The Indian banking system is safe, but NPAs may shoot up, says RBI

The gross NPA ratio may rise from 8.5 per cent in March to 12.5 per cent by March 2021, but could worsen to 14.7 per cent under a very severely stressed scenario. However, no bank will fail

The banking system is safe and resilient, thanks to higher capitalisation and shrinking inter-bank linkages, but the pandemic could push up non-performing assets (NPAs) significantly, warned the Reserve Bank of India (RBI) in the bi-annual Financial Stability Report (FSR), released on Friday.

While the downside risk to economic recovery is high, there are early signs of recovery, and “we need to remain extremely watchful and focused”, wrote RBI Governor Shaktikanta Das in the foreword to the report.

The gross NPA ratio of banks may increase from 8.5 per cent in March to 12.5 per cent by March next year under the baseline scenario, but it could worsen to as much as 14.7 per cent under a “very severely stressed scenario”, the FSR said.

The capital to risk-weighted assets ratio (CRAR) of banks has fallen marginally to 14.8 per cent in March 2020 from 15 per cent in September 2019. But the common equity Tier I capital ratio of banks may decline from 11.7 per cent in March to 10.7 per cent under the baseline scenario and to 9.4 per cent under the very severe stress scenario in March 2021.

“Furthermore, under these conditions, three banks may fail to meet the minimum regulatory CET 1 capital ratio of 5.5 per cent by March 2021,” the FSR said.

Banks have enough high-quality liquid assets (HQLAs) for meeting day-to-day liquidity requirements, and 50 of the 53 banks in the sample will remain resilient in a scenario of sudden and unexpected withdrawals of around 15 per cent of deposits, along with the utilisation of 75 per cent of their committed credit lines.

The FSR, written after taking inputs from all regulators, assesses the systemic risk to the financial system, which includes banks, non-banks, insurance, and capital markets. It is released by the banking regulator with a foreword by the governor. This time the report has been tweaked important concepts, such as introducing a “very severe” stress scenario in risk analysis, while leaving out some such as frauds in the banking system. Those left out would be part of the annual Trends and Progress Report.

The spread, intensity, and duration of the pandemic have “imparted extreme uncertainty not experienced in our lifetime”, Das wrote in his foreword.

The pandemic hit India at a time when the country was going through a growth slowdown, and coincides with “a growing disconnect between the movements in certain segments of financial markets and real sector activity”.

Of late, “signs of a gradual recovery from the nationwide lockdown are becoming visible”, but the overarching objective should be to preserve the long-term stability of the financial system, the governor noted.

The report, however, warned that the near-term economic prospects appeared “severely impacted by lockdown induced disruptions to both supply and demand side factors, diminished consumer confidence and risk aversion”.

Even with measures taken by the regulators and the government, “the downside risks to short-term economic prospects are high”.

According to the RBI governor, once the pandemic spends itself, efforts should be made to unwind the regulatory and other dispensations. Policy measures have so far kept financial markets from freezing up, and eased liquidity stress, and borrowing costs have softened with illiquidity premia shrinking. Nonetheless, risk aversion and lacklustre demand have impeded the fuller flow of finance from both banks and non-banks into the economy, the FSR noted.

The latest systemic survey done by the RBI shows risks have increased across all major groups. Global risks, risk perceptions on macroeconomic conditions, financial market risks, and institutional positions were perceived to be “high”. Risks to domestic growth and fiscal housekeeping were perceived to be “very high”.

The pandemic could also amplify financial vulnerabilities, including corporate and household debt burdens in the case of severe economic contraction, the FSR noted.

Troubled non-banking financial companies (NBFCs) and housing finance companies (HFC) remained the largest borrowers from the financial system. Of that, a substantial part comes from banks. However, the failure of the largest of them is unlikely to destabilise banks, given better resilience and capital support and the shrinking size of inter-bank markets, the FSR noted.

“Non-PSU NBFCs with the maximum capacity to cause solvency losses to the banking system could knock off 2.7 per cent of the latter’s total Tier 1 capital but it would not lead to failure of any bank,” the report said.

“Failure of the (HFCs) with the maximum capacity to cause solvency losses to the banking system will knock off 6.77 per cent of the latter’s total Tier 1 capital but without failure of any bank,” it said.

The report found bilateral exposures among entities in the financial system declined marginally during 2019-20; “with the inter-bank market continuing to shrink and with better capitalization of public sector banks (PSBs), there would be reduction in contagion losses to the banking system under various scenarios in relation to a year ago”.

There has been a sharp drop in demand beginning March across both urban and rural segments but not all sectors were affected. Manufacturing has been the worst affected while agriculture and IT have remained buoyant. However, corporate sector leverage has increased and demand contraction means their capacity utilisation has been hampered.

“As such, the downside risks to growth remain significant and full restoration in economic activity would be contingent upon the support for robust health infrastructure, recovery in demand conditions and fixing of supply dislocations, in addition to the state of global factors like trade and financial conditions,” the FSR said.

The report found among PSBs “there was a sharp credit contraction across all rating categories except ‘AA and above’ as also among non-PSU obligors”. In contrast, private sector banks registered positive credit growth across all rating categories and across both PSU and non-PSU obligors, indicating less overall risk aversion compared to PSBs.

The behaviour of private banks in the past two quarters “is in sharp contrast to their behavior in the past three years”, the report noted.

As of April 30, 67.9 per cent of PSB loan books were under moratorium, and as many as 80 per cent of their individual borrowers had availed of the moratorium.

For private banks, 31.1 per cent of the book was on moratorium, and for NBFCs, about 49 per cent of the loan book had availed of moratorium as of April 30, the FSR said.