Banks

India

Stress Test on Indian Banks

Reasonable Defences, But Mounting Pressures
Special Report

Mounting Concentration Pressures: The credit profile of a few Indian banks has weakened
due to high single-name concentrations and stress in infrastructure loans. India Ratings stress
test considers non-performing loan (NPL)-like provisions on these exposures even though they
enjoy regulatory forbearance of restructuring, given that some of the problems may be long-
term and structural in nature and linked to sensitive public policy issues. Banks reported profits
do not reflect this underlying pressure; however the structural weakness has already impacted
the ratings of a few government banks.

Mostly Unimpaired Core Capital: A key finding is that most Indian banks can absorb stressed
credit costs through profits and general loan loss reserves, leaving common equity largely
unimpaired. Only five out of the 22 banks studied show capital impairment above 10%, with the
highest reduction under stress being 36% of existing common equity. The stressed common
equity Tier 1 (CET 1) ratios of 20 banks remain above 6% and only one bank (government
owned) is below the regulatory minimum of 4.5%.

Tighter Stress Assumptions: The prevailing slowdown in the Indian economy is the longest in
the last 10 years, a marked difference from the 2008 crisis when the economy benefited from a
globally coordinated rebound. The pressures on the governments fiscal position also reflects
the growing uncertainties and therefore India Ratings has tightened credit loss assumptions in
the stress test compared with a similar exercise in 2009.

Cyclical Pressure Dominates: Over 50% of stressed credit losses are from cyclical sectors
that would benefit from a pick-up in growth, which is India Ratings base case for 2013. The
slowdown may, however, continue before improving and the incremental two-year loss
assumptions for various sectors are robust by historical standards. For example, the stress test
studies the impact of gross NPL ratio increasing to an average 14.5% (from the current 3%),
with loan loss reserves building up to an average 60% of NPLs in two years.

Regulatory Strengthening Positive: With the Basel III requirements beginning in January
2013, Indian banks will be driven to improve core capitalisation. A proposed regulation to phase
out the forbearance on restructured loans may be introduced in 2014, which will improve
transparency and help report the true credit costs of banks. The governments commitment to
Related Research ensure that its banks are adequately capitalised provides comfort the shortfall in the stress
2012 Outlook: Indian Banks (January 2012) test should not stretch the governments finances.
India Restructured Loan Proposal Would
Boost Transparency (July 2012)
Continued Funding Challenges: While funding is primarily from customer deposits with
Indian Banks: A Health Check (August 2011)
steady refinancing, the seasonal demand for credit results in incremental loan / deposit ratio
Stress Test on Indian Banks: Higher-Rated
Banks Mostly Able to Preserve Equity being higher than 100% during parts of the year. This was sustained in some mid-sized
(October 2009)
government banks during FY12, leading to a weakening funding profile and increased
dependence on bulk deposits. The government has asked its banks to reduce this
Analysts
dependence. Banks may consider increasing long-term refinance from policy institutions or
Ananda Bhoumik
+91 22 4000 1720 issue bonds, or even cut back growth.
ananda.bhoumik@indiaratings.co.in
Ratings Mostly Aligned: Most of India Ratings ratings are aligned with the results of the
Urval Goradia
+91 22 4000 1710 stress test, with a downward bias on the standalone creditworthiness of those banks that
urval.goradia@indiaratings.co.in
underperform the test compared with their rated peers. While a large part of the current
Ehsan Syed pressures are cyclical, a further build-up in sector concentrations and single-name
+91 22 4000 1722 concentrations during 2013 could lead to a negative outlook on the sector.
ehsan.syed@indiaratings.co.in

www.indiaratings.co.in 10 October 2012

 Banks
Cyclical and Structural Challenges
The stress test is carried out in the backdrop of the economic slowdown and build-up of
structural weaknesses in Indian banks. Some of these, including growing single-name
concentration and exposure to infrastructure lending, have built up over time.

Growing Concentration: Infrastructure lending was the growth driver for Indian banks
between 2008 and 2011, a period that followed the consumer loan boom in the mid-2000s.

