLs. Resolution takes its own time but the fact that recognition has happened which we believe is the first step towards ultimate resolution and the bigger point is as soon as NPL formation starts showing up, so, right now if you see, in second half of FY16 more than 600 basis point of NPLs were recognised in the bank’s balance sheets and that we expected to start going down closer to 200 bps in next couple of years. So, once recognition happens that is the first step and we are very firmly moving towards the resolution. So, yes it is a unique opportunity across Asia where a large banking market like India has in what we believe turned the corner and moving towards growth rather than more stresses on NPLs. Latha: Just two more points I have heard to the contrary. One that there is still unrecognised stress, part of it is of course restructured assets that will come in and fresh unrecognised stress, there are some people who believe that the total amount of bad loans could be northwards of Rs 8.5 lakh crore. So, what is your counter to that and secondly even if the stress is recognised, only about 20 percent is provided. So, are banks still going to bear the burden of past sins? A: These are fair questions and we also believe that recognition is not done yet. All we are saying is peak of NPL formation is already there, so, as I said in second half of FY16, we had north of 600 basis point of NPL recognition, NPL formation that is going to 270-280 basis point in this fiscal and then below 200 bps in FY18 and FY19. The more important point is not that there is more to go, definitely there is more to go, but that the process of recognition has already started; so that is one. On credit costs and NPL ratio, definitely they will lack. Once you recognise NPLs, second step is then you start providing for it. However, the more important point from a stock perspective is, as an investor and analyst, we can put our hands around okay this is what the total problem loans are, call it NPL, call it watch list, call it stressed loans, at least we know what it is, we can take a stab at what kind of losses will it entail, take it out of capital, take it out of your return on equity calculation but then we can move on from that. More importantly, more than what we do as investors is what bank managements does. For a large part of last five to seven years a lot of the bank management time and efforts were spend in not calling a spade a spade, saying okay there is a problem asset but can we not call it NPL, can we restructure or whatever. Now, they have moved from that towards we have classified it as a stressed loan, as an NPL, we have to provide and in due course it will happen but let us think about growth, let us think about pre-provision operating profit, the number which genuinely matters towards higher profitability rather than fighting the past battle of NPL. So, reported numbers, it is a long tail but the process has begun. Anuj: In that case our Indian public sector banks are good buy even at current levels, we have seen quite a bit of rally for example in State Bank of India (SBI), that has been of course the leader of the pack, even Bank of Baroda (BoB) and Punjab National Bank (PNB) from the lows we have seen quite a bit of rally and price to book value still looks quite attractive for most of them trading sub book. So, are they still good buys? A: On PSUs, there are three factors we would say. One is the fact that these banks have very strong deposit franchise. That has been the case and as of now 74 percent of market share is held by PSUs. It has been coming off, the peak was 77 percent about three years ago, we are at 73 percent but still it is a big number. That is one. The second factor is, this is deteriorating very fast which is the private sector banks are taking away share and that is continuing so that is negative. The third and the most important factor is the capital adequacy at these banks. It is challenged. However, what is also fair to say that the regulators are essentially stepping in and there is a degree of forbearance which partly offsets this limitation on capital inadequacy. So, these are the three different factors. Now, so then how do we think about valuations? In a scenario where both book values and earnings are challenged, we have tried to focus again on a regional perspective more towards what is the franchise value. So, we did comparison with Chinese banks, we did comparison with Korean banks, with Thai banks post 98 and when I say franchise value, we are looking at market capitalisation to deposits, we are looking at operating profit generating ability of these banks and on those metrics, as a cohort PSUs stand up relatively well compared to the regional similarly placed regional banks. So, I would say in terms of taking a view on the private sector bank stocks, it has to be a triangulation of these three factors and those changes over a period of time. Latha: NBFCs have run crazily, are you still a buyer there? A: NBFCs have created a very nice, niche business in last five to seven years and our belief is again a combination of three different offerings. One is a lot of these businesses are built up on what their sister companies or parent companies built franchise on. Second was a lot of private sector banks took the eye off some of these smaller niche, in fact they were not even there and PSUs actually took the eye off especially in the semi-urban and the rural segments where NBFCs made a very good business out of it. Some of that is defendable and we definitely think over next couple of years there is earnings visibility in some of these segments especially housing finance related. The challenge though is once PSUs and the private sector banks choose to either chase for yield in the niche segments of NBFCs or come back for growth in some of the rural related sectors especially PSUs, we will have to be very careful on picking the right names rather than having a blanket view on NBFCs as a whole. So, I think we are getting to a point where we should start seeing a more nuanced pickup between different names in NBFCs rather than the entire cohort in one go.