BS Banking Annual: Worst may be coming as recovery path remains uncertain

The FSR has warned that while easy money is intended to support growth, it can encourage leverage, inflate asset prices and endanger financial stability

The optimism shown by bankers in public statements that there is buoyancy in the economy may be misplaced. The Reserve Bank of India’s (RBI’s) Financial Stability Report (FSR) of December 2020 has stated that banks’ gross non-performing assets (GNPAs) may rise sharply to 13.5 per cent by September 2021, and escalate to 14.8 per cent, nearly double the 7.5 per cent in the same period of 2019-20, under the severe stress scenario.

And despite this, on the day the FSR was released, the Sensex hit a life-high of 49,000 points! The irony is that the FSR mentions the growing disconnect between certain segments of financial markets and real-sector activity, pointed out in the last FSR (June 2020), has got further accentuated, with abundant liquidity spurring a quest for returns. Within the financial market spectrum too, the divergence in expectations in the equity market and the debt market has grown.

An examination of the transition of a constant sample of non-state-run non-financial wholesale performing exposures to SMA-2 (special mention accounts-2) reveals that overdues between 61-90 days stood at 7.2 per cent of standard assets in November, up from the 1.7 per cent a tad over a year ago. Admittedly, the asset classification standstill inhibits the true underlying economic categorisation of assets, although the trend is worsening.

And remember, the FSR has been tweaked. In the last FSR, a one-time additional scenario of “very severe stress” was introduced in view of the pandemic-induced uncertainty, its economic costs, and delays in the data-gathering process. With a better appraisal of the pandemic’s impact on economic conditions, it is assessed that the worst is behind us, though the recovery path remains uncertain. Accordingly, stress tests have reverted to the regular three-scenario analysis in this issue.

The FSR said banks need to prepare for these adversities by augmenting their capital base. While easy financial conditions are intended to support growth prospects, they can have unintended consequences, like encouraging leverage, inflating asset prices and fuelling threats to financial stability.

Will stimulus packages work, and what are the implications on this front?

The FSR has highlighted that emerging economies also face constraints in the form of large employment-intensive unorganised sectors affected by the pandemic and the embedded risks of adverse selection in designing support schemes. Also, any restructuring of corporate credit obligations would possibly require conversion of some credit claims to equity, where selection of projects eligible for such conversion is critical. “Hence, while the ‘optimal response’ may vary by jurisdiction, the report stresses the urgency to act before the underlying strength of the business sector is completely eroded.”