India’s financial system remains stable, but the deteriorating asset quality of banks will pose a challenge in a smooth transition towards new international capital adequacy norms that kick in from April under the Basel III regime, the Reserve Bank of India (RBI) said in its report on financial stability released on Friday.
“Indian banks will face challenges as they migrate to Basel III, given the declining asset quality and regulatory changes necessitating additional provisioning,” the report warned.
This is the central bank’s second financial stability report. The first, released in June, also highlighted the RBI’s concerns over banks’ deteriorating asset quality.
Slowing economic growth and high borrowing costs have made it difficult for many Indian debtors to repay their loans, causing bad loans to pile up and banks to set aside more money to cover the risk of default. In the fiscal first half ended September, gross non-performing advances of all banks rose sharply to 3.6% of total advances, from 2.9% a year ago.
The report is critical of the deteriorating asset quality of Indian banks, particularly those owned by the government.
“Aggressive lending by banks in the past, banks not exercising oversight on diversification into non-core areas by companies, banks not enforcing discipline on companies regarding unhedged forex exposures and delay in disbursements are areas on which banks ought to exercise much better control,” the report said.
The banking regulator is also concerned about the expansion in banks’ restructured advances. Between March 2009 and March 2012, while total gross advances of the banking system grew by less than 20%, their restructured standard advances grew by over 40%, the report said.
“The proportion of restructured standard advances to gross total advances increased from 3.5% in March 2011 to 4.7% in March 2012. This has further increased to 5.9% as at the end of September 2012,” it said. “The reasons for rise in restructuring may be attributed to the effects of global recession coupled with internal factors like domestic slow down, which have played a significant role in the deterioration in asset quality.”
The latest RBI report also examined the impact of the so-called liquidity contagion in the Indian banking system. It found that in case of large bank failures, there could be a significant impact on the availability of liquidity in the system and “could also cause a few other banks to be, in turn, liquidated”. Theoretically, banks which have borrowed from the liquidated bank will need to replace these borrowings through their own liquidity buffers and accessing inter-bank loans. However, this may propagate the liquidity shock in the process of calling in loans and for some banks, “the buffers and short-term inter-bank loans will not be sufficient to replace the funds borrowed from the trigger bank”.
“These banks will, in turn, be liquidated ... and will restart the next round of liquidity contagion. The contagion stops when no further banks are liquidated,” the report said.
The study, however, is academic in nature as there is no indication of such a thing happening in Indian banking system at this point.
“I don’t think anybody is worried about a systemic risk. Also, we are at the bottom of the growth cycle and things could only improve from here, depending on the global situation and investment,” said DK Joshi, chief economist, Crisil Ltd.
According to RBI, the Indian banking system is highly interlinked and had a high distress dependency during the financial crisis period. While the effect was down in 2010, it has shown an increasing trend since the beginning of 2011.
The central bank also reiterated its caution that some banks are significantly dependent on mutual funds for their funding needs and this could lead to a systemic risk in case the mutual fund industry is in stress. However, the banking sector has managed to limit their average borrowings from mutual funds at 20% of their capital funds.