India's banks are well positioned to handle even adverse stress scenarios and are expected to improve asset quality on the back of robust earnings.
A Reserve Bank of India (RBI) stress test exercise showed that commercial lenders have sufficient buffers in place and that their capital ratios will remain above the regulatory minimum even under adverse stress scenarios, according to a recent report.
Under the central bank's baseline scenario, the average gross nonperforming asset (NPA) ratio of Indian banks may improve to 3.1% by September 2024, from 3.2% currently, the RBI wrote in its biannual Financial Stability Report, released Dec 28. In the case of a medium stress scenario, gross NPAs could increase to 3.6% and climb to 4.4% under a severe stress scenario.
Thanks to improved provisioning, the net NPA ratio of Indian banks has fallen to a "multi-decadal low" of 0.8%, according to the report.
India remains one of the fastest growing major economies in the world on the back of robust domestic consumption, high public capital expenditure, a recent upturn in private investment and strong exports of services. India's gross domestic product expanded 7.7% year over year in the first half of the fiscal year, which ends March 31, and closed the calendar year with a 7.0% growth, according to the RBI.
Healthy balance sheets
Banks' healthy balance sheets, coupled with robust credit demand, have facilitated broad-based expansion in lending. Credit growth continues to outpace deposit growth in India, while high interest margins and lower impairments have boosted the banking system's net interest income (NII). The profit after tax of lenders rose 43% year over year in September 2023, the report said.
"Further gains in earnings could, however, be moderated by [a] rising cost of funds for banks," the RBI said, adding that the average cost of funds of scheduled commercial banks rose to 5.2% in the fiscal second quarter of the fiscal year, which ends March 31, from 4.4% in the final quarter of the previous fiscal year.
The capital to risk-weighted asset ratio — an indicator of how a bank can meet its obligations — is expected to fall to 14.8% by September, from 16.6% in September 2023, in case of the central bank's baseline scenario. However, none of the lenders will breach the minimum capital requirement of 9% in the next one year, the RBI said.
Average CET1 ratio will also likely decline to 12.2% by September, from 13.6% in the same month a year earlier. All banks would be able to meet the minimum regulatory CET1 ratio of 5.5%, the report said.
NBFCs less sanguine
While the stress tests indicate banks would be able to meet capital requirements even under a severe stress scenario, the nonbanking financial companies (NBFCs) face greater risk than they did in March 2023, according to the report.
"The presence of weak tail of banks and growing interlinkages between banks and NBFCs, however, necessitate both nimble and proactive regulatory and supervisory monitoring and actions that prevent build-up of systemic risk and shore up capital buffers of weak banks to improve their resilience," the central bank said.
The report warned that growing bank-NBFC interlinkages could be a source of systemic risk as vulnerabilities in the NBFC sector could amplify financial system stress and spillovers to the banking system.
Bank lending to NBFCs rose sharply by 70.7% during September 2020 to September 2023, against a 50.2% growth in aggregate bank credit. An analysis of the bilateral exposures show that most of the NBFCs have a net borrowing position with banks. The top three and top five NBFCs have the potential to cause maximum solvency losses to the banking system, the report said.
