Rating agencies: Whom to trust?

Mon, 14 Nov Pre-Open

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When S&P downgraded the United States from its AAA notch in August, other rating agencies remained silent. The world watched in horror as America had to step down from its top perch. Now, while S&P has upgraded India's banking sector, Moody's has assigned it a negative outlook. Now, what exactly is the reason for this difference? Or is S&P really losing the plot. The rating agency recently mistakenly downgraded France's top credit rating. Two hours later, the agency released a note saying that this was due to a technical error. Are these ratings just hogwash Well, they definitely should not be followed blindly.

Well, when it comes to the Indian banking sector, concerns are definitely at the fore. Gross non-performing loans (NPA) for the 36 listed banking entities in India swelled to Rs 1.1 trillion, a 33% rise over last year, according to Livemint. A move to the system based recognition of NPAs, the rising interest rate environment and slower economic growth all contributed to this spike. Moody's downgraded the sector to negative from stable citing lower profitability, worsening asset quality and capital concerns as its main concerns. It expected an increase in provisioning over the next 12-18 months, which would further impact profits.

S&P on the other hand declared that Indian banks are not in muddy waters. They do not have heavy exposure to high risk lending. Plus they have a very negligible presence of complex financial products like derivatives and collateralized assets. Exposure to sovereign debts of the troubled Eurozone countries is also minuscule. Their American and European counterparts however fare poorly on these counts. S&P also stated that the government and especially the regulator RBI have been prudent in their support to the system. Indian banks also have a stable base of core customer deposits, and their dependence on external borrowings is limited. Thus puts the system less at risk in light of a global meltdown. This strength was seen during the 2008 crisis as well. Even though there are concerns in the system about a shortfall in capital, especially for mammoth lender State Bank of India (SBI), the capital adequacy maintained by Indian lenders is higher than what the Basel II standard requires.

Banking stocks have taken a beating over the past 9-10 months. The Bankex has corrected by around 20% since the start of the year, and is currently trading at a price/earnings multiple of around 13 times compared to 17.5 times in January. Thus, we believe that most of the concerns that Moody's highlighted, have already been priced in. Plus, the fundamental strength of Indian banks and the long term prospects of the economy cannot be denied. While short term pains may continue to exist, we believe that this sector has a strong ability to bounce bank. S&P may have got its facts right this time around.