The financial problems of Indian companies are now being reflected in the asset quality of banks that have lent them money.

The disappointing fourth quarter results announced by the State Bank of India in May are perhaps the starkest example of how the financial condition of Indian banks has deteriorated in tandem with the economic cycle. A recent report by India Ratings and Research, an arm of Fitch Ratings, predicts further deterioration—1.26 trillion of bank loans may potentially be in distress over the next 12 to 24 months, it says.

The Reserve Bank of India (RBI) has done well to begin making it tougher for banks to brush their problems under the carpet. The central bank on Thursday tightened the rules for corporate debt recasts, asking banks to set aside more money for restructured loans as well as making promoters of companies personally liable for loan losses. This follows an earlier decision in November to increase provisioning for restructured assets.

Non-performing loans have been climbing. The problem of restructured assets has also been increasing over recent quarters. The total value of restructured loans in bank books under the corporate debt restructuring facility was an estimated 2.29 trillion in March. There are an additional 1.7 trillion of loans that have been restructured on a bilateral basis between individual banks and their troubled borrowers, according to unofficial estimates.

Such restructured loans as well as the usual bad loans now weigh down bank balance sheets.

The recent moves to raise the cost of loan restructurings—or the withdrawal of regulatory forbearance—is an implicit signal from the central bank that problem loans will not disappear in a jiffy. It usually makes sense to give lenders breathing space to put their loan books in order when companies are hit by a temporary downturn. A few quarters of leniency can help companies get back to their loan repayment schedules quickly. But it is now increasingly clear that the Indian economy is in the midst of a long slowdown, so banks will need to be far tougher with problem loans.

The rise in problem loans should not come as a surprise. It is the inevitable aftermath of a credit boom, as is the case in other economies as well. Loan growth in India was around twice of nominal gross domestic product in the years that immediately preceded the 2008 crisis, a sure sign of effervescent lending. Part of this unusual buoyancy in lending can be explained by the decisions taken within banks but the pressure from New Delhi to step up lending in those exuberant years was also a factor. This is the moment of the inevitable hangover.

What now? A quick improvement seems unlikely. First, it seems that India has still not seen the bottom of the credit cycle. Second, the standard metrics on the ability of companies to service their debt (such as interest cover and free cash flow) are also flashing amber. Third, a sharp reduction in interest rates seems unlikely despite the unexpectedly sharp drop in inflation in recent months. Our assessment is that asset quality in Indian banks will continue to deteriorate for at least a few more quarters (though rising bond prices as a result of a fall in long-term yields could provide some buffer to banks that collectively own more than a quarter of their assets in bonds).

The asset quality of banks is closely related to the state of the underlying economy, which is now in the midst of a structural slowdown. The recent regulatory tightening should be examined against this backdrop, as a recognition of the true state of the Indian economy.

Investors too should welcome the stricter measures, because the regulatory forbearance we saw after 2009 was an attempt to postpone the day of reckoning, when a bank has to take a hit from its problem loans.

Indian banks will have to clean up their books before they are ready for the next economic upswing.

Will the financial health of Indian banks deteriorate further before it starts to improve? Tell us at views@livemint.com

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