Capital crunch

Structural problems in banking system would affect recovery

The latest Financial Stability Report of the Reserve Bank of India (RBI) underscores the kind of damage the ongoing pandemic can cause to the Indian banking system. Overall gross non-performing assets (GNPAs) for the scheduled commercial banks declined from 9.3 per cent in September 2019 to 8.5 per cent in March 2020, but things could worsen significantly in the coming quarters. The stress tests conducted by the RBI showed that GNPAs could go up to 12.5 per cent by March 2021 under the baseline scenario, compared with 8.5 per cent in March 2020. However, if the macroeconomic outlook worsens further, which is a real possibility, the GNPA ratio could go up to 14.7 per cent under a very severe stress scenario. The central bank has assumed gross domestic product contraction of 8.9 per cent under the very severe stress scenario, which cannot be ruled out. While other assumptions such as those related to inflation and current account are unlikely to materialise, the scale of contraction in the economy is perhaps the biggest risk for the banking system. The re-imposition of lockdown in various parts of the country and continued increase in Covid-19 cases could worsen the macroeconomic outlook.

The potential increase in bad loans would mean that banks need to build capital buffers. While private banks are raising capital, public sector banks (PSBs), which are likely to take a bigger hit, are lagging. GNPAs in PSBs as a group could go up to 15.2 per cent by March 2021 under the baseline scenario, compared with 11.3 per cent in March 2020. Non-banking financial companies (NBFCs) — the largest net borrowers from the financial system — could also be affected significantly. The aggregate funding of stressed NBFCs and housing finance companies by PSBs is increasing. As a result, trouble in the NBFC space will affect the banking system, particularly the PSBs, which also have a larger share of loans under moratorium. To be sure, things would be clearer once the moratorium is lifted. But a weak banking system would affect economic recovery once the pandemic subsides as the stress in PSBs could be prolonged. It would be difficult for the government to recapitalise PSBs because of stretched finances. There is talk of privatising select PSBs. However, given their asset quality, depressed valuations, and legal hurdles in the way, this would not be easy.

Aside from capital, there is another big risk: The lack of intent to clean up the financial system and contain bad assets. Former RBI governor Urjit Patel has noted in his new book that the move to dilute the bankruptcy law caused disagreements between the central bank and the government. In fact, the current suspension of the bankruptcy law would affect the bargaining power of the banking system. The other major structural problem, as Mr Patel has noted, is the “creeping banking sector-fiscalisation”. When governments are unable to increase spending, they use banks to pump-prime the economy. The PSBs are being nudged to increase lending and, given the state of the economy, it would affect their asset quality. Also, this is unlikely to result in a sustainable recovery. Thus, the inherent systemic weakness of the Indian banking system could be a big risk to recovery in the post-Covid world.