Asset quality set to worsen, but banks resilient enough: RBI report

Indian banks’ asset quality may deteriorate but lenders have enough capital to withstand a severe shock, said the bi-annual Financial Stability Report, prepared taking inputs from all the financial regulators and released by the Reserve Bank of India (RBI), on Wednesday.

A similar sentiment was expressed by the RBI’s trend and progress report released on Tuesday. It had said the asset quality of banks and non-banking financial companies (NBFCs) will witness pressure as regulatory forbearance and standstill on asset classification come to an end in a few months.

Global policy environment, repeated supply shocks, and inflation are risks but “Omicron haunts near-term prospects,” the Financial Stability Report said.

In his foreword to the report, RBI Governor Shaktikanta Das said the Indian economy is “regaining strength and resilience”, after a destructive second wave of the pandemic in April-May.

“Consumer confidence and business optimism are on the rise as the spread and scale of vaccination expands. The outlook is progressively improving, though there are headwinds …,” the RBI governor said.

The recovery hinges on the revival of private investment and shoring up private consumption; both are below their pre-pandemic levels.

“While the pandemic induced bouts of volatility, spillovers, and heightened uncertainty are challenging, the Indian financial system has stood up well and remains well prepared to meet the funding requirements of the economy,” Das said. 

Stress tests

Macro-stress tests show the gross non-performing assets (GNPA) ratio of the banking system may increase from 6.9 per cent in September 2021 to 8.1 per cent by September 2022 under the baseline scenario and to 9.5 per cent under a severe stress scenario.

However, “all banks would be able to comply with the minimum capital requirements even under severe stress scenarios,” the December FSR said.

The GNPA ratio of PSBs, which was 8.8 per cent in September this year, may deteriorate to 10.5 per cent by September 2022 under the baseline scenario. Private banks could see their share of bad loans rise from 4.6 per cent to 5.2 per cent; foreign banks may witness 3.9 per cent of their assets books going bad by September 2022, from 3.2 per cent in September 2021.

“On the other hand, if stress conditions do not materialise and the situation turns optimistic relative to the baseline, the GNPA ratio of all SCBs (scheduled commercial banks) may moderate,” the FSR said.

The capital adequacy ratio may decline to 15.4 per cent by September 2022 under the baseline scenario and to 14.7 per cent and 13.8 per cent under the medium and severe stress scenarios, respectively. However, “all 46 banks would be able to maintain CRAR above the prescribed minimum capital level of 9 per cent as of September 2022 even in the worst case scenario,” the FSR said.

“Even under adverse scenarios, no bank would face a decline of the CET 1 capital ratio below the regulatory minimum of 5.5 per cent.”

The report noted the systemic risk posed by public sector banks was higher than private banks and “the risk generated by the category of merged PSBs is comparatively higher than the unmerged PSBs”.

The banking stability indicator showed improvement in soundness, asset quality, liquidity, and profitability but the efficiency parameter worsened relative to the position in March 2021.

The RBI’s latest systemic risk survey expected all broad categories of risks to the financial system – global; macroeconomic; financial market; institutional; and general – as “medium” in magnitude but risks arising on account of global and financial markets were rated higher than the rest.

The FSR report warned that the retail-led credit growth model is facing headwinds as delinquencies in the consumer finance portfolio rise. The new-to-credit segment, a key driver of consumer credit growth in the pre-pandemic period, is showing a decline in originations.

Companies having exposure of Rs 1,000 crore and above have lowered their borrowing, while smaller borrowers, with a loan size of Rs 5 crore-Rs 1,000 crore “maintained a sustained appetite for credit”.

Compared with the pre-Covid period, however, more companies are showing signs of migration in the special mention account (SMA) category, indicating rising stress. But a recent test showed some improvement. “The pace of ratings upgradation has, however, reduced,” the report noted.

The banking system, particularly private banks, is witnessing more volatile deposits than stable deposits. Deposits by companies are growing faster than retail, as firms stay away from fresh investments.

Commensurate with the rise of volatile deposits, banks increased their share of high-quality liquid assets and government securities.

In the financial system, banks have the largest share of bilateral exposure. Dominant fund providers in the system remained mutual funds, followed by insurance companies; NBFCs were the biggest receivers of funds, followed by housing finance companies.

“Considering the significant share of funding absorbed by NBFCs at the system level, continued attention to their financial health is warranted in the interest of financial stability,” the report stated.

The FSR also discussed the “proliferation of private cryptocurrencies” across the globe. “Private cryptocurrencies pose immediate risks to customer protection and anti-money laundering/combating the financing of terrorism. They are also prone to frauds and extreme price volatility, given their highly speculative nature.”

Longer-term concerns relate to capital flow management, financial and macroeconomic stability, monetary policy transmission, and currency substitution.

The rapid growth of decentralised finance (DeFi) is geared predominantly towards speculation and investing and arbitrage in crypto assets, rather than towards the real economy, and is being used for illegal activities, the report warned.