PNB scam can trigger a major market crash

'The financial sector will be hit even harder than the overall market.'
'The banking sector will eventually be rescued.'
'But it may go into a long downwards spiral before things turn around.'
'Threat or buying opportunity?' asks Devangshu Datta.

Photograph: Toby Melville/Reuters

When there's a crisis in an industry that's too important to fail, is it a threat or opportunity for investors?

Analysts of Indian banking will be wondering about the answer. The non-performing assets crisis has had a crippling effect. Banks have become cautious about fresh lending as bad debts mounted.

They have also been trying to hide the extent of the problem.

Raghuram Rajan started the process of forcing banks to recognise NPAs when he was the Reserve Bank of India governor and the central bank has stepped up its efforts to force NPA recognition.

In its last financial stability report (FSR), the RBI reckoned that NPAs would hit 11 per cent of all advance by September 2018, up from 10.2 per cent in September 2017.

In Q3, 2017-2018 results, NPAs have exceeded expectations. Norms for NPA recognition have since been tightened further.

The RBI has wound down schemes like CDR, SF4, which allowed banks to kick the problems down the road and it has shortened the default period for NPA recognition.

By September 2018, the stressed asset levels will almost certainly, be significantly higher than the RBI reckoned in the last FSR.

We're talking maybe 10 per cent of GDP.

Going by the cases that have gone through the IBC process, big haircuts will be required.

More scams like the PNB mega-scam (or more fallout from that scam) are likely to float to the surface as banks scrutinise operational processes.

Given a series of upcoming elections, the chances of further loan slippages with agricultural loans being forgiven, power subsidies that lead to defaults, etc, is high.

The recapitalisation needed for bringing banks into line with Basel III will be at least double the current bailout package of Rs 2.2 trillion. It might well be more than even 2x eventually.

The problems are too large to wish away.

Allowing a collapse of the banking sector is not an option. So there will be bailouts, or perhaps, bail-ins.

We know from economic history that financial crises cause more lasting damage than crises in other sectors. India is also bank-dependent because it doesn't have a corporate bond market to speak of.

The banking sector is oddly valued, with PSU banks at low PEs and private banks at high PEs.

Private sector banks have relatively cleaner balance sheets. However, there are problems evident there as well.

PSU banks seem undervalued at first glance, since most trade at discounts to official book value.

But as their net worth is wiped out, and NPA recognition toughens up, PSU banks will also start to look over-valued.

The latest results indicate that official BV is overstated for most PSU banks.

The conventional way to clean up banks involves pain.

Let bad banks fail, force mergers, etc. This would kill credit flows until the sector is cleaned up.

It would lead to growth deceleration and probably, to deflation and recession.

When the global financial crisis developed in 2008, the major central banks resorted to unconventional, desperate, measures. They kicked off Quantitative Easing programmes to create liquidity.

The central banks bought bonds, releasing money.

They also cut interest rates to zero, and then to negative in Yen and Euro to encourage re-flation.

The US Treasury (equivalent to the Indian finance ministry) started the Troubled Assets Relief Programme buying up bad debt at very deep discounts.

Ten years later, the Bank of Japan and the European Central Bank still have ongoing QE programmes and negative interest rates.

The QE route isn't really open to the RBI anyhow. The rupee isn't hard currency.

Negative interest rates could lead to a currency crash and flight of capital.

There aren't enough bonds for the RBI to buy, assuming it wants to impart liquidity.

The credibility of the Indian financial system is also low after the shambles of demonetisation.

This scam coupled to the poorly-drafted FRDI Bill will further erode confidence.

The political connections to the PNB scam are also likely to be embarrassing to the government.

This scam has the potential to trigger a major market crash and the financial sector will be hit even harder than the overall market.

But there's no question that PNB is much too large to be allowed to fail.

The banking sector will eventually be rescued.

But it may go into a long downwards spiral before things turn around. Threat or buying opportunity?