Figure 1

Key Exposures and Growth Drivers of Indian Banks

16%

14%
Share in System Loans (July 2012)

System Loans CAGR

12% Agriculture

10%
Mortgage

8% Power

6%
Trade NBFC
Iron & Steel
4% Personal
Loans Textiles
Engineering Roads
CRE
2% Chemicals Telecom

0%
0% 5% 10% 15% 20% 25% 30% 35% 40% 45%
Loan CAGR (Mar 2009 - July 2012)
Source: RBI, CRE refers to Commercial Real Estate, Chemicals includes Fertilizer, Pharma and Petrochemicals

Figure 2 By mid-2012, infrastructure loans at 14.5% had replaced residential mortgage and agriculture
Indian Banks - Single-Name as the single largest sector exposure of Indian banks. Together with growing corporate
Concentration exposure, the resulting single-name concentration in the Indian banking system is now
Top 20 exposures/equity
significant enough to generate spikes in stressed assets.
Wtd.
average
Mounting Cyclical Pressures: Corporate performance is affected by the weakening economic
Maximum
performance; profitability and interest cover have only slightly improved compared with those
during the 2008 economic crisis. A continued slowdown in demand means that corporate
Minimum
performance may continue to suffer till early-2013, putting further cyclical pressure on banks
0 200 400 asset quality.
(%)
Source: India Ratings. As on end-March 2012
Figure 3

Financial Performance of Indian Corporates

Profit after tax to sales (LHS) Interest coverage (RHS)
(%) (x)
15 9
12
6
9
6
3
3
0 0
Apr-Jun 07

Jul-Sep 07

Oct-Dec 07

Jan-Mar 08

Apr-Jun 08

Jul-Sep 08

Oct-Dec 08

Jan-Mar 09

Apr-Jun 09

Jul-Sep 09

Oct-Dec 09

Jan-Mar 10

Apr-Jun 10

Jul-Sep 10

Oct-Dec 10

Jan-Mar 11

Apr-Jun 11

Jul-Sep 11

Oct-Dec 11

Jan-Mar 12

Source: RBI

Related Criteria
The resulting asset quality pressures are reflected in the spike in restructured loans, which at
Financial Institutions Rating Criteria an estimated 6% of loans by March 2013 (restructured in 2011 and 2012) is already 1.4x the
(12 September 2012)

Stress Test on Indian Banks 2

October 2012
 Banks
amount of restructured loans in the aftermath of the 2008 crisis. Regulatory forbearance of
restructured loans means that most of this pressure is not reflected in the reported credit cost.
The governments ownership of some of the weak borrowers and viability of infrastructure
projects in India help mitigate the ultimate loss expectations on some of these loans.

The recent scheme for restructuring loans to state electricity boards is one such example
where the government has intervened. However, given the long-term nature of these loans,
India Ratings stress test assumes an NPL-like situation for most of restructured exposures as
the weak economic environment may result in some short-term losses for lenders.

Figure 4

Indian Banks - Build-up of Stressed Assets

System NPL ratio Performing' restructured loans Real GDP growth
(%)
12

0
Mar 05 Mar 06 Mar 07 Mar 08 Mar 09 Mar 10 Mar 11 Mar 12 Mar 13
Fcst.
Source: Reserve Bank of India, India Ratings

Stress Test Assumptions

India Ratings stress test on rated Indian banks checks their ability to absorb sudden shocks in
credit cost that may arise due to cyclical or structural reasons. The stress case examines the
impact of incremental credit cost over two years on banks stressed pre-provision profits, during
which time banks are required to make an average 60% specific provisions on additional NPLs
that are generated in a hypothetical worst-case scenario. The stressed credit cost is first
absorbed by pre-provision profits and general provisions (Tier II capital) before impacting
common equity Tier I capital.

The two-year credit cost assumptions are robust by historical standards (see Table 1 in
Annexure), particularly in infrastructure where reported credit losses have so far been
negligible. India Ratings base case scenario is more benign, and these stress assumptions
reflect a worst-case scenario to examine the relative position of banks in the system. For
example, a key addition in the 2012 stress test compared with the 2009 test is an assumption
that two of the top 20 exposures of a bank could turn into NPLs. This is driven by idiosyncratic
risk factors emanating from high single-name concentration in Indian banks, rather than any
sector specific problem.

