Systemic weaknesses in the Indian banking sector imminent. RBI must remain vigilant

The need of the hour is to look beyond the positive headlines and identify possible cracks in the system which may threaten the overall stability when the economy is chugging along swiftly.

The Reserve Bank of India’s FY23 closing balance sheet reveals that the Indian economy has normalised and the coordinated fiscal-monetary reaction to Covid-19 may have been successful. However, signs of weaknesses are now emanating from across the system, and Q1 FY24 may augur an impending shock, if the RBI does not remain vigilant.

Amidst capex-driven growth and somewhat robust yet waning consumer confidence, liquidity has become the first casualty. Understandably, credit offtake continues to outstrip growth in public deposits, and systemic liquidity is currently just a quarter of what it was at the same time last year. At the same time, demand at the Marginal Standing Facility (MSF) has now increased 40-fold, and this signifies liquidity inadequacies in the non-collateralised and money markets. Likely, this has a direct bearing on smaller and vulnerable commercial banks, which might have to struggle for liquidity and encounter higher stress levels.

The overall decline in the cost-effective current account savings account (CASA) deposits among commercial banks in relation to time deposits has not helped the cause either.

Rising Demand For Cash

Secondly, in a bid to control inflationary tendencies, and partly due to currency withdrawal, the RBI has not expanded its balance sheet through Q1 FY24. This has resulted in no net additional printing of new money, in line with the expanding economy’s needs. Given the high growth in credit offtake, bank reserves with the RBI are continuing to expand by over 15 percent, signalling insatiable cash demand in the system. As a result, the overnight call rate now exceeds 6.7 percent, which is almost 25-27 bps over the policy rate itself.

If the miniscule 20 percent subscription of RBI’s recent Variable Rate Reverse Repo (VRRR) operation is anything to go by, then apparently, commercial banks are not interested in parting with their money any longer than overnight to three days. Besides, attractive yields elsewhere have given banks fresh, albeit riskier avenues to diversify earnings. This in turn can be taken as an indication of margin pressures among banks.

Thirdly, rate normalisation and inflation are eating into corporate margins and the banking system’s large exposures must remain under the RBI’s protracted monitoring, until necessary. Stress in the system is already apparent, as the RBI’s latest Financial Stability Report reveals that bank exposures under special mention accounts (SMA) Category 1 have risen by almost 39 percent Q-o-Q in Q4 FY23. Since the SMA Category 1 has debt overdue period of 31-60 days, it is likely that some doubtful corporate exposure classified under the category, if not manipulated, would have transitioned into SMA Category 2, in Q1 FY24.

With a debt overdue classification of 61-90 days, SMA Category 2 is perhaps the final frontier before commercial banks are required to transition an exposure into the dreaded non-performing asset (NPA) Category. For this reason, the former is often considered to be the calm before the storm in bank management parlance.

Possibly, the traditional evergreening of non-performing assets within SMA levels by commercial banks may subdue the concerns for now. Nevertheless, while some of these doubtful exposures may be attributed to creditor-debtor-days-mismatches, how long would the ongoing rising interest rate transmission allow this manipulation to continue is a point to ponder.

Indications Of More Tightening

Fourthly, government securities yields, for both 5- and 10-year duration have also increased substantially by roughly 10 bps, over the last few weeks, and point towards further tightening in the system and possible mark-to-market losses for banks. Continued rise in yields, in consonance with the tightening elsewhere (US Fed and ECB) may have adverse effects on perfectly curated CRAR and CET1 ratios of commercial banks as well.

Also, this year’s frontloaded capex may result in increased issuance of public debt, not only increasing yields across all durations but also crowding out private issuers, mounting additional funding pressures on the system.

Finally, as far as the RBI’s balance sheet is concerned, the size is now slightly lower than the average of two percent of nominal GDP. FY19 was the last time this threshold was reached, until of course Covid-19 related measures changed everything. Importantly, however, the composition of deposits, which show on the liability side of the RBI’s balance sheet was over 23 percent by the end of Q1 FY24 — higher than both FY23 and FY19 closing numbers. What this means is that liquidity in the system has now gone down substantially and this not only checks inflationary tendencies in the economy but also reduces available cash in the system. At the same time, this also impedes the RBI’s ability or for lack of a better word, intention to print new money, as discussed earlier in this piece.

Not to forget, the RBI’s own Net Domestic Asset holdings (NDA) have lost slightly over Rs 2,200 crore in mark-to-market losses since the beginning of the current financial year, possibly due to yield curve flattening, and volatility in the short end of the curve. This has a direct bearing on commercial banks, which are now increasingly classifying their treasury holdings as Available-for-Sale (AFS) and not Government of India pacifying Held-to-Maturity (HTM). After all, government securities are the most hedgable commodities in an Indian commercial bank’s arsenal, and a shift of this scale only points towards yield anxiety, capital losses, or intention to make a quick buck on volatility to offset losses elsewhere.

Therefore, the need of the hour is to look beyond the positive headlines and identify possible cracks in the system which may threaten the overall stability when the economy is chugging along swiftly. While the RBI’s default models do give the market a sense of safety as things stand today, experience tells us that banking crises generally follow the domino theory and spread like wildfire. Perhaps the best strategy for the RBI would be to remain cautious and nip any spark in the bud.

Karan Mehrishi is an economist, specialising in monetary economics and fixed income. Views are personal, and do not represent the stand of this publication.