Global credit rating agency Moody's Investors Service on Tuesday said Indian public sector banks will first use their operating profits to increase the loan loss coverage before marking down their non-performing loans (NPLs).
In its latest report on the measures taken by the government and Reserve Bank of India (RBI) to resolve the NPL issue, Moody's said: "Our base case remains that state-owned banks will use most of their operating profits over the next two years to gradually increase loan loss coverage from the current low levels."
"It is only at that stage that they will be in a position to appropriately mark down NPLs and clean up their balance sheets," Moody's added.
On May 5, the central government provided RBI with greater powers to intervene in the resolution of NPLs.
At the same time, RBI lowered the threshold for consensus required among lenders in Joint Lenders' Forum (JLF) to approve resolution proposals.
These measures improve the efficacy of NPL resolution mechanisms and are credit positive. However, they do not address the lack of capital at the state-owned banks that has prevented them from writing down NPLs to realistic levels, Moody's said.
Moody's expects the NPL resolution to be a relatively long drawn out process.
The government's recent ordinance provides RBI with greater legal authority to intervene in NPL resolution.
RBI can now direct banks to initiate insolvency proceedings with respect to specific borrowers who are in default, and can appoint advisory committees to advise banks on the resolution of stressed assets.
This ordinance was followed by a RBI notification lowering the threshold lenders in Joint Lenders' Forum (JLF) to approve a resolution proposal, to 60 per cent from 75 per cent of lenders by value, and to 50 per cent from 60 per cent of lenders by number.
"Both these measures aim to encourage banks to be more proactive in NPL resolution as well as improve co-ordination among banks. For instance, RBI can now direct banks to undertake a plan of action for specific assets if it feels that banks are not taking the prudent approach," Moody's said.
Similarly, as most of the large NPLs involve a consortium of banks, improved co-ordination among them should facilitate the resolution process. Hence, these moves are credit positive for Indian banks, the credit rating agency said.
According to Moody's, these measures are broadly along the same vein as a long series of actions that the government and regulators have taken to address banks' asset quality challenges.
"The reason for the limited success of the various regulatory measures so far is that they do not address two related structural factors. First, the operating environment in key stressed sectors remains quite challenging," Moody's said.
For instance, in the power sector, which is the biggest stressed sector, plant load factor remains at multi-decade lows, leading to projects run at much lower capacity than originally assumed in the project financing.
"Also, the actual cost of project completion has often been much higher than originally planned. Operating conditions in other stressed sectors such as steel and construction remain challenging as well, although not to the extent seen in power," Moody's said.
Second, in part because of these challenging operating conditions, the market value of stressed assets is typically much lower than what the banks currently reflect on their balance sheets, Moody's said.
Hence, successful resolution, either through debt relief or asset sale, will require banks to take a big hit when they write-down the value of these assets to market value.
However, the state-owned banks' weak capital levels mean that they do not have the capacity to take these sort of write-downs, the rating agency said.