Are bank balance sheets priced to truth as SC leash is off bad loan recognition?

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Shares of Indian banks have received their final booster shot after the Supreme Court lifted the standstill on bad loan recognition. So far, banks couldn’t declare defaulters since the 6-month moratorium ended in August.

The Bank Nifty has gained a massive 98% since the case on compound interest was filed at the apex court on 27 March last year. The rise gathered pace October onwards and the index has outpaced the broad market since then. The question is whether bank balance sheets are priced to truth.

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Headline bad loan ratios have not been reflecting the true extent of trouble so far because of the standstill. To be fair, most lenders have already been giving their slippages through proforma bad loan metrics which investors have appreciated. As such bank shares reflect these numbers today, according to analysts.

So what’s new? The Supreme Court verdict on Tuesday removed the uncertainty over compound interest matter. The moratorium period was not extended and a complete interest waiver was not given. To be sure, the compound interest waiver is extended now to all loans. This will result in a temporary dip in interest income of lenders. If banks end up footing the bill for the additional interest they need to forgo, the outgo will be 7500-8000 crore, according to ICRA Ltd.

Investors now need not worry about a judicial event on interest repayment anymore. With the lifting of the standstill on bad loan recognition, lenders can now begin their resolution process. Since lenders couldn’t label defaulters, they couldn’t chase defaulters for repayments effectively. Now that is possible which is likely to show up in improved recovery. “Withdrawal of the stay on NPA recognition will allow lenders to recognize actual NPAs and actively pursue recovery efforts,” wrote analysts at Motilal Oswal Financial Services Ltd in a note. Note that fresh admissions under the Insolvency and Bankruptcy Code (IBC) will begin from today as the suspension of the code is lifted. Bankers expect a slew of applications at the courts.

All said and done, the fact remains that banks saw stressed loans rise in the December quarter compared with the previous quarters. Even though the extent of rise has been far lower than earlier feared, the probability of continued stress is still there. Further, the success of recovery efforts of banks in the case of corporate loans is sketchy at best despite IBC. Barring select large recoveries, lenders have struggled to get their monies back and have been at the receiving end of deep haircuts.

Analysts at Edelweiss Securities Ltd also raise the point of judicial intervention as a key risk for investors. “Absence of earnings materiality does not render this ruling insignificant. Judicial intervention into an essentially private commercial relationship between a bank and its customer and that the recommendations of the honourable court constitute a strain on shareholders, however small, would be noted,” said a note from the brokerage.

So far Bank Nifty’s flight may seem justified given the sanguine outlook on bank earnings. But the real test begins now when lenders chase growth alongside a two-faced recovery in the economy.

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