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Three indicators—independent but not unrelated—now point to the precarious state of the banking industry. Each on its own is a worry for banks but viewed together, they are a big concern for the economy. For the moment, these signals are being muffled by the surprisingly good quarterly results of banks. But left unaddressed, the interplay between them can lead to a severe macroeconomic disturbance.

First, there has been a sharp increase in the asset-liability gap. In 2012, the aggregated asset-liability mismatch for the banking sector increased eight times over the previous year. In the operationally crucial one-to-three years maturity time bucket, the gap, which was 0.5% in 2011, has increased to 4.7%. This is an aggregate number and there will be banks with a much higher incidence of this mismatch.

Significantly, this spike has emerged because of a sharp drop in deposits. Thus, even as the share of assets with one-to-three years maturity remains the same, the drop in deposits of this maturity has caused the asset-liability mismatch to rise rather dramatically.

In the longer maturity buckets such as that between three and five years and more, the gap is high though not rising. In fact, there is a marginal drop in these cases. This is so largely because of long-term bond issues.

The second factor at work is that non-food credit to gross domestic product (GDP) ratio is at a decadal low—almost the same as it was in the mid-70s. This shows that the flow of credit to the commercial sector is significantly lower compared with the long-term trend of the past four decades.

Underlying this growing gap are the structural factors in the relationship between growth and credit. It has been empirically established that from 1950-51 to 1979-80, there was a one-way cause and effect from credit to growth: credit drove growth during the period of government-directed lending. In the following decade—1980-81 to 1990-91—the causality broke down with no clear relationship between credit and growth. Between 1991-92 and 2010-11, there is a clear causality from output to credit. In this phase, it is the output cycles that drive credit cycles, the obverse of what it was earlier.

As such, when policy attention is focused by the government or the Reserve Bank of India on driving up bank credit to the commercial sector, they seem to be operating in the mindset of an earlier era.

This reversal of causality has a policy implication: it reduces the effectiveness of monetary policy as an instrument to drive up credit. Even if growth of credit is ensured through a policy diktat, it will not necessarily increase the rate of growth of output. Also, even an interest rate reduction is unlikely to stimulate credit growth in a phase of slow growth of the economy.

The third factor is the consistent deterioration in asset quality. There has been a sharp increase in non-performing assets (NPAs). Over the last year or so, NPA growth—at around 45% on a year-on-year basis—has consistently outpaced growth in advances. While standard assets grew by 20%, restructured assets increased by twice that rate. This raises the level of impaired assets in the banking system to double-digit levels for the first time ever.

These three pressure points should be seen in the context of impending stricter prudential norms, large scale ownership of banks by the sovereign and the need for capital infusion by a fiscally stretched government. On the whole, it is the picture of an impending crisis; a crisis that can be sparked off by any extraneous global or domestic event.

Given the asset-liability mismatch in the face of uncertain capital refurbishment plans, individual banks may be forced to shrink their asset book. Along with that, asset restructuring, which has been going on, may be taken to higher levels. At this stage, an increased incidence of loan loss provisions will further cut their capital adequacy and individual banks’ capital requirements will become even more binding.

Concurrently, given the uncertainty, the cost of issuing equity to sustain lending will become prohibitively high. As a consequence, faced with the choice between issuing new capital and curtailing lending, banks will opt for the latter.

It is at this stage that asset-liability can cease to be a bank-specific issue and will become a sovereign risk given the government’s ownership of banks and other financial institutions.

In such a fragile situation, the real problem is that a liquidity problem, even if it is in one large financial entity, can quickly become a solvency issue. A localized concern can erode the confidence in the banking sector.

From there on, even an accidental drying up in systemic liquidity can have a knock-on effect on the real economy and rapidly give way to a wider solvency crisis.

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

To read Haseeb A. Drabu’s earlier columns, go to www.livemint.com/methodandmanner

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