Risks to the Indian financial system have increased over the past six months, the Reserve Bank of India (RBI) said in its fifth Financial Stability Report released on Friday. It said, however, that stress tests showed a banking crisis was unlikely.
While the financial system “remains robust”, there are threats to financial stability from issues such as the global sovereign debt crisis as well as domestic issues such as the growing fiscal deficit, the widening current account deficit, and structurally high food inflation. Falling global oil prices and the prospects of a good monsoon are positives.
While the call on the monsoon may be a bit premature, the message in RBI’s report is one that has been aired with increasing consistency in recent times: India’s financial institutions look solid, but its macroeconomy doesn’t.
Indeed, RBI governor D. Subbarao said the report “is being released against a backdrop of worrisome global and domestic macroeconomic developments” and added that “despite some negative indicators, particularly on asset quality, the Indian financial sector has remained sound and resilient. Banks continue to be well capitalized with leverage at healthy levels”.
Stress tests that measure the ability of domestic banks to withstand economic shocks show that while asset quality may deteriorate under extreme conditions—including economic growth at 3.5% by March 2013, inflation at 12.2%, and a fiscal deficit of 7.9% of gross domestic product—the capital held by Indian banks will still be above the regulatory minimum. The stress tests essentially suggest that India is not likely to see a domestic banking crisis even if economic conditions deteriorate sharply.
RBI sounded a note of caution on the risks to the financial system because of the rapid growth in algorithmic high-frequency trading. “There have been many instances of extreme volatility and disruptions witnessed in Indian stock markets, resulting from various causes which can be directly or indirectly attributed to the increasing use of algorithmic high-frequency trading,” the central bank said. However, it pointed out that these types of trades accounted for only 17% and 11% of the cash market turnover on the National Stock Exchange (NSE) and BSE, respectively, which is relatively modest compared to developed markets in the US and Europe.
India’s stock market regulator, the Securities and Exchange Board of India (Sebi), too, has raised concerns over such trading. On 20 April, futures contracts of the Nifty, the 50-share index of NSE, crashed about 300 points in a few seconds, after an algorithmic trade without any specified sell price got triggered. NSE later said it was investigating the matter and will submit a report to the markets regulator.
The RBI report said risk that the failure of a large bank could ripple through all parts of the financial system has increased because of greater interconnections between diverse financial intermediaries such as banks, insurance companies and mutual funds. The largest net lenders in the system were the insurance companies and asset management companies, while the banks were the largest borrowers.
“The random failure of a bank which has large borrowings from the insurance and mutual funds segments of the financial system may have significant implications for the entire system,” the report said.
Risks arising from relationships or transactions between banks are also on the rise. The RBI analysis showed that the maximum potential loss to the banking system due to the failure of the “most connected” bank has risen during 2011.
“These trends would need to be carefully monitored, through rigorous microprudential supervision of the ‘more connected’ banks,” the central bank said.
“The concerns raised by the Reserve Bank are important, particularly with regard to the interconnectedness between financial institutions and worsening asset quality,” said Gaurav Kapur, India economist at Royal Bank of Scotland NV (RBS).
“RBI has been cautious in assessing the rising dependency between systemically important financial institutions in India in the aftermath of the 2008 global financial crisis. In times of stress, this can have adverse impacts on the system in the form of severe liquidity pressure,” Kapur said.
However, stress is rising in the banking system owing to bad asset quality as well as the lack of liquidity.
Not only have Indian banks been borrowing an average of close to Rs.1 trillion in the last few days, indicating a lack of domestic liquidity, but overseas liquidity is also constrained as European banks are tightening their pursestrings, making availability of money a problem.
However, the most critical worry right now in the banking system continues to be the deteriorating asset quality.
“An increase in slippage ratios, a rise in the quantum of restructured assets, and a high rate of growth in non-performing assets (NPAs) relative to credit growth implied that the concerns on asset quality of banks remain elevated,” the report noted.
S. Raman, chairman, Canara Bank, said, “The bad debt problem is a nagging issue, but banks do restructuring keeping in view the future cash flow of companies. In that sense, even if bad debts pile up for now, we are hopeful that they will be made good given that Indian companies are largely domestic demand driven.”
The gross NPA ratio for scheduled commercial banks rose to 2.9% end March against 2.4% a year ago. The growth in NPAs continued to outpace credit growth by a wide margin. While NPAs grew 43.9% in the year to March, credit growth was only 16.3%, according to the report.
The divergence in the growth rates has widened recently, which could put further pressure on asset quality in the near term.
The slippage ratio, or fresh bad debt accretion, increased to 2.1% at the end of March from 1.6% in March 2011 and 1.9% in September 2011.
Power, especially state electricity boards, and airlines were stressed sectors posing a threat to banks’ asset quality. Banks’ exposure to the power sector was close to Rs.5 trillion at the end of March, RBI said. Nearly three quarters of the more than Rs.1 trillion of exposure to the airline sector was either impaired or restructured, it said.
“The central bank is clearly concerned with the fact that the quality of assets of Indian banks may not be in good shape,” Madan Sabnavis, chief economist at CARE Ratings. “This, if not checked, could develop into a major concern for the overall stability of the banking system. In a way, RBI is cautioning the banks as it doesn’t expect the economy to do well in the near term.”
Rating agency Crisil Ltd has estimated that restructured loans in the banking system may cross Rs.2 trillion by the end of this fiscal year. Bad debts in the banking system crossed Rs.1 trillion in September. RBI officials have repeatedly warned about the risk of asset quality deterioration.
Bad loan concerns have been stoked by economic uncertainty in the euro zone resulting from the continent’s debt crisis, slumping demand for Indian goods overseas, and companies putting off investments in new projects amid slowing economic growth.
Morgan Stanley said on Wednesday after a meeting with the management of State Bank of India (SBI), the nation’s largest lender, that the bank’s “asset quality pressures will intensify” in the fiscal year ending 31 March 2013, while the “flow of bad loans will be lumpy”.
SBI reported a fall in its bad debt in the quarter ended 31 March. The bank’s gross NPAs had peaked at Rs.40,098 crore at the end of December, but fell in the following three months to Rs.39,676 crore, or 4.4% of assets.
RBI warned against the rapid rise of gold loan companies, saying the exponential growth in their balance sheets coupled with the rapid rise in the price of the metal “could be a cause of concern”, as these firms are highly dependent on the banking system for their resources, which could pose risks to the banks.
Banks are also getting increasingly dependent on high-cost deposits to make good their shortfall in retail deposits.
The deleveraging by European banks is having some impact on the cost of borrowing of Indian firms and banks.
“The problem in Europe is a bad news for the Indian banking system only to the extent that the European banks will not subscribe to bond issuances of Indian banks,” said Raman of Canara Bank. “They are major buyers of our bonds and the shrinkage in their balance sheet spells trouble for our overseas funding requirement.”
The RBI report said any change in India’s external rating could have “cliff effects”, impacting both the availability and the cost of foreign currency borrowing for Indian banks and firms.
The effect will not have any impact on domestic credit availability even as specialized types of financing such as structured long-term finance, project finance and trade finance could be impacted, the central bank said.
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