Mumbai: The Reserve Bank of India (RBI) cautioned Indian banks about rising non-performing loans, increased capital requirements because of stricter Basel III norms and greater pressure on domestic liquidity as European banks may reduce their exposure to the country if the crisis there persists.

Warning note: RBI deputy governor Anand Sinha says the problem of bad loans has arisen because there was aggressive lending by banks in the pre-crisis boom period coupled with laxity in monitoring and proper due diligence. Photo: Hemant Mishra/Mint.

“The situation is under control, but there is an underlying reality that it is not very comfortable,” he said. “From 15% in 1995, NPAs (non-performing assets) came down till 2008, but they have risen sharply by 91% or Rs 46,670 crore between 2005-06 and 2010-11.”

Slowing economic activity and liberal lending by banks in the boom years have led to bad loans rising.

“As we see it, the NPA problem has arisen because in the pre-crisis boom period there was an aggressive lending stance by the banks that was coupled with laxity in monitoring and proper due diligence. The NPAs have also risen because of the system-generated NPAs,” Sinha added, referring to public sector banks moving from manually entered records of NPAs to an automatic computerized system that identifies a bad loan as soon as a borrower delays payment beyond 90 days.

State Bank of India (SBI), the nation’s largest bank, said on Monday that bad loans rose to a record Rs 40,098.43 crore in the October-December quarter. In percentage terms, these constituted 4.61% of SBI’s total advances, the highest since September 2005.

The RBI deputy governor said gross NPAs are rising despite write-offs. The ratio of actual recoveries to total creation of NPAs was 40.74% in 2008, and is constantly declining. In 2010, the ratio was only 28.74%, he said.

Sinha, however, said that the situation was not alarming.

“Even if 20% of the restructured advances slip into NPAs, such a situation will not be a cause for concern as the Financial Stability Report has shown that even with 40% of restructured advances turning NPAs, the banking system will not collapse,” he said.

Sinha said banks will have to be prepared to set aside more capital under Basel III norms even as the demand for loans increases, as the credit to gross domestic product ratio improves and more loans are disbursed to the capital-intensive manufacturing sector versus most of it going to the services sector currently.

“Though banks are well capitalized and poised for a smooth transition, going ahead it will be difficult because...the capital requirement will be very substantial. Raising of capital will be a huge challenge,” Sinha told the bankers in the audience, which included SBI chairman Pratip Chaudhuri, ICICI Bank Ltd managing director and chief executive officer Chanda Kochhar, HDFC Bank Ltd managing director Aditya Puri, Citibank India CEO Pramit Jhaveri, Bank of Baroda chairman and managing director M.D. Mallya, and HSBC Asia CEO Stuart Davis.

Sinha said it will be more challenging for banks to find equity investors after the stricter capital norms kick in because the return on equity will become depressed. “Hopefully, investors will understand that to lower risk they have to sacrifice some returns,” he said.

The European sovereign debt crisis is likely to create a foreign exchange issue for Indian banks, Sinha said, because European banks may reduce their exposure to emerging markets such as India.

“Problems in foreign exchange borrowing will put pressure on rupee borrowing,” he said, adding that it could increase pressure on the local currency due to capital outflows as was between August and December last year since India is running a current account deficit.

The rupee weakened more than 16% against the dollar between July and December mainly because the euro zone crisis forced investors to withdraw investments from India and invest in safe havens such as US treasuries and dollars. It weakened beyond Rs 54 per dollar for the first time ever in December and at one time was 20% down from its peak.

However, Sinha said that the positive factor in the recent turmoil in foreign exchange rates was that foreign direct investment was not significantly altered.

“The biggest change in the regulatory framework to come now relates to the macro-prudential aspects. How to deal with systemic risks? Euro area will adversely affect us through trade, confidence channels, which will adversely impact our banks here,” Sinha said.

joel.r@livemint.com