Stressed credit cost is calculated on a banks total exposure to a sector, and both funded and
non-funded exposures are treated identically. Experience in some banks suggest that non-fund
exposures could be less risky compared with funded exposures, particularly for performance
guarantees linked to projects or transactions that may continue performing irrespective of the
issuers liquidity problems. However, since this exercise considers a worst-case scenario where
an issuers solvency may be at stake, non-fund exposures have been considered to be equally
at risk compared with funded exposures.

Pre-provision operating profits of banks have been stressed in the test depending on their
funding profile. For example, banks FY12 pre-provision profit has been reduced by 5%-20%,
based on an inverse relationship with their funding profile and base of low-cost deposits (CASA
- current account and savings account). The reduction is least (5%) in banks whose share of
low-cost deposits is over 40% of total deposits, as these banks have the most stable funding
structure with least dependence on volatile wholesale deposits. Conversely, the reduction in

Stress Test on Indian Banks 3

October 2012
 Banks
profits is highest (20%) in banks that have a low CASA base (below 20% of deposits) and are
prone to volatile net interest margins.

If a banks stressed pre-provision profit is inadequate to absorb incremental credit costs, then a
shortfall is first absorbed by its general loan loss reserves, after which common equity Tier I
(CET 1) is impacted. The CET 1 calculation is consistent with the Reserve Bank of Indias (RBI)
definition under the Basel III guidelines (unamortised defined benefit obligations have been
reduced), with one additional adjustment: if a banks reported specific loan loss reserve at end-
March 2012 was below 60% of gross NPLs, then its CET 1 under the stress test is reduced to
the extent of this shortfall. By doing so, all banks have been brought to a minimum common
provisioning level covering existing NPLs (60% specific reserves), thereby creating a common
starting point for measuring the impact of incremental credit costs.

Stress Test Findings

For the Indian banking system, pressure in cyclical sectors is the largest contributer to stressed
credit cost, but is reasonably absorbed by pre-provision profits. Profits are still adequate after
adding stressed credit costs of infrastructure lending, suggesting that the system as a whole is
able to absorb worst-case sector losses without impacting equity.

However, profits prove inadequate to absorb the third layer of idiosyncratic single-name risk,
suggesting that cyclical pressures, sector concentration and single-name concentration
together are borderline negative for the Indian banking system. The deficit can be fully
absorbed by the outstanding general provisions in the system, leaving the overall equity
unimpaired. This intrinsic resilience together with a large part of the problem being cyclical in
nature helps explain the stable outlook for the banking system.

Figure 5

Stress Test Result/Past Financials of the Indian Banking System

As % of average loans Single name stress
Infrastructure stress
Cyclical stress
Addl. estimated cost if all restructured were treated as NPLs
Historical credit cost
(%) Historical PPOP
Stressed PPOP
5
4
3
2
1
0
FY07 FY08 FY09 FY10 FY11 FY12 Stress case
Source: India Ratings. System Test Result obtained as weighted average of individual bank stress test results

The impacts of the stress test on individual banks vary and are presented in three peer blocks:
(i) large banks with strong standalone credit profile (ii) other large and mid-sized government
banks and (iii) mid-to-small private banks.

Large banks with strong standalone credit profile: These banks typically have diversified
loan portfolios with strong earnings profile. Credit stresses are primarily cyclical in nature,
providing resilience. Funding profile is strong (with usually high and stable CASA ratios) and
provides stability to net interest margin (NIM).

Pre-provision profits are adequate in most cases to absorb stressed credit costs. HDFC Bank
has the strongest profile with the most superior profit buffer among the large Indian banks in
the study. A visible weak outlier is Canara Bank on account of its relatively larger wholesale
banking profile, resulting in lower NIM and the highest relative exposure to stresses from
infrastructure lending and single-name concentration. This vulnerability exposes its equity to
potentially higher pressures than its peers; moreover, the banks equity adjusted for provisions

Stress Test on Indian Banks 4

October 2012
 Banks
is also among the lowest in the peer set, suggesting a somewhat weaker standalone credit
profile compared with its peers.

