Why Moody’s downgraded outlook of Indian banks?

Moody’s has identified 5 key factors that could pressure banks in coming months.

April 07, 2020 10:27 IST | India Infoline News Service
It almost looked like the stock markets had a premonition of the downgrade of Indian banking sector by Moody’s. On a year-to-date basis, Bank Nifty is down (-46.27%), much worse than the Nifty-20. The fall in the Bank index has been specifically sharp in the last 45 days, as depicted in the graphic below.

Data Source: NSE

The market premonition turned out right as Moody’s downgraded the outlook for Indian banks from “Stable” to “Negative”. One of the main reasons cited by Moody’s for their outlook downgrade was that the economic disruption caused by the COVID-19 lockdown could impact yields and asset quality of banks. Moody’s has identified 5 key factors that could pressure banks in coming months.

Macro environment for banks to remain tepid
Bank credit has a high degree of sensitivity to GDP growth. That is where Moody’s really foresees the pain point. Q4 GDP for March 2020 is expected to be either negative or flat. There is a similar expectation for the June quarter too. Fitch has downgraded India’s GDP growth estimates for FY21 to just 2%. If that were to materialize, it would be the worst rate of growth in 30 years. The major business disruption caused by lockdowns is likely to hit banking services the most even as an uncertain macro environment is likely to reduce consumer credit appetite. Major capital spending decisions are likely to be postponed.

Asset quality expected to deteriorate
Data: Source: Moody’s Investor Service

A clear risk that Moody’s sees due to the macro slowdown is the relapse of asset impairment. Between FY-18 and FY-19, NPAs sent down from 11.7% to 9% due to a better recoveries and the efforts of NCLT. The concern is that these worsening macros could rekindle the problem of bad assets. Moody’s sees pressure on two specific fronts’ viz. SME loans and consumer loans. The shutdown could result in rising joblessness and lower incomes. These could trigger a spate of defaults on consumer loans and SME loans. Even the 3-month moratorium, Moody’s feels, could create a problem of cash flow clustering.

Capital buffer of banks could take a hit
The recent case of Yes Bank has proved that the chain can be quite lethal. Weakening macros leads to deterioration in asset quality which, in turn, depletes capital as losses have to be written off. Moody’s believes while the larger private banks may be relatively safer, the second level private banks and some PSU banks could feel the heat as capital adequacy gravitates closer to minimum statutory levels. This calls for urgent shoring up of capital and without capital infusion, the ability of the bank to expand its asset book would be impacted. For banks, this could be Catch-22; damned if you do and damned if you don’t.

Efficiency and profitability could take a back seat
The combination of asset stress and a lowered capital buffer will mean that profits could come under pressure. That is the revenue part of it. There will also be pressure on the cost side; especially cost of credit. Today, most private banks are able to get funds at reasonable cost. However, that could quickly change if the government borrowing program pushes yields higher. Most analysts are already predicting the fiscal deficit to worsen to beyond 6% by end of fiscal 2021. That would mean constant pressure on yields and crowding out of private borrowings. Then we come to the efficiency perspective. With revenues unable to keep up with assets, many banks may be actually forced to downsize their balance sheet. That could raise question marks over the short to medium term growth traction that is currently visible.

Limited budgetary support from the government
Between 2015 and 2019, the government managed to recapitalize stressed PSU banks to the tune of Rs350,000cr. In the 2020 budget, the Finance Minister has made it clear that banks will have to raise their own capital from the markets. With markets in the midst of such turmoil, fund raising in the market looks doubtful. The government fiscal deficit has spiralled to 3.8% this year and experts are already talking about 6.2% fiscal deficit next year. That would leave very little room for the government to provide any kind of capital support to PSU banks. In the Yes Bank case, the government was able to seek SBI support to bail out Yes Bank. But with a tight budget, the ability of the government to intervene even in case of systemic risk appears to be limited.

In a nutshell, the above relationship tome explains why Moody’s has painted a grim picture of Indian banks. The onus is now on the government to design appropriate monetary and fiscal measures to help banks in these trying times. Policy response could be critical.

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