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The LIC–IDBI Deal

Sieving the Substance

Ashok Banerjee (ashok@iimcal.ac.in) is with the Finance and Control Group and Partha Ray (pray@iimcal.ac.in) is with the Economics Group at the Indian Institute of Management Calcutta, Kolkata.

In the context of the recent deal between the Life Insurance Corporation of India and Industrial Development Bank of India, is this proposed investment prudent from its impact onLIC’s balance sheet and income prospects as well as from an average premium payers’ standpoint? A possible alternative in whichIDBI’s retail assets could have been sold to a commercial bank and the remaining project finance portfolio turned into a wholesale and long-term finance bank is discussed.

Over the last few years, the Indian financial sector had been attracting newspaper headlines perhaps for the wrong reasons. As stressed assets, that is, gross non-performing advances plus restructured standard advances, began to pile up since 2009, the government tried to initiate a number of corrective measures to rescue public sector banks. In due course of time, a number of corporates with non-performing loans approached the National Company Law Tribunal, the government infused capital into banks with stressed assets, the Insolvency and Bankruptcy Board of India (IBBI) was established, and the Central Bureau of Investigation (CBI) registered cases of corruption against some senior bankers. But, irrespective of these measures, the stressed assets to advances ratio increased from 23.9% in September 2017 to 24.8% in March 2018; and the future looks gloomy. The gross non-reforming advance of scheduled commercial banks is projected to rise from 11.6% of total advances in March 2018 to 12.2% by March 2019, as per the macro-stress tests of the Reserve Bank of India (RBI) Financial Stability Report of June 2018.

Against this background, the situation in the Industrial Development Bank of India (IDBI) had become a matter of concern in recent years. During two consecutive years, 2016–17 and 2017–18, the IDBI Bank had recorded losses of ∝51.58 billion and ∝82.38 billion, respectively. As of March 2018, the non-performing assets (NPAs) of the IDBI Bank were nearly 28% (of which 20.4% comprised of substandard assets, 75.4% doubtful assets and 4.2% loss assets).

In this context, the Life Insurance Corporation of India (LIC)–IDBI deal in which the LIC is supposed to buy a 51% stake in the IDBI Bank assumes importance. The Insurance Regulatory and Development Authority of India (IRDAI) has already approved the deal and given the insurer an exemption from the 15% investment cap. The union cabinet has approved the deal on 1 August 2018.

The LIC Perspective

To begin with, let us analyse the implications of this deal from the perspective of the LIC. In March 2018, LIC’s holdings in IDBI Bank were 11% of its equity. However, it had reportedly slightly trimmed its stake in IDBI Bank to 8% by the end of July 2018 (Sharma 2018). With the LIC’s proposed investment, it would invest up to ∝130 billion (0.5% of its investment book) in IDBI Bank, for the majority stake. What would this imply? Is it beneficial to the policyholders who have paid their hard-earned money as premium? To answer this question, it may be useful to take a look at the balance sheet of the LIC (Table 1, p 20).

 

Interestingly, the book value of investments has always fallen short of the corresponding liability. The gap (investment–liability) has remained steady at around ∝2,200 billion over the past five years. This implies that the market value of investments has to be sufficient to take care of the investment shortfall. In such a situation, if some of the investments perform poorly, the investment shortfall would only widen. It is true that LIC makes investments for longer durations as the liabilities are generally long term. Hence, one should not be too perturbed by short-term fluctuations in the market value of investments. However, such investments should generate decent periodic returns.

What does the income statement of the LIC indicate? Table 2 (p 20) shows the income statement (revenue account) of the insurer. The average premium income accounts for 62% of the total income, and the balance comes in as income from investments. Insurance claims, on the other hand, account for 92% of the total income. Obviously, the gross margin of LIC would be very low. The five-year average pre-tax profit is less than 2%. The financial results clearly show that the LIC has to depend on the performance of its investment portfolio to fund a large part of insurance claims. If income from investments and their market value fall due to bad investment decisions, the policyholders would be in trouble. The insurer cannot increase premium rates due to competition and hence, the only way to grow premium income is through growth in business volume. But, there is a limit to volume growth as well. Therefore, it is important that the insurer manages its investment portfolio more prudently.