Figure 6

Stressed Credit Costs of Large Banks with Strong Standalone Credit Profiles
As % of average loans
Cyclical (incl. NBFC, CRE, agri & retail) Infrastructure Exposure concentrations Stressed Pre-provision profit
(%)
5

0
HDFC Bank SBI Cons PNB Axis BOB Indian Canara

Source: India Ratings, Based on March 2012 Annual Reports/ Basel II disclosures

These banks have strong business franchises in the domestic market with easy access to
equity markets, helping them maintain above average common equity capital ratios. Most
banks are able to maintain their strong equity position at the end of the stress test; HDFC Bank
has the highest common equity tier 1 ratios (stressed result: 11.5%). Canara Bank, which has
the lowest capitalisation ratio, still manages a somewhat adequate common equity Tier 1 ratio
of 7.3% at the end of the test.

Figure 7
Post-Stress Common Equity Tier-1 Capital Ratios of Large Banks with Strong
Standalone Credit Profiles
As % of risk-weighted assets
(%) Impaired due to LLR adjustment Impaired due to stress Unimpaired CET1
14
12
10
8
6
4
2
0
HDFC Bank SBI Cons PNB Axis BOB Indian Canara

Source: India Ratings, CET1 Calculated after adjusting for Unamortised Pension obligations and removing Non-Equity
Tier 1 instruments. LLR Adjustment involves raising Specific Loan Loss Reserve Coverage to 60%

Other large and mid-sized government banks: A notable feature in most of these banks is
their high exposure to infrastructure lending, which dominates their stressed credit costs. NIMs
are weaker than the first peer set and given their greater dependence on wholesale funding,
these also tend to be more volatile. As a result, the weaker banks in this peer class appear
unable to absorb stressed credit costs through profits, leaving their equity exposed to
impairment during a crisis.

The weaker profitability and lower internal accruals also result in weaker capital ratios in these
banks. This combination of lower buffers in both profitability and equity is reflected in the
weaker standalone credit profile of some of these banks and consequently lower rating of their
hybrid capital instruments. UCOs post stress common equity Tier 1 ratio is the weakest
amongst all banks, partly due to the banks lower profitability and also due to equity depletion in
the test through adjusting for the banks low specific loan loss reserves.

While performance of these banks may therefore be volatile, their position as government-
owned banks boosts deposit refinancing and mitigates their liquidity risk. In addition,
expectations of timely government support helps provide a support floor to their long-term
issuer rating, which is typically higher than their standalone credit profile.

Stress Test on Indian Banks 5

October 2012
 Banks
Figure 8

Stressed Credit Costs of Other Govt. Banks

As % of average loans
Cyclical (incl. NBFC, CRE, agri & retail) Infrastructure Exposure concentrations Stressed Pre-provision profit
(%)
5

0
Allahabad Andhra Union Dena UCO IDBI Vijaya
Source: India Ratings. Based on March 2012 Annual Reports/ Basel II disclosures

Recent rating actions on some of these banks reflect these relative vulnerabilities. For
example, the ratings of hybrid capital instruments issued by Vijaya Bank and UCO Bank were
downgraded in May 2012. Both banks fare poorly in the stress test and also have low equity
buffers. The issuer ratings of these banks are at their support floor.

Figure 9

Post-Stress Common Equity Tier-1 Ratios of Other Govt. Banks

As % of risk-weighted assets
Unimpaired CET1 Impaired due to stress Impaired due to LLR adjustment
(%)
9
8
7
6
5
4
3
2
1
0
Allahabad Andhra Union Dena UCO IDBI Vijaya

Source: India Ratings. CET1 Calculated after adjusting for Unamortised Pension obligations and removing Non-
Equity Tier 1 instruments. LLR Adjustment involves raising Specific Loan Loss Reserve Coverage to 60%

Mid-to-small private banks: This is a more varied peer set with ratings ranging from IND
AA+ to IND BBB. Loan segments suggest strong cyclical correlations; this is particularly
relevant for banks with higher loan yields and profitability through exposure to more vulnerable
customer segments. Many of these are also regional banks with asset quality linked to the local
economy

