The RBI recently amended norms relating to provisioning for banks. Banks have to make provisions for loans so that in case some of the loans go bad (i.e. the borrower delays payments or cannot pay), the bank can use these provisions as a cushion. These provisions are made out of the earnings of the bank for that year.
The technical term used for bad loans is non-performing loans (NPLs). Of course, there are several more terms like write-offs, loan losses, past due loans still accruing interest income etc. But for purposes of our current analysis, the term NPL would do.
In 2009, the RBI had mandated that all banks should have a minimum provision of 70%. This meant that if a bank had INR 100 crores of NPLs on its books, it should have (from its revenues each year), cumulative provisions of INR 70 crores to cover these NPLs. However, this was changed recently when the RBI declared that for loans made after Sep2010, the requirement would not apply.
What does this imply for an equity investor in the banking space?
From a bank’s performance perspective, it bring no dramatic changes, therefore long-term investors don’t really benefit (or gain) by this relaxation of norms.
For banks which have had historically low provisioning, they will now have to meet the 70% target only for loans made before Sep2010. Since provisioning comes out of earnings, it means that the EPS (earnings per share) of these banks will go up in the short-term – all of course at the cost of lower coverage for the last 2 quarters of FY11.
Among the larger banks, SBI and ICICI Bank have had below 70% provisioning. Axis bank and Bank of India have just about met the 70% coverage ratio. But banks like HDFC Bank, Yes Bank, Bank of Baroda, PnB and Canara Bank meet these coverage requirements more than adequately.
Interpreting RBI action
The relaxed provisioning norms for loans made after Sep 2010 may be part of preventive action taken by RBI to thwart the threat of NPLs given that rates have increased by 100-125 basis points between Sep 2010 and Mar 2011 and are close to/at their peak.
