Restructured loans vulnerable to shocks

On a day when rising inflation numbers raised many a concern, the Reserve Bank of India (RBI) said rising prices and interest rates may adversely affect banking assets. Restructured standard loans remain vulnerable to shocks, and stare at the threat of turning into non-performing loans.

Stress tests to check the ability of loans to withstand shocks had earlier showed the system’s resilience. However, banks need to remain vigilant to headwinds from the prevailing inflation and interest rate situation, which may hit the quality of assets, RBI said its Financial Stability Report.

A change in interest rates has the most significant (negative) impact on the slippage ratio of banks. Put simply, higher interest rates, coupled with the rising inflation, could erode the capacity of households and small and medium enterprises to repay loans. This raises risks of defaults and a rise in non-performing assets.

The report said the banking system had the ability to withstand an adverse shock in non performing assets (NPAs) through their capital funds. The stress tests for the near term (end-March 2012) showed the percentage of gross NPAs, compared to total advances, rose to 2.92 per cent from 2.34 per cent in end-March. The tests assumed a standard 30 per cent of restructured standard assets turning into NPAs.

The banking system’s capital adequacy ratio remained at 11.27 per cent and almost all banks maintained the ratio at above nine per cent. When the NPA level rose to 6.33 per cent, the system capital adequacy ratio stood at 9.33 per cent. However, the capital was adversely affected under an extreme deterioration of the asset quality (when NPAs rose by 168 per cent). The capital adequacy fell below below nine per cent for most banks.

Indian banks withstood the fallout of the global financial crisis in 2008. Now, stress testing on banking assets in end-March confirmed their capacity to effectively face systemic shocks, albeit with some impact on profitability, RBI said.