The Reserve Bank of India’s latest Financial Stability Report says that a “noteworthy feature” amidst the current dynamic and the uncertain macroeconomic situation is the “overall resilience of the financial institutions”, navigating the waves of the COVID-19 pandemic and bolstered by the risk absorption capacity.
This robust assessment of the financial sector is critical for the Indian economy amidst global headwinds and tightening liquidity, which could severely pose a threat to macroeconomic and financial stability.
Despite the positives, one cannot be absolutely certain that the improved asset quality of the financial sector and better profitability numbers could lead to a credit off-take and steer the private investment cycle, as the corporate sector sentiments have been severely dampened by the multiple lingering shocks and heightened uncertainty. Plus, we have entered a “rate-hike cycle” in the Indian economy, which means both consumers and corporates will weigh in the interest rate risks.
The asset quality (measured by gross non-performing asset ratio or GNPA ratio) of scheduled commercial banks continued to decline from 7.4 percent in March 2021 to a six-year low of 5.9 percent in March 2022 led by the support measures of RBI during the pandemic. This fall, along with a notable improvement in the provision coverage ratio from 67.6 percent in March 2021 to 70.9 percent in March 2022, does ensure that the major cleaning of the bad loans in the banking system is behind us.
The RBI needs to be commended for introducing as well as unwinding the regulatory forbearance and other liquidity support measures at the appropriate time during the COVID-19 pandemic. However, the headline number should be read with a pinch of salt as double-digit GNPA numbers for some sectors like gems and jewellery (18.4 percent), construction (19.4 percent), food processing (12.4 percent) and mining (12 percent) do highlight concerns and need for some more cleaning.
Also, the recent bank credit off-take needs close monitoring as there has been higher lending to MSMEs and other sectors which were hit badly by the pandemic. This, coupled with the current phase of tightening of liquidity and the interest hike cycle, means higher repayments. As operating profits of companies are not likely to see a notable improvement in the current fiscal year due to cost pressures, the delinquency rate requires a watchful eye.
The focus of the financial stability report is more about the resilience of the financial sector as highlighted by the macro stress test. The stress test results reveal that the SCBs are well-capitalised and capable of absorbing macroeconomic shocks even in the absence of further capital infusion. The CRAR is projected to decline from 16.7 percent in March 2022 to 15 percent (baseline), 14.2 percent (medium stress) and 13.3 percent (severe stress). Just as seen in the FSR in July 2021, none of the 46 SCBs (scheduled commercial banks) is projected to breach the minimum capital requirement of 9 percent in the next one year. This is a significant improvement because in July 2020, the stress test had projected 5 banks to fall below the minimum CRAR (capital to risk-weighted assets ratio) requirement.
The GNPA ratio may decline from the current level (5.9) to 5.3 percent by March 2023 (baseline scenario) and could deteriorate to 6.2 percent and 8.3 percent in the medium and severe stress scenario respectively.
The report points out that the financial stability risks to the Indian economy are skewed towards external factors more than domestic ones. However, the spillover of the external risks to the financial sector stability can be quick in a volatile environment and more importantly they can strike as a surprise to the lenders, either via unexpected delinquency or higher yields impacting non-core income. Therefore, banks and other financial institutions should not pull down their guard following the recent improvement in profitability and asset quality. Additionally, the report describes some emerging risks to financial stability emanate from cryptocurrencies (although limited as the overall size is 0.4 percent of global financial assets) and cyber risks that requires special attention.
Just at the onset of the COVID-19 pandemic, the financial sector was perceived to be one that could be adversely impacted due to deterioration in asset quality, restructuring loans and requirement of capital infusion. However, the financial sector has defied the odds with proactive regulatory support – a big positive for the Indian economy. The lingering uncertainty, however, means that the financial sector and borrowers are likely to tread cautiously until abatement of external risks.
