Indian banks face risk of worsening asset quality: RBI report

Risks to the stability of Indian banks, especially state-owned banks, have increased over the six months ended 30 March 2014 with deterioration in asset quality and decline in lending activity amidst a slowdown of economic expansion, the Reserve Bank of India (RBI) said in its bi-annual Financial Stability Report released on Thursday.

The central bank expects gross non-performing assets (NPAs) of banks in India to remain steady at 4-4.1 per cent of gross loans by the end of fiscal 2015, against 4 per cent at the end of March 2014. However, there are chances that the NPA ratio could increase further to 5.5 per cent if macroeconomic conditions deteriorate, RBI stated.

Indian banks, particularly state-controlled lenders, are facing rising loan defaults as the nation's economy expanded near the slowest pace in a decade amid high interest rates, making it difficult for borrowers to repay loans.

State-run banks are more vulnerable than their private sector counterparts. The stress tests indicated that under a severe stress scenario, gross NPAs for public sector banks may rise to 6.1 per cent by March 2015 from 4.6 per cent in March 2014, the RBI report said.

A stress test of sectoral credit risk conducted by RBI revealed that the iron and steel sector is expected to register the highest NPAs of around 6.7 per cent by March 2015, followed by the construction and engineering industry.

However, there are some indications that corporates with stressed balance sheets could see some relief in the coming months as companies take advantage of improved sentiment in the capital market to raise equity to cut their debt. This, in turn, will benefit banks.

Indian companies are increasingly resorting to qualified institutional placements to raise funds. At least four companies have raised about Rs.10,390 crore through share sales to qualified investors since late May, when the new government took over, according to Mint's estimates. But new risks are emerging.

''India's financial sector remains stable, although public sector banks face challenges in coming quarters in terms of their capital needs, asset quality, profitability and more importantly, their governance and management processes,'' said RBI governor Raghuram Rajan in the foreword to the report.

RBI calculations project the total capital requirement of public sector banks at Rs4,15,000 crore between now and March 2019 when the new international banking capital norms - Basel III norms - are set to be applied in India. Of the total capital required by state-owned banks, Rs90,000 crore will have to come from the government if it intends to maintain its current stake in these banks.

''Amidst the government's fiscal position constraints, PSBs' (public sector banks) ability to raise additional capital from the market depends on the conditions in capital markets and the 'market perception' of their relative strengths and weaknesses,'' noted the RBI report, while highlighting the undervaluation of public sector banks in the market.

Private sector banks have commanded a stronger valuation in the market.

For instance, the one-year forward price-to-book ratio of ICICI Bank Ltd is 2.02, while that of State Bank of India is 1.54. The price-to-book ratio is a valuation measure commonly used for banks. RBI argued in its report that an implicit government guarantee should allow the valuations of public sector banks to broadly converge with industry averages.

While the capital adequacy ratio of banks improved to 12.9 per cent in March 2014 from 12.7 per cent in September 2013, in case of a severe stress, this ratio could fall to 10.6 per cent, RBI said.

The report also noted that as the liquidity capital requirements (LCR) under Basel III norms progressively increase, RBI may consider it desirable to further reduce the SLR (statutory liquidity ratio) requirement for banks from the current 22.5 per cent. ''Given the roadmap for fiscal consolidation to reduce fiscal deficit to 3 per cent of GDP (gross domestic product) by 2016-17, any decline in incremental availability of government securities may not thus impinge on SLR and LCR requirements,'' said the report.

RBI has assumed a baseline scenario of 5.5 per cent economic growth in 2014-15, which could drop to 3.6 per cent in case of ''medium stress'', and to 1.7 per cent in case the stress is severe.

Wholesale prices are assumed to rise 5.3 per cent under the baseline assumption, but could rise more rapidly by 7.5 per cent and 10.7 per cent in case of medium and severe stress, according to RBI.

The economy grew 4.7 per cent in the year ended 31 March, after expanding 4.5 per cent in the previous fiscal, the slowest in a decade. The increase in defaults has, in turn, crimped profits of the banks and increased their need to boost capital.

The FSR reflects the collective assessment of the sub-committee of the Financial Stability and Development Council (FSDC), on risks to financial stability.

The report aims to promote awareness about the vulnerabilities in the financial system, to inform about the resilience of the financial institutions and to encourage debate on issues relating to development and regulation of the financial sector.

The latest issue is being brought out at a time when global financial markets are showing signs of improved stability although growth is still not on strong ground and easy monetary policy continues in many jurisdictions.

On the domestic front, the return to political stability has provided impetus to the outlook and the capital markets reflect the expectations on policy measures to address the adverse growth-inflation dynamics and saving-investment balance as also efficient implementation of policies and programmes (See:  Stable government spells brighter economic recovery prospects: RBI)

India's financial system remains stable, though the banking sector is facing some major challenges, mainly relating to public sector banks (PSBs). Although there has been some improvement in the asset quality of scheduled commercial banks (SCBs) since September 2013, the level of gross non-performing advances as percentage of total gross advances (GNPA ratio) of PSBs was significantly higher as compared to the other bank groups.

While the ownership pattern and recapitalisation of PSBs are contingent upon government policy and the fiscal situation, there is a case for reviewing the governance structures of PSBs, with a greater emphasis on market discipline, the report pointed out.

However, macro stress tests show that the system level capital to risk-weighted assets ratio (CRAR) of SCBs remains well above the regulatory minimum even under adverse macroeconomic conditions, it added.

The regulation of securities markets in India is in sync with international developments, although mutual funds and other asset management activities in Indian markets do not carry risks similar to those experienced in other jurisdictions.

The lending activity of insurance companies, though relatively small and within the prescribed exposure limits applicable for insurance companies, may need to be streamlined and monitored under a prudential framework comparable to that for banks to eliminate the possibility of regulatory arbitrage, the report said.

Revised norms for corporate governance as also warehouse and related processes are expected to strengthen the functioning of the commodity derivatives market.

For the pension sector, the report said, inadequate liability computation in case of several defined benefit pension schemes can be a potential source of fiscal stress in years to come.