Fragile conditions in key economies and the transition to stricter regulation will continue to weigh on banks globally in 2013. India is also grappling with slowing economic growth and stuttering fiscal reforms to address the widening deficit of the central government. Reduced economic activity, high inflation and steep interest rates are added challenges. Standard and Poor’s Ratings Services, therefore, expects the asset quality of Indian banks to remain under stress through fiscal year 2014.
Moderating credit growth and increasing credit costs should also continue to constrain bank earnings. We expect the system-wide return on assets in India to be less than 1% this year. The need for banks to raise capital in view of the impending Basel III regulations is an additional hurdle.
Given the challenges in the corporate sector, we anticipate that the percentage of non-performing and restructured loans could cross 10% by March 2013 from about 5% in March 2011. We continue to expect about 25%-50% of the restructured loans to slip into the non-performing category over the economic cycle.
The government recently announced policy initiatives that could improve the credit profiles in the corporate sector over the next two to three years or longer. And that, in turn, could pave the way for the asset quality in the banking sector to turn around. But much depends on whether the government’s policies are implemented properly and measures continue to spur growth.
We estimate that the Indian banking industry would have a $3 billion-$4 billion shortfall in capital if it immediately tries to attain an 8% common equity tier-1 ratio to comply with Basel III guidelines. Our simulations suggest that the capital shortfall could even reach $10 billion-$15 billion by 31 March 2018 if we assume the following: the banks’ risk assets grow annually by 18%, their return on assets gradually improves from 2010-2011 levels, and dividend payout ratios are constant for each individual bank. Under our base-case scenario, we assume that the top-tier banks could manage the shortfall without cutting risk assets because they may receive capital directly from the government or they could tap the capital markets.
The government’s capacity to provide sufficient capital in a timely manner is a risk factor, however. Higher capital adequacy would improve the credit profile of the banks, but it could depress their returns on equity. Delays in raising capital could also limit the credit growth of some banks.
Positively, Indian banks have a strong core customer deposit base due to their good franchises, extensive branch networks, and the country’s large and growing domestic savings. These banks are not highly dependent on external borrowings for funds. Of late, deposit growth in India has slowed down as depositors chose to hold cash in an inflationary economy and reallocate some savings to other assets because real interest rates on deposits were negative. These factors will increase the challenges for Indian banks, but the risk level appears low in a global context.
Overall, we believe deteriorating asset quality and earnings could continue to constrain credit profiles over the next year. In the longer term, if economic growth increases and corporate performances improve, the growth in business should enable banks to maintain sound financial health. Indian banks could also benefit from the Reserve Bank of India’s more conservative capital requirements, which will enable them to have risk-adjusted capital that is in line with their global peers.
Geeta Chugh is director and analytical manager, Financial Institutions Ratings, Emerging Asia, Standard and Poor’s.