Figure 10

Stressed Credit Costs of Other Pvt. Banks

As % of average loans
Cyclical (incl. NBFC, CRE, agri & retail) Infrastructure Exposure concentrations Stressed Pre-provision profit
(%)
6
5
4
3
2
1
0
Kotak Cons JK Bank Federal Indusind City Union South Indian Lakshmi Vilas Catholic
Syrian
Source: India Ratings. Based on March 2012 Annual Reports/ Basel II disclosures

The results are broadly in line with the rating levels, with banks rated in the IND A category
and above having generally adequate profitability and equity to absorb the stressed credit
costs. The two weakest banks are in the IND BBB category; post-stress, their common equity
Tier 1 ratio is still around 7%.

Stress Test on Indian Banks 6

October 2012
 Banks
Figure 11

Post-Stress Common Equity Tier-1 Ratios of Other Pvt. Banks

As % of risk-weighted assets
Unimpaired CET1 Impaired due to stress Impaired due to LLR adjustment
(%)
18
15
12
9
6
3
0
Kotak Cons JK Bank Federal Indusind City Union South Indian Lakshmi Vilas Catholic
Syrian
Source: India Ratings. CET1 Calculated after adjusting for Unamortised Pension obligations and removing Non-
Equity Tier 1 instruments. LLR Adjustment involves raising Specific Loan Loss Reserve Coverage to 60%

Funding
The stress test has focussed on credit costs and banks ability to withstand stress through
resilience in profitability, general loan loss reserves and common equity capital. Funding for the
system is largely (more than 80%) domestic and dependent on customer deposits, and a
traditional strength.

Nevertheless, the loan/deposit ratio for the system crept up closer to 80% in FY12 as deposit
growth trailed loan growth, given the negative real interest rates that shifted domestic savings
to investments in gold. While real interest rates may not pick up given the sticky inflation
situation, RBI has been easing liquidity for banks through gradual reductions in statutory
liquidity ratio and cash reserve ratio, which are regulatory co-options of bank deposits. These
reserve ratios are still significant at 27.5% of deposits, providing the regulator with considerable
headroom to inject liquidity into the banking system, if required.

Figure 12

Indian Banks - Deposit Profile, Loans/Deposit Ratios

As on end-March 2012
Term Savings Current Loans/deposit ratio
100%

80%

60%

40%

20%

0%
Large Govt. Banks Large Pvt Banks Large Pvt. Banks (ex- Mid / Small Govt. Other Pvt. Banks
ICICI) Banks
Source: Bank Annual Reports, India Ratings

Incremental loan/deposit ratios are more volatile, given the seasonal nature of credit demand.
For example, the incremental three-month loan/deposit ratio in the system periodically jumps to
well over 100% towards the end of the financial year when the working capital cycle for
corporates peak given the push to maximise annual sales. The ratio had eased off between
FY07 and FY09 when deposit growth was strong during the high interest rate regime.

With customer deposit growth rate falling during the negative real interest rate regime since
FY10, the year-end incremental loan/deposit rates have been high, leading to a rising share of
wholesale deposits especially in government banks. In mid-2012, the government instructed its
banks to reduce this dependence in a time bound manner, which may lead to a temporary fall
in credit growth together with banks switching to long-term refinancing lines from nodal
agencies.

Stress Test on Indian Banks 7

October 2012
 Banks
Figure 13

Indian Banks - Incremental Loans/Deposits

(%) Incremental Loans / Deposits in Preceding 3 months
700
600
500
400
300
200
100
0
-100
Mar 01 Mar 02 Mar 03 Mar 04 Mar 05 Mar 06 Mar 07 Mar 08 Mar 09 Mar 10 Mar 11 Mar 12
Source: RBI. Spike in Nov 2004 due to conversion of a non-banking entity into a bank

