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In its Financial Stability Report 2011, the Reserve Bank of India (RBI) concludes, rather bravely, that there are no major issues of stability and stress within the financial sector in general and the banking sector in particular.

This is being said at a time when the banking sector seems set to slide, taking the ongoing industrial slowdown into its second stage and converting it into a macroeconomic crisis that will pervade the real and the financial side. Already, the currency and equity markets have been affected.

Despite domestic macroeconomic stress, adverse global situation and cost shocks caused by policy changes the top line has been doing rather well; loan growth is still quite high and net interest margins have been maintained.

But behind these robust numbers lie some very disturbing trends. Even as the earning has been good, the quality of earning has deteriorated considerably. So far there has been anecdotal evidence that a slow stress is brewing in banking. RBI now confirms and quantifies the contours of the crisis. Some of the trends are pretty startling: a near 100% growth in non-performing assets (NPAs) excluding recoveries; and a threefold increase in the growth of gross impaired assets.

So far, asset quality has been seen more as a bank-specific issue rather than a banking-sector problem. Now, even as a high loan concentration is posing a problem for some individual banks, sectorial overleverages are threatening the banking sector as a whole.

From a macro perspective, overleveraged sectors rather than overleveraged companies are the problem: 85% of the total NPAs of the banking sector are in real estate, infrastructure and priority sector lending. This is the root cause of the incipient banking crisis.

Add to these numbers the impending power sector impairment—with losses of distribution companies mounting, state electricity boards’ payment defaults creeping in, and coal production seeing no improvement, this sector is in the throes of a crisis—the banking sector is staring down the barrel.

To put matters in perspective, the balance sheets of all banks in 2011 are weaker than they were in 2008. The banking sector as a whole today is less liquid, less profitable, less stable, less sound and with poorer asset quality as compared with 2008 and the recent past. In fact, adjusted for restructuring, the ratio of NPAs to aggregate lending is now nearly 6% compared with 3.5% during the 2008 meltdown.

This systemic deterioration across the board will accentuate and exacerbate the need for capital. As capital adequacy of banks declines, capital requirements will be higher, in addition to the need for regulatory compliance. This will impair lending growth causing a further weakening of an already anaemic macroeconomic growth.

To add, a fiscal deficit of more than 5.5% will send the bond markets into a tizzy and most banks are bound to get hit by the mark to market losses on bond portfolios, like some major banks did in the first quarter of the year. With some of the biggest banks having portfolio duration of nearly four years, the sensitivity to yield changes is considerable, making the earnings very volatile.

RBI has contributed its bit to the deterioration of the banking sector by relaxing the provisioning norms in September 2010. It was a regressive move, the consequences of which are becoming clear now.

Emboldened by this relaxation and the low level of 2% of provisions required on restructuring, banks seems to be postponing NPAs to the future by restructuring these loans.

In a macroeconomic situation of a slowdown, the likelihood of these loans turning around is bleaker than before. So banks are sitting on NPAs without providing for them adequately. Ever since RBI relaxed the provisioning norms, banks, especially the public sector ones, have reduced their coverage ratios. The game now is to show profits at the expense of provisioning: a sure recipe for disaster. It is this that might underlie the growing disconnect between accounting profits and economic profits.

As far as investors are concerned, institutional investors, especially foreign institutional investors (FIIs), compare the Indian banking space with banks around the globe. Most of these banks, be they Japanese or Korean or even European, maintain a coverage ratio of near about 100%. From that perspective, it will have an adverse impact on the FII flows into the Indian banking sector.

It is interesting to note that the capital adequacy of Indian banks is the lowest in the world, except that of banks in Greece, Spain, Italy and France.

Haseeb A. Drabu is an economist, and writes on monetary and macroeconomic matters from the perspective of policy and practice. Comments are welcome at haseeb@livemint.com

Also Read | Haseeb A. Drabu’s previous columns

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