RBI’s latest Financial Stability Report suggests further shocks for banking sector; risks to domestic financial stability staring banks

Bad Loans are on the rise for Banks leading to market crisis

Gross bad loans on banks’ balance sheets could rise to 13.5 per cent by 30 September 2021 according to the estimates given by the Reserve Bank of India (RBI). This is against 7.5 per cent in September 2019 

The Indian banking system is headed for a big shock as gross bad loans on banks’ balance sheets could rise to 13.5 per cent by 30 September 2021 according to the estimates given by the Reserve Bank of India (RBI). This is against 7.5 per cent in September 2019.

This is not all as there could be a further escalation to 14.8 per cent if the macroeconomic environment worsens into a severe stress scenario, the RBI noted in its report. This will be highest in almost two decades.

Among the bank groups, Gross Non Performing Assets (GNPA) ratio of 9.7 per cent in September 2020 for Public Sector Banks (PSB) may increase to 16.2 per cent by September 2021 under the baseline scenario, the RBI estimated.

As for Private Sector Banks (PVBs) and Foreign Banks (FBs), GNPA ratio of 4.6 per cent and 2.5 per cent may increase from to 7.9 per cent and 5.4 per cent, respectively, over the same period. In the severe stress scenario, the GNPA ratios of PSBs, PVBs and FBs may rise to 17.6 per cent, 8.8 per cent and 6.5 per cent, respectively, by September 2021.

The revelations were made by the banking regulator in its Financial Stability Report released on 11 January 2021.

This was the 22nd issue of the report which has been prepared keeping the current macroeconomic situation of the country in the view amid the coronavirus pandemic.

The latest report is indicative of the problems that lie ahead for the banks and by no means can be taken lightly. These GNPA projections, if fall as per the estimates of the RBI, would trigger “economic impairment” latent in banks’ portfolios, with implications for capital planning.

Potential risks to domestic financial stability

Let us examine the enormity of this potential damage. The banking sector stress will have significant implications on the Capital Adequacy Ratio (CAR) – a benchmark of a bank’s available capital, expressed as a percentage of a bank’s risk-weighted credit exposures. It is also known as capital-to-risk weighted assets ratio (CRAR) and is used to protect depositors.

As per the report, the system level capital adequacy ratio is projected to drop from 15.6 per cent in September 2020 to 14 per cent in September 2021, under the baseline scenario and to 12.5 per cent under the severe stress scenario. The stress test results indicate four banks may fail to meet the minimum capital level by September 2021 under the baseline scenario, without factoring in any capital infusion by stakeholders. In the severe stress scenario, nine banks may not be able to meet the minimum levels mandated by the regulator.

The common equity tier I capital ratio of scheduled commercial banks (SCBs) may decline from 12.4 per cent in September 2020 to 10.8 per cent under the baseline scenario and to 9.7 per cent under the severe stress scenario in September 2021. Under the baseline scenario, two banks may not be able to meet the regulatory minimum of 5.5 per cent CET-1 ratio, while five banks won’t meet the requirement under the severe stress scenario.

The RBI also noted that the ongoing stress in specific segments of the service economy, viz., hotels, entertainment, travel, tourism and taxi services could lead to credit stress on corporate and retail assets in the financial system.

Also, India is among the top three nations identified by investors as likely to suffer from significant debt distress. A global risk aversion towards emerging market assets could lead to “massive capital outflows”, creating pressure on the rupee as well as on bond yields, the RBI report said.

Inflation remains a pain point for RBI. Inflationary pressures coupled with poor GDP growth could limit the policy space for rate cuts and keep yields under pressure, the RBI said.

As for NBFCs, the growth prospects in the immediate term will likely be impacted by the funding challenges especially for lower rated NBFCs. There is not much to inspire confidence under the current situation.  Moreover, tightening underwriting standards on expectation of increasing delinquencies is not helping either. The outlook for housing and vehicle finance is lacklustre.

Country’s backbone in terms of employment and contribution to GDP – the MSME sector’s fall continues unabated. The RBI said that the continuing adverse impact on MSMEs due to lack of cash flows, low demand, lack of man power and lack of capital could lead to prolonged stress in the sector and large-scale permanent closure of units with associated implications for employment.

Real estate prices and cash flows in commercial real estate could undergo a major structural correction due to transformation in the model of conducting work, resulting in further pressure on real estate developers and lending to the sector, the RBI said in its 119-page report.

“In this context, uncertainty on the roadmap for tapering unconventional measures taken by the regulators could impact investor confidence,” the RBI said.

Stress test for banking sector

In its attempt to gauge the adequacy of capital and liquidity buffers with financial institutions for withstanding severe but plausible macroeconomic and financial conditions, the RBI did a stress test. The above numbers cited in the Financial Stability Report were based on the macro stress tests incorporating the first advance estimates of gross domestic product (GDP) for 2020-21.

There was a caveat, though. “By design, the adverse scenarios used in the macro stress tests are stringent conservative assessments under hypothetical adverse economic conditions,” the RBI said.

“It’s emphasised that model outcomes do not amount to forecasts.” “…considering the uncertainty regarding the unfolding economic outlook, and the extent to which regulatory dispensation under restructuring is utilised, the projected ratios are susceptible to change in a nonlinear fashion,” the RBI said.

Stress tests also indicate that SCBs have sufficient capital at the aggregate level even in the severe stress scenario but, at the individual bank level, several banks may fall below the regulatory minimum if stress aggravates to the severe scenario. What is required currently is actions from banks to assess their respective stress situations and follow it up with measures to raise capital proactively.

Some Silver Linings

The RBI in its assessment claimed that the gross NPAs have been consistently falling over the past two years, with the number at 7.5 percent for the September 2020 quarter. The net NPA for this month was 2.1 per cent. It further said that the slippage ratio or the rate of accretion of fresh bad loans, has come down to 0.15 per cent as of September.

The RBI gives credit for this downward trend to actions taken by various regulatory dispensations amid the Covid 19 pandemic.

Asset quality for banks improved noticeably in the case of industry, agriculture and services in September 2020 over March 2020, with a decline only marginally and stressed advances remained flat.

Moreover, the share of large borrowers in the aggregate bank credit and gross NPA of the system fell to 50.5 per cent and 73.5 per cent respectively as per the estimates of the RBI.

The share of restructured standard advances increased, indicating that large borrowers have commenced availing restructuring benefits extended for Covid-19, the regulator noted.

Another important takeaway from the report is the commentary on very severe stress, which the regulator had introduced in the last Financial Stability Report. A one-time additional scenario of ‘very severe stress’ was introduced in view of the high uncertainty around the evolution of the COVID-19 pandemic, its economic costs and delay in the data gathering process. “With 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,” the report said.

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