Mumbai: India’s banking system is strong, although the rising volume of bad loans poses a minor concern, said a report by the Reserve Bank of India (RBI) on the health of India’s financial sector, which juxtaposes that largely cheery picture with gloomy ones about the economic environment and the markets.

In its fourth Financial Stability Report published on Thursday, the central bank said India’s banks can handle shocks to the system—even when bad debts rise 150% from current levels. “The banking sector remained resilient even under severe credit risk stress scenarios, though a few individual banks could come under duress," the biannual report said. The central bank identified agriculture, power, real estate and telecom as the sectors responsible for most bad loans.

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Mint’s Anup Roy says RBI’s Financial Stability Report concludes India’s banking sector can withstand some shocks, though bad loans pose a concern

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Still, in a response that perhaps reflects both the extent to which Indian companies are leveraged as well as the extent to which rising bad debts can play havoc with the banking system, respondents of a risk survey carried out by RBI picked poor asset quality (or loans that run the risk of turning bad) as their biggest concern, even ahead of market volatility and global risks.

Bad debts have emerged as the biggest threat to the Indian banking system. With the economy cooling, bad debts are piling up at banks.

Abizer Diwanji, head, financial services at KPMG India, said that though the situation of non-performing assets (NPAs) is manageable, banks could face challenges in the future, especially when it comes to raising money.

“If bad loans continue to pile up, the ability of banks to contribute productive capital to a growing economy will suffer. Also, the credit assessment mechanism of Indian banks to identify and resolve potential risks will be questioned, which will lead to an increase in the cost of capital for banks," Diwanji said.

An 11 November analysis by Mint, based on the results of 36 listed banks showed that gross NPAs, or bad loans as a percentage of loans disbursed, have grown to 1.07 trillion, up 33% from last year. More importantly, the rise in bad loans has been the fastest, quarter-on-quarter, in at least the past five years.

Asset restructuring is on the rise, although defaulting companies continue to have difficulties in servicing the restructured loans. In fact, one of the stress tests conducted by the central bank assessed the impact on banks of 40% of the restructured loans turning bad.

According to RBI, the gross NPA ratio of banks has increased from 2.3% at the end of March to 2.8% at the end of September. The net NPA ratio, or the proportion of bad debts after provisioning, has increased from 0.9% to 1.2% in the same period, while the slippage ratio, or fresh accretion of bad debts, increased from 1.6% to 1.9%.

The latest data from RBI shows the asset base of the Indian banking system at 42.35 trillion. The asset base has shrunk in recent months with companies not borrowing much.

While the changes may seem small, they are significant in percentage terms.

“The growth rate (year-on-year) of NPAs at 30.5% as at end of September has outpaced credit growth of 19.2%. Slippages...too have outpaced credit growth and grew at 92.8%," RBI said, adding that the growth rate of NPAs shows that the growth rate in the first half of 2011-12 at 25.5% is more than triple the average growth rate of 7.4% in the first half of the year between 2006 and 2011.

To be sure, RBI still doesn’t think there is reason to panic.

“Despite the recent spurt in NPAs, the impairment levels in Indian banks compare favourably with the banking sectors in both the major advanced countries as well as peer economies," the report said.

The Indian banking system can withstand these credit risk shocks, but in case of “large shocks a few individual banks could come under duress".

RBI’s stress test found that while the capital base of Indian banks remained above the prescribed level—and can handle “severe stress"—it is eroding steadily.

The capital to risk-weighted assets ratio, or CRAR, fell from 14.2% at the end of March to 13.5% at the end of September, while the core CRAR ratio dropped from 10% to 9.6% during the same period.

“However, both ratios remained well above the regulatory requirement of 9% and 6%, respectively," the report said.

Of the four sectors responsible for most bad loans, real estate and agriculture pose the highest threat, according to the central bank.

Restructured and impaired assets in the power and telecom sectors have increased in recent months. Together, they amounted to 8.5% of total restructured accounts of the banking sector in June as against 5.0% in March.

“The fact that incremental credit to these sectors was also high, higher than the aggregate growth in banking sector credit, called for careful monitoring of asset quality in these segments," RBI warned.

Bankers said an increase in loan growth to the power sector is primarily due to the rising number of projects.

“With the number of projects progressing in the power sector in the last few years, it is quite natural that the loan exposure too shows an increase," S. Raman, chairman and managing director of Bangalore-based Canara Bank, said.

Though there has been a rise in NPAs and the number of companies admitted to corporate debt restructuring, Raman said there are no serious concerns. “Rise in NPAs is the reflection of overall slowdown in both domestic and international markets. Indian banks are strong enough to handle this," Raman said.

RBI does not see the euro crisis plaguing the Indian banking system as much as those in other countries, as local banks have “negligible exposures to the more affected European countries".

The report highlighted the risks faced by many firms on account of their foreign currency convertible bonds, or FCCBs, through which they raised foreign loans at almost zero or very low interest rates before 2008.

FCCBs coming up for redemption may pose a “systemic risk" for the country as firms that issued the bonds do not have the wherewithal to repay.

“Foreign sources of lending are getting reduced as a result of the rise in risk aversion. Further, the Indian rupee has depreciated sharply in recent months, thus raising the cost of redemption," the report warned.

The rupee has depreciated about 17% this calendar year and a falling rupee means buying dollars to pay back the loan—an expensive proposition, especially for firms that have unhedged positions on their liabilities.