How thorough are RBI’s stress tests?

The RBI has been worrying about the rapid growth in unsecured personal loans.

We have yet another financial stability report from the RBI that sticks to the familiar theme of banks being resilient to face external shocks given their low NPAs as also adequate capital and profitability.

There is no universal definition of financial stability though it is the top goal of every regulator. The US Fed has a working definition of it viz. the ability of banks and financial markets to provide households, communities, and businesses with the financing they need in the face of adverse events or shocks.

It categorizes vulnerabilities of the financial system into four, namely, excessive asset valuations, excessive leverage in financial players, excessive borrowing by businesses and households and funding or liquidity risks.

India’s approach to vulnerability

It is not known if the RBI has a similar definition, but the report at least seems to suggest that the system is considered stable if banks can pay their debts and pass regulatory capital tests. To be fair, it also addresses the other issues relating to valuations, excess borrowing and leverage but some of these are either not relevant or potent enough; market froth and exuberance rarely spill over to other markets, while excessive leverage among non-bank financial actors such as hedge funds, a huge issue in the US, is not really heard of.

As for excessive borrowings, India right now has the opposite problem, namely, inadequate offtake, though the RBI has been worrying about the rapid growth in unsecured personal loans. It must be pointed here that the report seems to overstate the extent of personal debt in the system (41% of GDP) by including the debt of unincorporated enterprises and non-profits under household borrowings. Its own data show that personal credit (home loans, durables and vehicle loans and consumption loans) amounted to only about half the reported number, which puts the ratio at a more modest 25%.

Liquidity risks are what bother regulators

But funding or liquidity risk is a more serious threat that regulators constantly watch out for, especially the contagion effects of investor withdrawal through bank runs or redemption pressures at mutual funds and other asset markets. The US Fed tracks the levels of aggregate runnables, liabilities that are prone to sudden withdrawal, which it estimates to be about 80% of US GDP. These are vital to both investors and businesses, offering cash-management options and short-term funding respectively. But they are also highly susceptible to runs and most financial crises in the US have originated from markets such repos and CPs.

Many small and mid-sized banks have had to liquidate assets to meet a run, as had happened with Silicon Valley Bank. In this regard, Indian banks seem better placed. About 40% of banks’ deposit liabilities are CASA deposits which are in the nature of transactional money rather than real savings and therefore presumably less prone to runs. Perhaps the reason why there have not been any major bank runs. Nevertheless, the RBI prescribes a 100% liquidity coverage ratio for all banks, a level that is mandated only for systemically important and large sized banks in the US.

Risks of interconnectedness

The problem of interconnectedness in the financial system is another vulnerability that RBI reports always focus on. Though it has stopped publishing data on receivables and payables of individual players, it is clear that banks are both the largest suppliers and users of funds and are mostly dealing amongst themselves. Mutual funds are the second largest supplier of funds but a large part of their investments have found their way back to banks and NBFCs through CPs and CDs with the possibility of default risks ricocheting through both sectors.

Risks arising from a surge in wholesale credit

While the banking system is resilient in terms of health and profitability, it is important to understand the underpinnings. It is well known that asset quality has gone up on the back of write-offs and risk avoidance rather than improved underwriting. A large portion of legacy NPAs were from industrial and infrastructure sectors which they have now stopped lending to. In terms of shares, industry is the second largest recipient (27%) but credit to the sector during the past eight years grew at a CAGR of only 3%, as compared to a 16% growth in retail credit. Risk avoidance also has a bearing on profitability because loan loss provisions are a major determinant of bottom lines given the thin margins.

The RBI evaluates impact to NPAs and capital adequacy based on macroeconomic stresses under two scenarios. But surely it also needs to stress-test them against an increased demand for wholesale credit from industry and infrastructure. Even on interest rate risk management banks seem to be dependent on benign regulatory forbearance than in-house skills. Most of all, the roll-out of the stricter IndAs accounting norms for banks has now been put off by the RBI for many years apparently due to the lack of preparedness of banks. These could impact profitability and capital adequacy in the future due to increased provisioning for bad loans necessitated by the expected loss-based provisioning regime. The non-bank segments in the system, NBFCs and Mutual Funds (MFs) also seem to be doing well but a constant worry about NBFCs has been about their high level of dependence on banks and MFs. Stress tests of AMCs mandated by the SEBI also show MF schemes in good light but again the interconnectedness with banks and NBFCs is a source of risk.

The RBI may be sanguine about banks now but their resilience has not really been put to a severe test yet.