Mumbai: The Reserve Bank of India (RBI) has warned that risks to the banking industry’s stability have worsened, with asset quality and profitability deteriorating further.

The latest edition of the regulator’s Financial Stability Report (FSR), released on Friday, said a severe credit shock is likely to impact capital adequacy and profitability of a significant number of banks.

The report forecast that the banking system’s gross bad loan ratio will rise to 10.2% of the total loan book a year later if economic conditions stay the same. Bad loans made up 9.6% of total assets as of March 2017.

In scenarios of severe stress, the ratio may jump to as high as 11.2% by March 2018, the report said. For public sector banks, the gross bad loan ratio could touch as high as 14.2% by March 2018.

Similarly, the capital adequacy ratio of six banks is likely to fall below 9% in a severe macro stress scenario, dragging the system-level ratio down to 11.2% by March 2018 from 13.3% as of March 2017. The report did not name the six banks.

Capital adequacy ratio is an indicator of a bank’s financial strength, expressed as the ratio of capital to risk-weighted assets.

The FSR is a twice-a-year report prepared by a department of the 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.

The June report showed that shocks to the infrastructure segment will considerably impact the profitability of banks. A severe shock scenario wherein 15% of restructured standard advances and 10% of standard advances become non-performing assets and move to the loss category could completely wipe out the recorded profits of financial year 2017.

“Weak investment demand, partly emanating from the twin balance sheet problem (a leveraged corporate sector alongside a stressed banking sector) is a major challenge," RBI deputy governor N.S. Vishwanathan wrote in the foreword to the report, noting the urgent need to restore the health of the banking system.

“However, nothing can replace credit discipline and appreciation of the sanctity of commercial contracts in order to ensure a robust financial system," Vishwanathan said.

In 2018, banks will transition to the new accounting standards Ind AS. This is likely to be challenging for banks as provisioning requirement rises under the new standards.

The banking industry is weighed down by around Rs10 trillion of stressed loans, the legacy of an economic slowdown coupled with delays in the completion of land acquisition and securing statutory approvals, which squeezed corporate cash flows and made it difficult for borrowers to pay back loans.

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