When Pratip Chaudhuri walked into the Taj Bengal hotel in Kolkata on April 17, he looked morose. “Downtrodden,” remembers one person who knows him well. “The weight of the world was on his shoulders.”
Chaudhuri had only been chairman of State Bank India (SBI) for 10 days, having taken over the reins from outgoing chief O.P. Bhatt. Yet he was at the iconic venue to reveal to investors, the listening public, and 200,000 employees that the bank he had worked at for 36 years had registered a staggering quarterly fall in profits.
SBI’s earnings didn’t just drop in the last three months of the Indian financial year, they hit terminal velocity. The bank registered a 99% drop in year-on-year profits for the quarter ending March 31 to just INR200 million (US$4.4 million), down from INR19 billion a year ago.
Small surprise then that Chaudhuri, described by analysts and investors as canny and engaging, and “well aware of the poor public image of state-run Indian banks”, felt so beaten up that April morning.
The collapse was especially marked given SBI’s shining performance in the three months beforehand. Between October and December the bank had reported near record profits for a single quarter, marking a glorious send-off for Bhatt, who was going on to tend his garden in semi-retirement.
SBI’s stock price tumbled. Its shares fell 15% over the 10 days after April 17, while by June 22 they had shed more than a quarter of their value. On June 27 they were trading at INR2,326, their lowest level in nearly a year.
How could a bank the size and stature of SBI move from hero to zero in the space of just three months? The answer is simple: tradition gone mad.
The chairmen of many of India’s public-sector banks (as well as a few prominent private lenders), traditionally rack up profits as high as possible in the final quarter they are in charge. The process is generally known as ‘kitchen-sinking’, because the chairman throws anything positive he can into the balance sheet (i.e. the kitchen sink) to improve its outcome. This tops up his pension pot (the chief reason why kitchen-sinking generally occurs).
That’s exactly what Bhatt did from September-December 2010. He left on March 31 and did not authorise the financials of the January-March 2011 quarter.
Usually the heir apparent then takes over and quietly cuts profits (normally a little at a time), before gradually ramping up earnings and dividends over his three- to five-year tenure, hopefully ending with another record set of quarters.
But this time was different. Chaudhuri cut earnings to the bone, hiking provisions to US$1.35 billion, an 82% year-on-year increase, unprecedented in the history of Indian banking.
The savagery of the cost hikes was due to SBI being hit with an abnormal combination of charges – including a change in India’s tax code that more than doubled its end-of-year tax bill to US$420 million – yet waiting until its former chairman retired before acknowledging them all.
Chaudhuri sought to appease angry investors by promising that the collapse in profits was down to “one-off provisions, which will not appear in subsequent quarters”. But most analysts, investors, the media, and even India’s banking regulator, didn’t see things his way.
One respected Mumbai individual who has worked within the public and private banking sectors in India, and speaking on condition of anonymity, notes: “This kitchen-sinking trend is now so ingrained that everyone gives up on the stock price once the new chairman comes in.
“In this case, the new chairman had been part of the management team for so long that most analysts assumed it would be different this time. And then he came in and did this. Nothing truly surprises me really in India, but this nearly did.”
SBI’s latest round of kitchen-sinking was disastrous for its investors and left its managers looking amateurish. It and its state-owned siblings need to take heed and end this outmoded management practice.
NPL provisioning pains
SBI’s disappointing figures in the January-March quarter resulted from the bank belatedly coughing up for several costs it had amassed during the previous fiscal year.
One was non-performing loan (NPL) provisioning. Back in October 2009 the Reserve Bank of India (RBI) had given all Indian lenders 12 months in which to cover 70% of all bad debts through provisions.
Most leading Indian lenders fell in line quickly. Bank of Baroda raised its NPL coverage to 74.46% by March 2010, along with ICICI Bank (59.48%) and Punjab National Bank (PNB, 69.46%).
By contrast, SBI inched its coverage up in increments, and it took much longer than the central bank had originally demanded. Its NPL coverage was only 44.36% by end-March 2010 and 46.82% three months later.
After Chaudhuri issued his first quarterly results, Reserve Bank officials noted that SBI could easily have raised provisioning sensibly and incrementally in the 18 months beforehand. This would have cut the damaging impact of higher provisions during Chaudhuri’s first quarter in charge by at least 75%. But instead the bank’s management “kept coming back to us seeking more time”.
There was more. In November last year, the RBI ordered all Indian banks to increase provisioning against controversial ‘teaser loans’ – essentially sub-prime mortgages handed to people on lower or infrequently paid incomes – from 0.2% to 2%.
