Rates, Risks and Ratings: Indian banks emerge more resilient than the US ones

Rating agencies appear to be sanguine overall about the Indian banking environment given the improved performance in earnings.

Just when they thought the crisis was behind them, banks in the US seem to be facing another one, this time from rating downgrades. Moody's downgraded ten mid-sized banks, citing elevated real estate exposures and high interest rates, followed by S&P. Fitch lowered the score of the banks’ “operating environment” to AA- from AA, quoting uncertainties about future interest rate hikes and warned that bigger banks could also get downgraded if the environment deteriorated. The risk came from the Fed’s interest rate hikes and not from anything banks were doing.

The all-pervasive impact of interest rates is hard to miss. Ultra-low interest rates had caused the 2008 mortgage crisis (through liberal subprime lending) and high interest led to the recent crash when banks failed to meet repayment obligations as their investments crashed in response to higher interest rates. Given banks’ high exposure to real estate (47 percent of total credit) and with over half of all their investments in mortgage securities, interest rates and mortgages seem inseparable from financial crises. For banks, inverted yield curves meant their deposits got re-priced faster than loans, depressing their net margins. Rising interest rates also drove deposits away from banks to money market accounts, making deposits more expensive. But the greatest impact was on their investments. Banks piled up large unrealised losses (estimated at around $500 billion and nearly 30 percent of their capital) as yields began rising. Realised losses and capital erosion could set off a stock price crash and in turn a run on deposits, as had happened with SVB and First Republic Bank.

Rising interest rates also impacted household wealth. Stock, bonds and pension entitlements form around 40 percent of household wealth and were highly susceptible to rate movements. Given the wealth effect on consumption, erosion would have a growth impact too. Rising interest rates can trigger loan delinquencies, already seen in the increase in credit card and auto loans, and compound the problems for banks. Rising interest rates clearly seem a huge risk to system stability.

India’s financial system also went through rate hikes around the same time. The Reserve Bank of India (RBI) had increased policy rates by 250 bps from May 2022 onwards, but there were hardly any ripples. For one, the financial system is bank-led, which means that interest rates work mainly through credit and banking channels. For banks, rising interest rates seemed a gift, as they registered impressive growth in both net interest margins and net profits during 2022-23, by 20 percent and 36 percent, respectively. This was in spite of interest expenses going up by 21 percent. It was made possible by the large level of current account-savings account (CASA) deposits (44 percent of the total) in the liabilities, which cushioned the impact of rate hikes. CASA are zero-cost or low-interest accounts that are not really rate-sensitive. It is believed that the massive growth in unified payments interface (UPI) transactions in the last three years has fuelled the spurt in CASA deposits.

Rising rates did not impact their investment portfolios either. An overwhelming 80 percent of investments are in government securities (G-Secs), one of the highest in the world. Interest-rate risk was definitely a huge threat considering that nearly all the securities were under the held-to-maturity category. But since long-term yields did not rise much, even as global bond yields spiked, banks were spared a major hit. Also, the RBI’s strategy of keeping bond yields low would have helped. The reason why banks held such a large level of G-Secs is in part statutory (statutory liquidity ratio requirement) and in part from sterilization exercises of the RBI for mopping up excess liquidity. Risk aversion was also a factor as banks preferred to hold excess securities because they carried low risk.

Another aspect that worked in their favour was the fact that accounting regulations for banks were less stringent. The Indian Accounting Standard (IndAS) which is the Indian version of International Financial Reporting Standards (IFRS9) regulations, has been deferred many times since 2018. Banks have also been reducing loan-loss provisioning over the years on the back of declining non-performing assets (NPAs) which would have helped public sector banks to pay out more dividends. But all this could change when the expected credit loss-based provisioning rules of Basel III kick in. So much so, a former governor of the RBI had termed the arrangement a mutually beneficial bargain where, in return for financing the government deficit and priority sectors, banks were assured of safety.

Rating agencies appear to be sanguine overall about the Indian banking environment given the improved performance in earnings, capital buffers and asset quality. Their concerns were about public sector banks whose capital infusion was dependent on the ‘government’s strategic priorities’ and on banks’ increased risk-taking in retail and unsecured lending. Forbearance, low-cost liabilities and risk avoidance may have kept the system safe, but in a bank-led economy such as ours, the more important question is about their role in growth. To make the transition from financing consumption and services to sectors that will power future growth, such as corporate capex, manufacturing and infrastructure, requirements will be different — greater risk-taking, better underwriting and a more diversified resource mix that will facilitate long-term financing.