Asset Quality and Provisions: What Every Shareholder Should Check

A bank’s profit is only as reliable as the loans behind it. A lender can report rapid growth for years and then see earnings vanish if borrowers stop repaying. This is why experienced analysts spend more time on credit quality than on almost any other metric. Anyone studying the HDFC Bank Share Price across market cycles will see how consistently low stress levels have supported investor trust. Meanwhile, the long recovery of the country’s largest state-owned lender offers a lesson in how cleaning a balance sheet can transform sentiment, as the SBI Share Price journey over the past decade demonstrates.

Gross and Net Non-Performing Assets

A loan becomes a non-performing asset (NPA) if the interest or principal is not paid for ninety days. Gross NPA is the percentage of such loans as a proportion of total advances. Net NPA is gross NPAs minus the provision, or the percentage of the risk the bank has already booked.

The lower, the better, though a declining ratio during a slowdown is to be expected, whereas during good times, an increase could indicate poor underwriting. It is important to compare the ratio year-on-year and against competitors rather than look at a single figure.

Provision Coverage Ratio

Provisions are amounts a bank sets aside from profits to offset bad loans. The provision coverage is the ratio of provisions to bad loans. A higher coverage implies that the bank has set aside enough money to offset losses, and any change is unlikely to affect its earnings much.

Regulators encourage banks to maintain healthy coverage, and prudent lenders take advantage of good times to build additional coverage, which can be a drag on profits when the recovery sets in. As an investor, one must be wary of exceptional profits due to provisioning changes.

Slippages, Restructuring and Hidden Stress

New slippages are loans that have turned bad during the period. This is a good indication of the bank’s ability to manage its account books. A decrease in slippage implies that the bank is doing a good job with collections and underwriting. However, a rising trend needs to be analysed to understand which segments are contributing to the problem – is it unsecured retail loans, small businesses or big companies?

Restructured loans are those where the bank negotiates terms with borrowers to improve cash flows. Though a restructured loan is not marked as bad, it can affect a bank’s earnings if there are too many such cases.

The notes to accounts and investor presentations usually carry information on such restructurings.

Sector Concentration and Borrower Quality

Even if overall stress is low, the lending mix can cause problems if the bank is too concentrated in a few sectors or promoters. Look out for the distribution of loans by sectors and promoters. Ideally, the lending mix should not be skewed.

Loans with collateral cover, such as property- or gold-backed loans, or loans to investment-grade companies, carry less risk than unsecured personal loans or microfinance. Default rates are lower for secured loans and for loans to large companies.

Capital Adequacy as a Safety Net

Capital adequacy is a bank’s last line of defence. The capital adequacy ratio (CAR) measures the amount of capital a bank has to cover losses. A bank with a healthy CAR can withstand losses without having to raise new capital, which can hurt existing shareholders.

Capital structure and the quality of capital is also important. Look out for the amount of core capital.

A Pragmatic Checklist

Record gross NPA, net NPA, provision coverage, slippage ratio and capital adequacy in a spreadsheet every quarter. Look out for trends rather than figures. Read out management commentary on collections, stressed sectors and outlook. Remember that asset quality follows the business cycle. Most defaults occur in the down cycle after the upswing has ended.

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