Why Indian banks will benefit from the increase in restructured loan provisions

The 2.75% provision is expected to strengthen their loss absorption capacity.

According to Moody's, last Tuesday, the Reserve Bank of India in its monetary policy review announced that it had increased the provision it requires on restructured loans to 2.75% from 2.00%.

Moody's believes the increase is credit positive for Indian banks because it will strengthen their loss absorption capacity and adds to bank management’s incentive to improve loan underwriting standards to strengthen asset quality.

Here's more from Moody's:

The growing number of restructured loans adds to the risks already looming over Indian banks 1 because of India’s weakening economy. Although a significant portion of restructured loans have turned into non-performing loans over time,2 they are subject to significantly less stringent provisioning and reporting requirements.

As the exhibit below shows, deterioration in Indian banks’ asset quality is characterized not only by 46% growth in reported gross non-performing loans, but also the more than doubling of restructured loans over the past year. Although the increased provisioning on restructured loans will result in Indian banks reporting lower net income, banks’ overall loss absorption capacity will benefit from higher provisioning cover. This is particularly the case for public banks where 6%-10% of their gross loans are restructured loans: Union Bank of India (Baa3 stable, D/ba2 stable),3 IDBI Bank Ltd (Baa3 stable, D-/ba3 stable), Syndicate Bank (Baa3 stable, D+/ba1 negative), Bank of India (Baa3 stable, D/ba2 stable), Bank of Baroda (Baa3 stable, D+/ba1 stable), Punjab National Bank (Baa3 stable, D+/ba1 stable), Indian Overseas Bank (Baa3 stable, D/ba2 stable), and Oriental Bank of Commerce (Baa3 stable, D+/ba1 negative).

The Reserve Bank of India’s move is also noteworthy in its timing because it decided to implement the increase ahead of other recommendations from its working group. If this signals an increasing policy push on banks to improve their internal risk monitoring processes, that would be good news for bank creditors.

Although the central bank remained silent on future steps, we note that a Reserve Bank of India working group tasked with reviewing existing prudential guidelines on restructuring of loans in July submitted a report proposing to increase the provision on restructured loans to 5% from 2% over a two-year period.

1. See Cancellation of Indian Telecom Licenses Adds to Mounting Challenges for Indian Banks, 27 February 2012.
2. No systemic study has been done on this topic, but anecdotally we have observed that 15%-25% of restructured loans turn into non-performing loans within one year of restructuring.
3. The bank ratings shown in this report are the bank’s deposit rating, its standalone bank financial strength rating/baseline credit assessment and the corresponding rating outlooks.