It may be noted that there are two factors which govern the performance of any investment portfolio: annual return on investment; and capital gain (that is, appreciation in market value of investments). The return on investment portfolio of LIC has been on the decline (Table 3). About 65% of the average investment has been in short-term and long-term government securities. Hence, a large part of the return on investment book of the LIC depends on the coupon rate of government securities. The insurer invests about a third of its portfolio in equity and equity-linked instruments. Such investments must generate enough return to compensate for the low-yielding investments in government securities. The equity portfolio should also generate higher capital gains, for only then would the policyholders’ future be financially well-protected.

 

In order to understand the quality of investments, a closer look at LIC’s investment book is required. It reveals that LIC holds a well-diversified equity portfolio with the financial sector accounting for 23% of total exposure, followed by energy (Table 4). The energy stocks have performed well in the past five years while consumer discretionary stocks were the worst-performing sector. The market value of LIC’s equity portfolio is $585 million poorer now, as compared to 2013. It is true that during this period, there have been churns in the equity portfolio with periodic sale/purchase of scripts. Still, the fact remains that the investment book of LIC, which is supposed to provide a cushion to the policyholders in case of claims and policy maturities, has shrunk quite a bit in terms of market value in the past five years.

It is also important to examine how well LIC has managed its investment in banking stocks, a subset of the financial sector. The LIC has, over the past five years, decreased its exposure in three out of the top 10 bank stocks. Surprisingly, the insurer has increased its exposure in stocks which have generally performed poorly in the market during the same period (Table 5, p 21). The maximum investments during the past five years were in IDBI Bank and the Central Bank of India, which have lost significant value. Is this prudent investment management? Or, are these reflective of non-economic considerations and government pressure on LIC’s investment strategy?

 

Of course, one may argue that LIC’s investment in the struggling IDBI Bank is strategic in nature, and hence, one should not look at the short-term return on investment as a metric to evaluate the investment decision. There was lots of confusion, however, with the type of ownership. The financial press initially mentioned that the bank would be offering preference shares to the insurer and hence, LIC would not have management control (Financial Express 2018).Later, it was clarified that the IDBI Bank would make preferential allotment of equity shares to the insurer for the investment of ∝130 billion, and hence the insurer would get management control with the status of a promoter (Hetavkar and Jha 2018). The argument that LIC, through this deal, would get access to 2,000 branches of the bank to sell its product is debatable as LIC already has its network spread across the country. Also, it may be noted that the investment by LIC would add to the capital buffer of IDBI Bank, and thereby save the government from further recapitalisation of the bank from the union budget. The sole beneficiary of the deal seems to be the bank.

Although IRDAI has given a green signal to the deal, there are regulatory concerns. Prudence suggests that an investing firm should have a diversified investment portfolio and avoid having too much
exposure to any particular stock. In the present deal, the usual investment cap of 15% was waived off by the regulator, raising questions on the safety of policyholders’ money. This is not the first time that such exemption has been provided to LIC by the regulator. In the past, it has allowed LIC to invest beyond the 15% cap in the equity of Larsen & Toubro, ITC and Axis Bank. But, unlike the present case, two out of the three scrips have done very well in the market and provided handsome returns to the insurer. Also, investment in Axis Bank was not a bail-out case. The LIC will have to reduce its exposure to other banks to below 10% in a short span of time. This might have an adverse impact on the net asset value (NAV) of its investment portfolio.

Thus, to summarise, the proposed investment may not look prudent from its impact on LIC’s balance sheet and income prospects, as well as from the average premium payers’ standpoint.

The IDBI Perspective

Having looked into LIC’s perspective, let us probe into the implications of the deal for IDBI Bank. The general view is that the IDBI Bank needed money, but with the government already burdened with budget constraints, direct capital infusion was unfeasible. Hence, this was the route it took to save the bank. We will argue that this strategy is both flawed, and cuts corners in policy implementation.

