Credit offtake for the banking sector has been slow over the last two to three years, with loan growth hovering at abysmal 5 per cent levels through FY17. But weak core performance aside, what has really ailed the banking sector is the persisting asset quality pressure.

The RBI’s asset quality review (AQR) that led to sharp rise in bad loans in FY16, resulted in huge losses, particularly for state-owned banks. While many banking stocks have rallied sharply over the past year, driven by market sentiment, much of the exuberance lacks fundamental backing. Expectations of a turnaround in the economy and bad loan woes bottoming out, have not quite played out.

Punjab National Bank (PNB) is one such stock that has nearly doubled over the past year. True, after reporting a huge loss of around ₹4,000 crore in FY16, the bank ended FY17 in the black, with a profit of ₹1,325 crore. Fresh slippages to NPAs too halved from about ₹42,200 crore in FY16 to ₹22,400 crore in FY17.

But these positives come with caveats. For one, while fall in bad loan provisioning aided earnings, weak loan growth and decline in margins are a concern. In fact, had it not been for the one-off adjustment in pension expenses to the tune of around ₹2,000 crore, the bank would have slipped into the red, reporting losses of about ₹700 crore for the FY17 fiscal.

Two, PNB’s gross non-performing assets are still a steep 12.5 per cent of loans at about ₹55,370 crore. A large bad loan book will likely keep provisioning requirement high, even in FY18. Given the weak underlying core performance, absorbing such high provisioning cost will weigh on earnings and the bank’s returns ratio which are already muted (return on asset of 0.19 per cent and return on equity of 3.52 per cent as of March 2017).

Moreover, slippages still remain elevated when compared to the past trend (before AQR); in FY15, slippages stood at around ₹15,600 crore. Write-offs too remain high at ₹9,200 crore in FY17 versus ₹6,485 crore in FY16. Write-off is a process wherein banks stop recording the bad loans in the books and take a hit on their profits by fully providing for such loans. Persisting high levels of write-offs can also continue to drag earnings.

Expectations of a turnaround and seemingly lower asset quality pressure has driven the stock price of PNB over the past year. The stock trades at 0.8 times its one-year forward book value, up from 0.4 times last year. While this is still lower than its long term seven-year historical average of about 1 time, valuations based on banks’ book value can be misleading.

Accounting for net non-performing assets and restructured book (assuming 30 per cent slippages) that have gone up significantly in the last two years for PNB, the stock trades at around 1.5 times its forward adjusted book. This can correct substantially if earnings disappoint in the coming quarters.

The stock can hence de-rate from the current levels. Investors can sell the stock and enter as earnings visibility emerges over the next several quarters.

Weak performance

While the bank’s weak core performance mirrors the overall lacklustre growth within the sector, it remains worrisome, given the still high level of provisioning requirement. After growing by 11.7 per cent in FY16, PNB’s domestic loans grew by just 3 per cent in FY17. The net interest margin (domestic) has fallen by about 30 basis points to 2.7 per cent in the FY17 fiscal. This decline follows a 60 basis points fall in FY16. Weak loan growth and continued pressure on margins led to a 2 per cent fall in the bank’s net interest income in FY17. But for the other income boost, which grew 49 per cent in FY17 and one-off adjustment in pension expenses in the March quarter, earnings would have slipped into the red again in FY17.

PNB’s weak capital position is also a cause for concern. The bank’s Tier I capital and total capital stood at 8.9 per cent and 11.6 per cent respectively as of March 2017. Current norms under Basel III require banks to maintain a minimum capital adequacy ratio (CAR) of 9 per cent (plus 1.25 per cent of counter cyclical buffer) and a Tier-I ratio of 7 per cent. The bank would require further capital from the Centre in 2017-18. Capital infusion at below book value can lead to increase in equity base and dilution in per share earnings and book value further.

Asset quality pressure

Even before the RBI’s AQR that led to sharp rise in bad loans in FY16, PNB’s asset quality had been under pressure. This was on account of the bank’s exposure to troubled sectors such as power and iron and steel.

Bad loans that moved up from 6.5 per cent in FY15 to 12.9 per cent in FY16, remained at these levels (12.5 per cent) in FY17, despite fall in fresh slippages and large write-offs. Provisions that more than doubled in FY16 from the previous year, fell by around 27 per cent in FY17.

However, given the large bad loan book, provision requirement is expected to remain high in FY18 as well, even if the bank manages to contain slippages. The bank’s stressed assets (net NPAs plus 30 per cent of restructured assets) is over 80 per cent of net worth, implying lesser bandwidth to improve provision coverage ratio substantially.

Of the total restructured assets, about 22 per cent is from the power sector, 12 per cent from road and port, and 10 per cent each from sugar and iron and steel. Possibility of sharp slippages from the restructured accounts into bad loans persists.

The bank’s restructured loans as of March 2016 had fallen to 4.6 per cent of loans, from about 9.7 in the previous year, because a majority of the slippages into bad loans were from restructured assets. In FY17 too, slippages from these accounts have been high. As of March 2017, the bank’s restructured loans stood at 2.7 per cent of loans.

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