‘The Divergence Ratio’ – What The Newest Banking Indicator In Town Tells You About Banks – Money Perception

Loknath Das May 26, 2017 Banking

The gross nonperforming asset ratio. The slippage ratio. The credit cost. The provision coverage ratio. All part of a long list of indicators that banking analysts are tracking to understand how sound Indian banks are. Now welcome to that list a new indicator. The divergence ratio.

In case you are wondering what each of these means – the gross NPA or non performing assets ratio is the ratio of bad loans to total loans; the slippage ratio is the rate at which good loans are turning bad; the credit cost is the amount a bank expects to lose due to credit risks; and the provision coverage ratio tells you how much money a bank has set aside to cover for bad loans.

Being a new entrant to the Indian banking lexicon, ‘The Divergence Ratio’ (a name coined by BloombergQuint) deserves more attention.

So what are we talking about?

On April 18, the RBI released a notification titled ‘Disclosure in the “Notes to Accounts” to the Financial Statements – Divergence in the asset classification and provisioning.

Don’t let that long convoluted title stop you from reading further.

In that notification, the Reserve Bank of India said that there have been instances of “material divergences in banks’ asset classification and provisioning from the RBI norms”. This had led to a situation where published financial statements are not “depicting a true and fair view of the financial position of the bank.”

In simple words, the RBI thinks that banks have been under-reporting bad loans. And they want it to stop.

So banks have been told that if there is a more than 15 percent difference in their assessment of bad loans versus that of the regulator, the ‘divergence’ must be disclosed.

Since the RBI circular, some eyebrow-raising instances have come to light.

  • Yes Bank Ltd. reported a divergence of Rs 4,176.70 crore for the year ended March 2016. This was 558 percent higher than the reported gross NPA of Rs 748.9 crore as on March 31, 2016.
  • Axis Bank Ltd. reported a divergence of Rs 9,480 crore, again, for fiscal 2016. This is about 156 percent more than the reported gross NPAs of Rs 6,087 crore at the end of FY16.
  • ICICI Bank Ltd. reported a divergence of Rs 5,104 crore, or 19 percent of the reported gross NPA of Rs 26,221 crore

Some other banks, like State Bank of India, have said they have no material divergence to report. Others are yet to release their annual reports, where this divergence is being reported in a format prescribed by the RBI.

Banks argue that this divergence is from two fiscal years ago.

Ignore it, they say, because any divergence that may have existed in fiscal 2016 has been taken care of in fiscal 2017.

The second half of that statement is partly correct. Following the RBI’s asset quality review, which stretched out over fiscal 2016 and fiscal 2017, banks have been forced to recognise visibly stressed assets as NPAs. Through this exercise, the banking industry’s view of bad loans and the RBI’s view of bad loans have converged.

But if a bank tells you to ignore the information about the bad loan divergence, ignore them. The information matters and here’s why.

Over a period of many years, Indian banks had become accustomed to ever-greening stressed loans. At first, this was happening with the regulator’s blessing as the RBI allowed for corporate debt restructuring on exceedingly lenient terms. When the regulatory forbearance ended on April 1, 2015, banks and companies tried to find various ways to keep their accounts standard, some of which tread the fine line of regulation. Short term loans taken to pay interest on long term loans. Borrowing from one bank to pay another. Lending to subsidiaries to ensure the parent firms have access to the money to repay its liabilities.

As the RBI said in its notice, all this meant that the outside world was not getting the true picture of a bank’s financials.

What the divergence is telling you is how skewed the picture presented by a bank was. If the divergence is high, in absolute terms and in terms of ratio of bad loans reported, investors and shareholders would be wise to see this as a governance red flag.

Questions that a bank’s board and its investors should then be asking include:

  • Why was there so much under reporting of bad loans?
  • Is the bank taking too much risk to push growth?
  • Is the bank ignoring obvious risk-related red flags?
  • Is the bank making enough provisions against likely risk?
  • And finally, does the under reporting point to weak governance?

A valid question to ask as banks report the divergence in bad loans is whether the RBI should take action against these banks.

The answer to that question lies in understanding what exactly the RBI found during the asset quality review. The results or findings of the review have not been made public in a comprehensive document. We wish they would be. In the absence of a comprehensive understanding of what the asset quality review found, we go by comments made by RBI deputy governor SS Mundra in a lecture on February 12, 2016. Mundra, in a speech at the peak of the bad loan clean-up, said that the regulator had detected malpractices such as round-tripping of funds by companies, repayment of short-term loans through overdraft facilities and incomplete evaluation of viability of projects.

It is not clear whether the transgressions the RBI found were clear breaches of regulations . If, indeed, banks were flouting norms, the regulator should take action. It should also disclose any action taken in the interest of the same transparency that it cites as a reason for asking banks to disclose divergences.

If the transgressions were more in the way of ‘managing’ bad loans using various loopholes or if they were a result of poor understanding of the true quality of a loan asset, then it is up to the board of banks to take the managements to task.


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