Risks to banking sector's stability up sharply : RBI report

Six months after it flagged concerns over weak corporate balance sheets and conducted its first asset quality review (AQR) of banks, the Reserve Bank of India (RBI) has warned that risks to the banking industry’s stability have increased sharply, indicating more pain ahead.
The latest edition of the regulator’s financial stability report (FSR), released on Tuesday, said gross non-performing assets (GNPAs) of banks jumped to 7.6% in March from 5.1% in September. The top 100 borrowers accounted for nearly a fifth of these NPAs. Total stressed assets increased slightly to about 11.5% of banks’ combined loan book.
“The banking stability indicator shows that risks to the banking sector have sharply increased since the publication of the previous FSR,” said RBI.
The FSR is a twice-a-year report prepared by a department of RBI and endorsed by a sub-committee of the Financial Stability and Development Council.
The report details the results of stress tests on bank balance sheets and the backdrop against which the central bank conducted those stress tests.
This edition of the FSR also captures the impact of RBI’s AQR, which forced banks to label a large stock of stressed loans as bad and set aside money to cover the risk of default.
The clean-up process resulted in the bad loan stock of banks rising to a record Rs.5.8 trillion as of 31 March from Rs.3.4 trillion as of September 2015. Given the provisions that are required to be set aside for this stock of toxic assets, 12 lenders out of 39 listed banks reported an annual loss and profits of the rest declined sharply in the year ended 31 March 2016.
The FSR highlights that a bulk of the incremental pain has come from large borrowers.
The top 100 borrowers of banks accounted for 19.3% of the system’s bad loan stock, a massive jump from just 2.9% in September 2015. Restructured standard advances fell to 3.9% from 6.2%, indicating the impact of the AQR.
“The overall stressed assets of the banking sector form 11.5% of the total advances as of 31 March, a marginal increase from 11.3% as of 30 September 2015. The spike in gross non-performing assets as a percentage of loans to 7.6% as of 31 March from 5.1% six months before was mainly due to reclassification of loans following the RBI’s asset quality review,” the report said.
RBI warned that the pain may not be over and that stress tests indicate further risk to banks’ balance sheets.
The report shows that as a baseline case, the GNPA ratio would climb to 8.6% of total advances by September from 7.6% in March. The GNPA ratio is expected to stabilize at 8.5% by March 2017, the FSR said. This could jump to 9.5% under severe stress scenario, it added.
Capital levels of lenders also remain under stress.
Public sector lenders may see their capital adequacy ratio drop to 10.3% by March 2017, down from 11.6% in March this year. The capital adequacy of the banking system as a whole may slip to 12.1% by September under the baseline case and to as low as 11.7% under extreme stress, the report said.
The stress tests on individual banks showed that 20 banks with 38.4% of total assets may fail to meet the minimum regulatory requirement of capital adequacy under extreme stress.
Capital adequacy is an indicator of a bank’s financial strength, expressed as a ratio of capital to risk-weighted assets.
The numbers reflect the grim reality of banks’ weak capital, said Saswata Guha, director for financial institutions at Fitch Ratings.
“Internal resources for capital are not going to happen. We are not expecting stressed asset ratio to rise further. But we are still some distance away from asset quality to peak in a holistic sense. If some of the stress persists, banks will feel the pressure on capital,” Guha said.
RBI assumed a gross domestic product (GDP) growth rate of 7.6%, a fiscal deficit of 3.5% of GDP and retail inflation of 5.1% as a baseline case. A severe stress scenario would entail GDP growth falling to 2.9%, fiscal deficit at 5.9% of GDP and inflation at 9.1%.
However, interestingly, the corporate sector stability indicator has shown an improvement, the report said.
According to the FSR, a sample of about 2,600 listed non-government, non-financial companies (NGNF) showed that the proportion of leveraged companies in the total sample has fallen to 14% in March from 19% in September last year.
Leveraged companies are those that have a negative net worth and a debt-equity ratio of 2 or more.
Highly leveraged companies, which are those with a debt-equity ratio of 3 and more, formed 12.9% of the total sample, down from 14.2% in September. The share of these companies in total debt, too, came down to 19% from 23%.
“An analysis of the current trends in debt servicing capacity and leverage of weak companies defined as those having interest coverage ratio less than 1 was undertaken using the same sample, indicating some improvement in 2015-16,” said the report.
While the improvement in corporate balance sheets could be a relief, an analysis of unlisted companies using data from the ministry of corporate affairs in the FSR shows that weakness still persists among corporate entities.
In its analysis of 254,321 unlisted NGNF companies, the central bank found that risks due to lower revenue and liquidity pressures still remain.
The analysis also showed that the proportion of weak public limited companies (within the unlisted companies) rose to 24.5% in 2014-15 from 23.8% in fiscal 2014. Data beyond fiscal 2015 was not available for this set of firms.
The analysis also showed that the proportion of weak private limited companies rose to 25.8% from 24.1%.
For the second time, RBI flagged concerns over the impact on banks from their exposure to leveraged weak companies from the unlisted space.
“The credit extended by scheduled commercial banks to all NGNF companies was about 40% of total bank credit as at end March 2015. Therefore, the overall impact on account of assumed default by weak NGNF companies could be about 10.4% of total bank credit,” the report said.
In his foreword to the FSR, governor Raghuram Rajan reiterated the need to fix the banking sector’s issues as part of a larger goal for India to remain strong amid global turmoil.
“Although India stands out in terms of relatively stronger growth and improved economic fundamentals, we need to stay on the path of sound domestic policies and structural reforms,” he wrote. “We need to deal with legacy issues that hold back growth and bring changes to enhance the efficacy of our business processes and conduct. The stress in the banking sector, which mirrors the stress in the corporate sector, has to be dealt with in order to revive credit growth."