India’s financial sector moves from exuberance to resilience

25 Sep 2023 , 07:02 AM

The concerns were not just predicated on the macros, but also on the inherent weakness of the financial sector. Years of aggressive lending (at times bordering on the reckless) had pushed Indian PSU banks to report record NPAs. The good news is that the situation has improved substantially in the last 5 years, especially after the COVID pandemic. This improvement is not just true of the private and PSU banks, but it is also true of the non-banking finance companies (NBFCs), which have emerged as a critical link in last-mile financing in the Indian context.

It is in this context that a recent speech delivered by Michael Debabrata Patra, Deputy Governor, Reserve Bank of India at the 16th SEACEN-BIS High Level Seminar hosted by the National Bank of Cambodia, assumes significance. The gist of his speech was that the Indian financial sector had made a gradual transition from exuberance to resilience. The debate also assumes significance in the light of India moving towards becoming a $5 trillion economy in the next few years. That, obviously, cannot happen without a resilient financial system, especially considering that India is a high savings rate economy, like most of Asia. But, more importantly, there is a shift happening and India is also at the forefront of this shift. The financial sector is shifting from being a bank-dominated system to a more broad-based financial intermediation system which includes non-banks and capital markets too. In fact, the share of banks in financial intermediation today is just 59% with capital markets at 20%, NBFCs at 9% and global sources at 12%. This is how Indian financial sector has reshaped itself in the last few years.

Key takeaways from the financial sector resilience

Here are some key takeaways from the data shared by Debabrata Patra on how the Indian financial sector is gradually transforming into a very resilient system. There is abundant evidence on this shift and, in most cases, the data is quite compelling.

1. A cursory look at the evolution of banking in the last 15 years highlights that the stress has been reducing since 2019 onwards. Between 2010 and 2018, the gross NPAs were on a consistently rising trend. However, a series of efforts by the RBI like the Annual Quarterly Review (AQR) and the Prompt Corrective Action (PCA) have been instrumental in rapidly containing the asset stress.

    

2. Between 2015 and 2023, the Tier 1 capital adequacy has moved up from being marginally above the Basel requirements to being substantially above the requirements of Basel. There has also been a sharp spike in the loss buffers during this period. For instance, between 2015 and 2023, the liquidity coverage ratio has increased from 90% to around 145%. In the same period, the provisioning coverage has moved up from 40% to 74%, leading to a sharp fall in the net NPAs.

    

3. Two critical measures of banking profitability; ROE and ROA have shown a marked turnaround. Between 2018 and 2023, the banks have moved from negative ROA and negative ROE to strong positive numbers. The ROE currently stands at 12% for Indian banks while the ROA is at around 1.1%. This is even higher than the levels seen in early 2015, which shows the pace and intensity of bounce in the last 4 years. The spate of rate hikes in the recent past have resulted in a sharp improvement in the net interest margins (NIM), which has improved for banks from 3.3% to 3.8% in the last 2 years.

    

4. An important method of testing the resilience of banks globally is the macro stress tests. It basically evaluates how the banking numbers get impacted under medium stress and extreme stress. Here again the numbers are quite gratifying. If you look at all scheduled commercial banks, then the baseline gross NPAs for FY24 is estimated at 3.6%. Even under conditions of extreme stress, the gross NPAs are unlikely to exceed 5.1%. Similarly, the capital adequacy ratio is likely to be well above the Basel threshold, even under extreme stress conditions, indicating a lot of in-built resilience in banks.

    

5. One concern in the last few months has been what would be the potential losses that banks would be sitting on their investment portfolios due to the sharp spike in interest rates. In the US, the impact of investment depreciation due to higher rates itself is a $750 billion ticking time bomb. That has led to downgrade of US banks by Moody’s. In the Indian context, the overall potential loss on the HTM portfolio is just about $6 billion for all PSU banks and less than $3 billion for the private banks.

    

6. Let us now turn to the NBFC sector. In 2018, the NBFC sector saw two major bankruptcies viz. IL&FS and Dewan Housing. Both had outstanding loans of nearly Rs1 trillion. However, that has not really dented the performance and resilience of the NBFC sector as a whole. NBFCs have continued to maintain their credit to deposit ratio at 12%, which his at par with the last 8-10 years. 

    

7. How do the NBFCs measure up in terms of their level of gross NPAs and the level of capital adequacy ratio. Let us look at the numbers. Between 2017 and 2023, the gross NPAs of the NBFCs sector has come down from 6.5% to 4.3% and these NBFCs have maintained a clean balance sheet even through the pandemic. At the same time, the net NPA ratio over this period has fallen from 4.1% to 1.3%, showing substantial provisions already being made for the NPAs.

    

8. On the capital adequacy front, the NBFCs have consistently maintained the Capital Risk Adequacy Ratio (CRAR) at well above 20% in the last 5 years, as against the current regulatory stipulation of 15%. In addition, the CRAR of NBFCs have moved up gradually in the last 5 years from 22.5% to 27.5%. This 500 bps improvement in the CRAR offers adequate buffers to the NBFC balance sheets.

    

9. How would the NBFCs fare in a stress test. There are 3 situations that have been considered here viz. the baseline scenario, medium risk scenario and the high risk scenario. In the baseline scenario, the gross NPAs of NBFCs are likely to be at 4.1% while the capital adequacy will be at 24.4%. In this scenario, the percentage of NBFCs running the risk of failing will be just 3%. Let us move to the medium risk scenario. In this scenario, the gross NPAs would go higher to 5.5% while the capital adequacy ratio will fall marginally to 23.8%. In the medium risk scenario, the risk of percentage of NBFCs failing goes up to 5%. Finally, in the extreme case scenario, the gross NPAs could potentially spike to 6.8% while the capital adequacy would come down to 23.5%. The percentage of NBFCs with the potential to fail would still remain at 5% only. 

Between the banks and the NBFCs the banks look better off in an extreme risk stress test. What cannot be denied, as highlighted by Debabrata Patra, is that there has been a perceptible improvement in the profitability and resilience of the banks and NBFCs. That is the good news for the Indian financial sector.