SBI chairman Bhatt railed against this decision and opted not to raise the bank’s provisioning against such loans, which was equivalent to around US$111 million, in his final quarter in charge. But that just forced Chaudhuri to implement the higher cost three months later.
Then the nail in the coffin: the problem of pension provision, described by Brian Hunsaker, a banking analyst at Keefe, Bruyette & Woods (KBW) in Hong Kong, as the most “serious structural problem” facing SBI and other state-run Indian lenders.
New laws were set in place from 2007 to shift the onus on pension payments to the state-run lender and away from the state itself. They required all government banks to raise provisions year by year.
SBI belatedly made its huge provision of US$1.8 billion for the fiscal year 2011 in – you guessed it – the final quarter, and the first under Chaudhuri’s watch.
Sunil Shirole, chief executive of Yen Capital Advisors, a Mumbai-based securities-to-private equity investor and advisory firm, echoes the view of many people Asiamoney interviewed by describing Bhatt as Chaudhuri’s “main burden”.
Neither Bhatt nor Chaudhuri responded to repeated calls and texts asking for comment on this story.
Carrying the can
Yet the fault does not entirely lie with Bhatt; Chaudhuri’s actions have also been damaging to SBI’s future.
To pay for SBI’s pension provisions the new chairman didn’t just cut profits to the bone, he also drew upon capital from SBI’s tier-one capital reserves. This comes at a time when almost all other global lenders are trying to bolster their capital-adequacy ratios (CAR).
Chaudhuri’s decision cut SBI’s tier-one capital adequacy to 7.77%, below the benchmark minimum 8%. It was, notes one Mumbai-based analyst, a “hell of a foolish manoeuvre”.
Barring another round of begging the central bank to give it more time – likely years – to pay the pension provisions, Chaudhuri appears to have had little choice but to dig into the bank’s tier one capital. Yet, as another analyst notes, SBI itself said at the release of its quarterly results that it could have amortised some of its pension expense over five years, which would have cut the overall impact and meant Chaudhuri didn’t have to dig into the bank’s own reserves.
A debilitating tactic
The outcome of SBI’s latest kitchen-sinking is particularly extreme and underlines the fact that letting state lenders get away with such practices for so many years is actively damaging to their image and performance.
The process isn’t illegal, nor does it guarantee instability within the banking sector. But its impact is undeniably debilitating.
First, if a bank’s earnings and fortunes are linked to causes other than the natural cycle of an economy, the wealth of a nation’s people, or the rules governing lending, investors must take that into account.
“On the stability of a banking system, [kitchen-sinking] is not an issue, though in this case the change of management at SBI led to huge variability and volatility in results. But for long-term investors, it’s a definite negative,” says Devam Modi, an analyst at Equirus Securities in Ahmedabad. “You have to make a call about what the new management will do, and often that means buying [shares in] state banks in the middle two or three years [of a chairman’s tenure] and selling on either end.”
Do investors do this? The jury is out: bank stocks rise and fall along with the fortunes of both the local economy and the wider world. However superficial evidence appears to bear out Modi’s view.
SBI’s stock fell in June and July 2006, during Bhatt’s first two months in charge, before rising for five straight months. Likewise the stock fell during Chaudhuri’s first two months at the helm, after a solid-if-not-spectacular early 2011.
Little wonder: SBI profits fell 35% in the first quarter of Bhatt’s tenure and 35% during the first three months of his predecessor A.K. Purwar’s term, in 2002. As Yen’s Shirole notes: “Historically, SBI chairmen have preferred to start with a clean chit.”
This cycle has become so embedded that even the regulators are publicly commenting on it.
“I see when the chairman [of a local bank] retires, the profits go down,” RBI deputy governor K.C. Chakrabarty said in the days after SBI posted its controversial results.
India’s banking regulator declined to comment on the record for this article, as did the State Bank of India itself, despite repeated requests to both parties.
Sticking with tradition
Yet for all its palpable damage to share valuation, kitchen-sinking is a practised formality. It took the abrupt U-turn of SBI’s last quarterly results to cause a visceral reaction from analysts, investors and the media – and even now a few voices continue to bang the drum for kitchen-sinking.
On June 20 the outgoing RBI deputy governor Shyamala Gopinath defended the SBI’s actions during the final quarter, stating: “If a bank chooses to make a one-time provision, it is their choice and there’s nothing wrong with it.”
Gopinath, it should be noted for the benefit of those not well versed in Indian banking, retains a seat on the board of the very bank she is supposed to be regulating, State Bank of India.
India’s media has also tended to overlook kitchen-sinking in the past, seeing it as a tedious practice compared to steamy stories of stock-manipulating hedge funds, corrupt ministers, and bankrupt billionaire IT entrepreneurs.
