Beyond oil shock, Iran war is quietly straining India's financial system

A new report has flagged a delayed risk cycle for India from the US-Iran conflict, as liquidity tightens and cash-flow stress builds before defaults, even as headline indicators remain stable

As the US-Iran-Israel war continues into its second month with no clear end in sight, the economic fallout for India is no longer just about oil spikes or headline volatility. India’s financial system is absorbing the West Asia conflict in ways that are not immediately visible on balance sheets, but are silently building under the surface. Because the real risk is not the immediate shock, but a delayed, cumulative stress that will surface over the coming quarters, as liquidity tightens and cash-flow pressures translate into asset-quality risks. 

A latest EY India analysis of the impact on the financial sector has highlighted that the disruption is coming through freight costs, insurance premiums, trade finance friction and supply chains, reshaping cost structures and stretching liquidity across sectors.

 

A shock that spreads through systems

War risk premiums across marine, aviation and trade credit have risen 40-50 per cent, while crude volatility and a weakening rupee are pushing up input costs. These first-order effects are feeding into inflation and trade friction, but they are not where the primary risk sits, the report observes. 

Instead, sectors with direct exposure like oil, aviation, logistics, petrochemicals and import-heavy trading, are already seeing margin compression and liquidity strain due to higher freight costs, longer transit times, and foreign exchange volatility.  “The West Asia crisis is reshaping cost structures, cash flow dynamics, and balance sheet behaviour for India’s financial sector. Beyond immediate oil and FX volatility, the real impact is transmitting non linearly – from treasury pressures into borrower margins, working capital cycles, and eventually household incomes," said Pratik Shah, National Leader - Financial Services, EY India. 

As a result, the stress is beginning to transmit to sectors such as MSME manufacturing, auto ancillaries, cement and consumer durables, where rising costs are meeting softer demand and delayed pricing adjustments, the report noted.

Stress building underneath before it is visible

However, the more material shift is happening beneath the surface and banks are seeing the early signs of strain, not in defaults, but in cash-flow behaviour. 

Banks are now dealing with a non-linear transmission of stress, from margins to working capital to household incomes. This is showing up first as cash-flow volatility rather than outright defaults, challenging traditional risk models that rely on delinquency signals. 

The report highlights that second-order effects are emerging in the form of stretched working-capital cycles, higher utilisation of credit lines, delayed receivables and volatility in business filings as borrowers continue to service loans, but with increasing dependence on liquidity.  

Export-oriented MSMEs including apparel, with about 11.8 per cent exposure to West Asia, are particularly exposed as margins compress and cash cycles lengthen. This phase, the report said, often escapes traditional risk frameworks because stress is not yet visible in delinquency data.

The third order effect: From liquidity strain to credit risk

Third-order effects begin to surface with a lag but are broader in scope as stress moves through supply chains as supplier payments are delayed, anchor firms stretch payouts, and localised job disruptions begin to appear. 

On the retail side, the pressure is building gradually, the report said. Employment risks in IT and business process services due to rising interruption by artificial intelligence, alongside inflation, are compressing household incomes, particularly in urban lower-middle segments. And the early warning signs of the yet to come full-scale distress can already be seen in irregular salary credits and shrinking balances, factors that typically precede a rise in delinquencies by one to two quarters. 

The result is a delayed but sharper impact on asset quality, especially in unsecured and small-ticket retail loans, where stress becomes visible only after it has spread across the system.  "Stress is already surfacing as cash flow volatility rather than outright defaults, exposing the limits of delinquency led risk models. This makes anticipatory risk management – built on sector diagnostics and predictive early warning signals – far more critical than reactive intervention." Shah said.

Trade, remittances and financial flows under stress

Meanwhile, trade finance is emerging as an additional constraint. Disruptions in shipping routes and tighter sanctions screening are delaying cross-border payments and letter of credit confirmations, locking up working capital for longer periods and increasing reliance on bank funding. 

External flows also remain exposed. Around 35-40 per cent of India’s $138 billion inward remittances come from Gulf economies, raising the risk of a slowdown if labour markets in the region weaken. 

Insurance markets are already adjusting to the new risk environment, with sharp repricing in marine, aviation and trade credit segments alongside rising claims.

The risk of ‘what comes next’

For now, the financial system appears stable, but the EY analysis suggests that this stability may be misleading because the deeper stress, which is building through liquidity, cash flows and income disruption, is likely to surface later in the form of asset-quality deterioration.