Indian banks to turn around in 2020, but may find more dirt than gold

Indian banks struggled to stem the rot in their balance sheets this year but their share prices have surged. Will 2020 be a time when banks start delivering on investors' hopes?

Rajnish Kumar, chairman of State Bank of India (SBI), certainly thinks so. Encouraged by the recovery from the high-profile insolvency case involving Essar Steel, Kumar and others now hope this would pave the way for more such recoveries. "2020 would be a happy and good year in terms of recovery," Kumar said in an interview.

He is not alone. Analysts already think banks would successfully bring down their decaying loan pile. Since more non-performing loans would come down, earnings would automatically get a big boost. Ergo, most analysts expect banks to report better return on assets going into 2020.

Before investors continue to be swept by their own hopes, they should heed the words of the regulator. "The health of the banking sector hinges around a turnaround in macroeconomic conditions," the Reserve Bank of India's (RBI) said in its Report on Trend and Progress of Banking in India on 24 December.

RBI's financial stability report warns that banks' bad loan ratios will worsen next year. Gross bad loans could rise to 9.9% by September, the report said. Then there is the fact that banks have been able to bring down their bad loans largely by writing them off. This doesn't speak much about an improvement in their recovery heft.

Another crucial factor is credit growth. Banks make money through lending and a slowing economy hardly contributes to loan growth. ICRA Ltd has said loan growth would plummet to a 58-year low of 8% in FY20. A slowing economy also makes recovery difficult. Unless economic growth revives from a six-year low of 4.5%, banks will find it tough to recover their dues. Note that a little over ₹3 trillion worth of dues are stuck in insolvency courts and lenders so far have been writing off nearly a quarter of bad loans every year.

To be sure, analysts have flagged the constraints of a slowing economy. "With most private banks reporting some stability in fresh NPL (non-performing loan) creation but with elevated credit costs, earnings are likely to remain under pressure in FY20 unless there is an improvement in recoveries or a pick-up in GDP growth," analysts at ICICI Securities said in their outlook note on banks.

Then there is the re-emergence of the old problem of farm loan waivers. According to reports, the Maharashtra government is gearing up to waive off loans to farmers.

Analysts at Kotak Institutional Equities pointed out that previous loan waivers have had a negative impact on credit quality and growth. The bad loan ratio for agriculture loans has risen sharply ever since loan waivers began to be announced two years ago. At the system level, bad loans in the agriculture sector formed more than 12% of the farm loan book.

That leaves the pristine retail loan book, on which banks have been relying for more than two years for growth. Delinquencies here have been historically low and, hence, emboldened banks to pursue the average individual to increase his leverage. But the fast growth in unsecured personal loans at a time when outlook on unemployment is negative holds risks for banks. RBI has already warned that banks should tamp down on their enthusiasm in this segment.

It was not easy being a bank in 2019 and it won't be easy in 2020.

The slowdown has become all pervasive and deeper in perhaps the most important parts of the economy.

Investors hope banks will turn a corner and perhaps they will. But it is likely that banks would find more dirt simply because the economy isn't expected to recover in a big way.