In fact many of the local news articles have seemed resigned to the process, instead querying why investors should buy and hold stock in SBI and other state lenders. Rather more pointedly however, some of these articles also query whether these vicious cycles of profit and loss would be smoothed out if the chairmen of state lenders were differently remunerated.
Market specialists offer a resounding ‘yes’ to the latter point. Analysts note that while the salaries of the heads of Indian private banks are evaluated by a complex set of metrics – including share price, profits, provisioning, performing-loan ratios, net interest margins, and overall debt levels – state bank chairmen are paid according to a primitive system.
Notes Equirus Securities’ Modi: “The evaluation of an outgoing chairman is based entirely on his last two years of performance. So it’s in the interest of a chairman to cut profits when he arrives, and increase profits in the last few years that he is there.”
The well-placed Mumbai former public- and private-sector banker adds: “State bank chairmen don’t have any interest at all in their own share price, or in net profit, really. If you are a chairman, you want to be able to say: ‘I took profit from X to Y and the book value from Y to Z’. Of course when you are doing this it helps to create a low base for yourself from the start.”
Seeking stability
From any angle, rewarding bank bosses in such a manner flies in the face of shareholder rights. It’s hard to argue that by abandoning kitchen-sinking state banks in India wouldn’t achieve a higher level of profit-sheet stability, providing greater security for investors.
The country’s state banks could certainly do with the stability. The economy, experts say, is entering a rough patch in which key sectors will slow, leading to a deterioration of loan quality on most banks’ balance sheets.
KBW’s Hunsaker notes that credit quality is an “emerging risk” in India’s banking sector. In a March 28 note, he highlighted several sectors vulnerable to negative credit shocks: infrastructure (construction and engineering), commercial real estate and hotels, manufacturing, power generation; and, through all these industries, banks’ specific exposure to deals cut by internal and external non-bank financial companies (NBFCs).
Rising interest rates and slower loan growth over the next few months and quarters is likely to crimp capital flows (leading to an exit from India of foreign institutional investor capital and hurting most of the largest private firms, few if any of which boast positive free cashflow) as well as pushing up levels of soured loans.
Analysts are loath to put a precise figure on how much NPLs might rise – though KBW’s Hunsaker believes non-performing assets will surely “rise over the coming quarters” – and for good reason.
Within this environment, state banks in particular aren’t just seeking to boost profits and margins to fretful shareholders. They are also being squeezed on either side by industries desperate for capital but with poor performance on loan repayment (i.e. the farming sector) and by constant demands from the government to continue rolling out credit to these socially important industries under the banner of ‘financial inclusion’.
Analysts say that New Delhi is aware of the risks such lending carries, and that it is generally understood that the government will backstop any extraordinary levels of non-payment state banks may suffer. Of course, that also makes for a high level of government influence on these lenders.
It also raises questions about how much the government is bothered if a state-bank chairman who had loyally followed New Delhi’s lending preferences throughout his tenure decides to kitchen-sink at the end of it.
Equirus Securities’ Modi notes that such lending activity explains the “relatively low credibility” of state banks’ asset books.
“With private [Indian] banks you can be more or less assured about their numbers, but at state banks there is a looser way of assessing asset quality. Figures are less reliable. That’s why share prices are lower,” he said.
This matters, because it affects the stability of the likes of SBI. In its March 28 Indian banking-sector guide, KBW posted a target price of INR2,500 on SBI. On May 27 the research team shipped out a follow-up note on SBI alone, maintaining the stock’s rating of ‘market perform’ but lowering its target price to INR2,200 and noting worrying “weak trends” from the previous quarter’s reporting period.
“It is far too early to declare [that] SBI has seen the worst in terms of loan quality,” noted Hunsaker. “The sting of higher interest rates and slowing growth has yet to be felt.”
As India looks increasingly likely to enter a slowing economic cycle, where loan quality softens and NPL levels rise, it is hard to comprehend why SBI and other state banks don’t take a long hard look at how they pay their chairmen.
Equirus Securities’ Modi calls the process of kitchen-sinking at Indian banks a “chronic problem” that shows no sign of abating. Yet ending it would appear to be so simple.
Retaining this arcane remuneration policy just to ensure that an ageing bank chairman retires with a few more rupees in his pockets is illogical, unsupportable, and flies directly in the face of shareholders’ best interests.
After having had to suffer the consequences of Bhatt’s sunset decision-making, Chaudhuri might well look forward to the windfall he stands to make from his own eventual retirement. But if India’s regulators truly care about the stability of their banks with investors they will ensure that he earns it through the whole of his tenure, not just by putting off necessary costs to his successor.