At this point a discussion on the context of the birth of the IDBI Bank is in order. Following financial sector reforms, development banks like the erstwhile IDBI, had a sad demise. This was in line with the recommendations of the Narasimham Committee II (1997) which recommended corporatisation of the then IDBI. This was followed by the S H Khan Committee recommendations of gradual elimination of the extant boundaries between commercial banks and development financial institutions (DFIs), both on the assets as well as on the liabilities side. Finally, the RBI discussion paper of 1999 addressed the various issues concerning the universalisation of banking and elimination of the specific role of development banks. Later, in October 2004, the IDBI was converted into a banking company, and in April 2005, it merged its banking subsidiary (IDBI Bank) with itself. Thus, since its inception, the IDBI Bank had significant exposure to industrial/project finance, which it continues to have.

At this juncture, a reference may be made to the balance sheet of the IDBI Bank, which indicates that while the bank continues to have a substantial deposits base, the phenomenon of loss has started from 2016 (Table 6). The return on asset has sharply declined, from 3.92% in 2014–15 to close to a negative 20% in 2016–17. The portfolio of advance has not kept pace with the deposit growth. Even the investment book of the bank has not changed much since 2013.

 

What happened in 2015–16? When the RBI conducted an asset quality review (AQR) of banks during 2015–16, significant discrepancies in the reported levels of impairment and actual positions came out in the open. Accordingly, provisions were made and there was significant deterioration in NPA levels (Figure 1). The gross NPA of the bank was close to ∝556 billion in March 2018. Without infusion of capital, IDBI Bank would have to make provision for the entire NPA and that would entirely wipe out the reserves of the bank (Table 6). Additionally, the capital adequacy, measured by capital to risk-weighted assets, of the bank was lower (10.41%) compared to the minimum regulatory requirement (10.88%) (IDBI 2018: 10). With the LIC money, the bank’s capital adequacy will cross the minimum regulatory threshold. However, this would leave very little money on the table for running operations. It is not clear how the capital infusion will help the bank improve its profitability. It seems that the money is only for meeting regulatory requirements. It is also important to note that the capital infusion is not permanent, as the insurer would have to reduce the stake to 15% in next five to seven years. Will the bank face another liquidity crisis then? Will the government at that time find another saviour?

An Alternative

Does this mean that the IDBI Bank’s entire business was in the red? While we do not have firm data, informal discussions with a number of bankers revealed that at a conceptual level, perhaps a distinction could be made between the retail portfolio and the industrial finance portfolio of the IDBI Bank. In fact, the deposit and credit in the retail portfolio was quite sound like any other profit-making bank. Thus, if a bifurcation could be made between the retail and industrial finance portfolio, then the retail portfolio could have been sold quite successfully to any profit-making bank. The remaining entity could then be converted into a wholesale and long-term finance bank, in line with the arguments in the RBI discussion paper of April 2017 (RBI 2017). This could have been a worthwhile alternative.

However, instead of looking for an innovative solution, the government has taken the easy route of exposing LIC’s portfolio to IDBI Bank’s stressed balance sheet, while shielding its own budgetary envelope within the proposed provisions of the Fiscal Responsibility and Budget Management Act, 2003. This is escaping fiscal responsibility from the back door!

References

Financial Express (2018): “Only Investment, No Management Control! LIC–IDBI Bank Deal Gets Regulator’s Nod,” 29 June, https://www.financialexpress.com/industry/only-investment-no-management-....

Hetavkar, Nikhat and Somesh Jha (2018): “LIC Likely to Get Management Control of Debt-ridden IDBI Bank,” Business Standard, 18 July, https://www.business-standard.com/article/economy-policy/lic-likely-to-g....

IDBI (2018): “Annual Report, 2017–18,” Industrial Development Bank of India, Mumbai, p 10.

RBI (2017): “Discussion Paper on Wholesale & Long-Term Finance Banks,” Department of Banking Regulation, Reserve Bank of India, Mumbai, https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/WLTFB07042017CAE....

Sharma, Bharadwaj (2018): “LIC Trims Stake in IDBI Bank and Allahabad Bank in First Quarter,”Financial Express, 27 July.

Updated On : 24th Aug, 2018

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