Stress Test on Indian Banks 8

October 2012
 Banks
Annexure 1

Figure 14
Incremental Credit Cost Assumptions
Incremental NPL ratio
Loan loss
reserves (to be Incremental 2-
Sector (%) 2009 test 2012 test created in 2 years) year credit cost
1. Industry exposures
a. Exposure to infrastructure
Infrastructure, of which
Power + electricity (excluding SEBs) 5.5 10.0 40.0 4.0
State electricity boards (SEBs) 5.5 40.0 40.0 16.0
Telecom 5.5 5.0 50.0 2.5
Roads & ports 5.5 6.0 50.0 3.0
Other infrastructure 5.5 5.5 50.0 2.8

b. Exposure to cyclical sectors

Mining 3.5 7.0 60.0 4.2
Iron & steel 6.0 6.0 60.0 3.6
Other metals and metal products 3.5 4.0 60.0 2.4
Engineering 5.5 5.5 60.0 3.3
Textiles 6.0 6.0 60.0 3.6
Food processing 3.5 3.5 60.0 2.1
Paper/paper products 3.5 6.0 60.0 3.6
Chemicals/fertiliser/pharma 3.5 5.0 60.0 3.0
Cement 3.5 5.0 60.0 3.0
Gems & jewellery 6.5 6.5 60.0 3.9
Construction 6.5 6.5 60.0 3.9
Petroleum 3.5 3.5 60.0 2.1
Automobiles & trucks 5.5 7.0 60.0 4.2
Computer software 4.0 4.0 70.0 2.8
Other industries & services 3.5 6.0 60.0 3.6
Natural resourcesa 3.5 3.5 60.0 2.1
Trading 5.0 5.0 70.0 3.5
Shipping 6.0 6.0 60.0 3.6
NBFCs 4.0 4.0 60.0 2.4
Commercial real estate 17.5 17.5 60.0 10.5

2. Agriculture & allied 7.0 7.0 60.0 4.2

3. Retail exposures
Housing 2.0 4.0 40.0 1.6
Credit cards 17.0 20.0 100.0 20.0
Personal (incl. education) 6.0 10.0 60.0 6.0
Gold loans n.a. 8.0 30.0 2.4
Auto loans n.a. 5.0 60.0 3.0
Other retail exposures 6.0 5.0 60.0 3.0

4. International exposures n.a. 5.0 60.0 3.0

5. SME exposures 7.0 10.0 60.0 6.0

6. Other exposures 3.5 6.0 60.0 3.6

7. Top 20 exposures n.a. 10.0 60.0 6.0

a
Natural Resources: Coal, Sugar, Tea, Tobacco, Rubber, Paper, Edible Oils, Rubber, Leather
Source: India Ratings

Stress Test on Indian Banks 9

October 2012
 Banks
Annexure 2

Figure 15
Ratings
India Ratings
Long-Term/Lower Tier
Name of bank II Debt Rating Upper Tier II debt Perpetual Tier I debt
Allahabad Bank IND AA/Stable - -
Andhra Bank IND AA+/Negative - -
Axis Bank IND AAA/Stable IND AA+ IND AA+
Bank of Baroda IND AAA/Stable - -
Canara Bank IND AAA/Stable - -
Catholic Syrian Bank IND BBB/Stable - -
City Union Bank IND A/Stable - -
Dena Bank IND AA-/Stable IND A- IND A-
Federal Bank IND AA-/Stable - -
HDFC Bank IND AAA/Stable - -
IDBI Bank IND AA+/Stable IND AA- -
Indian Bank IND AA+/Stable - -
Indusind Bank IND AA-/Stable IND A -
Jammu and Kashmir Bank IND AA/Stable - -
Kotak Mahindra Bank IND AA+/Stable IND AA -
Lakshmi Vilas Bank IND BBB+/Stable - -
Punjab National Bank IND AAA/Stable - -
South Indian Bank IND A+/Stable - -
State Bank of India IND AAA/Stable - -
UCO Bank IND AA/Stable IND A- IND A-
Union Bank of India IND AA+/Stable IND AA IND AA
Vijaya Bank IND AA-/Stable IND A- -
Source: India Ratings

Stress Test on Indian Banks 10

October 2012
 Banks

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Stress Test on Indian Banks 11

October 2012