Global rating agency Fitch says the sustained improvement in the financial performance of Indian banks bodes well for the sector’s intrinsic risk profiles. The pace of asset quality and profitability improvement has exceeded the agency’s expectations, while capital buffers are broadly in line with its projections, the foreign ratings agency in a report on Tuesday.

“The sector's impaired-loan ratio declined to 4.5% in the first nine months of the financial year ending March 2023 (9MFY23) from 6% at FY22. This was nearly 60bp below Fitch's FY23 estimate,” it says.

In the recently concluded December quarter of the current fiscal (Q3 FY23), most of the banks, public as well as private, delivered robust results on the back of steady credit growth, higher interest rates, and improvement in asset quality. The Reserve Bank of India has increased the repo rate six times since May, 2022, resulting in a cumulative rate hike by 250 basis points.

As per Fitch report, increased write-offs have been a key factor, but higher loan growth, supported by lower slippages and improved recoveries, have also played a role. The agency expects a further improvement by FYE23, although banks still face the risk of asset-quality pressure associated with the unwinding of loan forbearance in FY24.

“The sector's improving provision cover (9MFY23: 75%, FY22: 71%) also supports banks' ability to withstand risks, although private banks are significantly better placed than state banks due to their lower impaired loan ratio of 2.1%, against state banks’ 5.6%,” the report highlights.

As per Fitch's estimate, sound economic momentum has contributed to a further drop in credit costs to 0.95% at 9MFY23 compared with 1.26% at FY22. Lower credit costs were the primary factor driving an improvement in return on assets to 1.1% in 9MFY23, outpacing Fitch's FY23 estimate of 0.9%, although earnings also benefited from higher-than-expected loan growth and improving net interest margins, it says.

The agency further says that banks have reasonable tolerance to absorb pressure from credit costs and margin normalisation. “Pre-impairment operating profit at private banks, at 4.5% of loans, offers greater headroom than the 3.0% at state banks and supported private banks’ return on assets of 1.9%, which far exceeded state banks’ 0.7%,” it says.

The agency cautioned that sustained high loan growth, accompanied by rising risk density, could pressure capital. The sector's common equity Tier 1 (CET1) ratio rose by around 54bp in 9MFY23 to 13.3%, alongside a 460bp drop in the net impaired loans/equity ratio to 9.6%.

Fitch believes there is further upside in bank performance and that this could persist for longer than it had initially expected, with Covid-19 pandemic-related risks largely in the background and a steady improvement in bank balance sheets over the past three years, in part due to forbearance. Sustained easing of financial-sector risks could support a higher operating environment score, but this will depend on assessment of various factors, such as medium-term growth potential, borrower health and loans under regulatory relief, rather than just near-term bank performance, it adds.

There is also a risk that continued strong loan growth may lead to selective or incremental increases in risk appetite, while net interest margin compression and higher credit costs post wind-down of regulatory forbearance could still weigh on financial profiles, it says.

The agency in its report says that any viability rating upgrades would consider whether financial profile improvements are sustainable and exceed any additional risks taken. 

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