India’s central bank, the Reserve Bank of India (RBI) acknowledges that the Covid-19 pandemic has changed the world with a devastating impact on human and economic conditions. In its recently released Financial Stability Report (FSR) of December 2020, RBI highlighted that governments, central banks, and other public agencies across countries have responded in an unprecedented manner to mitigate its impact.

For itself, RBI noted that in the initial phase of the Covid-19 pandemic, policy actions were geared towards restoring normal functioning and mitigating stress; the focus is now being oriented towards supporting the recovery and preserving the solvency of businesses and households.

According to RBI Governor, Shaktikanta Das, a multi-speed recovery is struggling to gain traction, infusing hope, reinforced by positive news on vaccine development. “Nonetheless, a second wave of infections and new mutations of the virus have spread heightened uncertainty, threatening to stall the fragile recovery,” the RBI report quoted Das as saying.

But, beyond the pangs of Covid-19, the bigger worry for the banking system is the ballooning of the non–performing assets in the system. Das, to begin with, does affirm that India’s banking system faced the pandemic with relatively sound capital and liquidity buffers built assiduously in the aftermath of the global financial crisis and buttressed by regulatory and prudential measures.

However, the RBI governor warns that the nature of the pandemic is such that one cannot take anything for granted. “Notwithstanding these efforts, the pandemic threatens to result in balance sheet impairments and capital shortfalls, especially as regulatory reliefs are rolled back,” he said. He further added that banks will be called to meet the funding requirements of the economy as it traces a revival from the pandemic. “Consequently, maintaining the health of the banking sector remains a policy priority and preservation of the stability of the financial system is an overarching goal.”

The latest FSR, which is published biannually, was rescheduled by the central bank in order to incorporate the first advance estimates of national income for FY21, that were released by the National Statistical Office (NSO) on January 7. And, the latest FSR does have some worrying projections from the RBI.

Macro stress tests, along with NSO’s first advance estimates of gross domestic product (GDP) for FY21, together indicate that, under the baseline scenario, the gross non–performing asset (GNPA) ratio of all scheduled commercial banks (SCBs) may increase from 7.5% in September 2020 to 13.5% by September 2021. The ratio may escalate to 14.8% under a severe stress scenario. “These projections are indicative of the possible economic impairment latent in banks’ portfolios,” the report noted.

Among the bank groups, GNPA ratio of public sector banks (PSBs) at 9.7% in September 2020 may increase to 16.2% by September 2021 under the baseline scenario; the GNPA ratio of private sector banks (PVBs) and foreign banks (FBs) may increase from 4.6% and 2.5% to 7.9% and 5.4%, respectively, over the same period. In the severe stress scenario, the GNPA ratios of PSBs, PVBs, and FBs may rise to 17.6%, 8.8% and 6.5%, respectively, by September 2021.

RBI's caveat

It is understood that reality may be very different from projections, and on its part, RBI highlighted that these GNPA projections are indicative of the possible economic impairment latent in banks’ portfolios, with implications for capital planning. “A caveat is in order, though: considering the uncertainty regarding the unfolding economic outlook, and the extent to which regulatory dispensation under restructuring is utilised, the projected ratios are susceptible to change in a nonlinear fashion,” RBI's report cautioned.

Similarly, market observers too advise against reading too much into the numbers. According to Siddhartha Sanyal, chief economist and head of research at Bandhan Bank, while the RBI has strongly cautioned about the likely surge in NPAs in the coming months, it may not be a surprise given the current economic scenario. “Meanwhile, the signs of tapering in fresh Covid-19 infections, and positive developments on the development of vaccines can help faster normalisation of economic activities,” says Sanyal.

However, Sohail Halai and Prabal Gandhi, research analysts at Mumbai–based Antique Stock Broking, have a different view. “RBI's asset quality outlook stays grimmer than expected and has shown longer deterioration of gross non–performing loans cycle despite improvement in economic activities,” the duo noted in their January 12 research note. For the record, in the July 2020 edition of the FSR, RBI had projected SCBs’ GNPA ratio at 12.5% for March 2020.

On similar lines, a team of analysts at JM Financial Institutional Securities, led by Sameer Bhise, argues that the RBI has not considered the quantum of restructuring when arriving at the above figures. “Thus, effectively, if a sizeable proportion of potentially troubled assets adopt restructuring, projected GNPAs are susceptible to change in a nonlinear fashion,” Bhise and his team note.

Bhise and his team also highlight that the GNPA and net NPA (NNPA) ratio of 7.5% and 2.1%, as of September 2020, appear to be optically low as they are aided by the Supreme Court order on asset classification standstill. However, sectorally, GNPAs improved noticeably for industry, agriculture, and services to 12.4%, 9.6%, and 6.95%, respectively, as of September 2020, from 14.1%, 10.1%, and 7.2% as of March 2020, while for retail advances, the GNPA improved marginally to 1.7% as of September 2020, as compared to 2% as of March 2020. “A broad based decline in GNPA was visible across all major sub-sectors within industry,” the JM Financial team noted.

Separately, RBI’s stress tests also indicates that SCBs have sufficient capital at the aggregate level even in the severe stress scenario but, at the individual bank level, several banks may fall below the regulatory minimum if stress aggravates to the severe scenario. “The need of the hour is for banks to assess their respective stress situations and follow it up with measures to raise capital proactively,” RBI noted. “Banks that maintain high CRAR should be on a distinctly better footing,” Bandhan Bank’s Sanyal points out.

The good news is that the capital to risk-weighted assets ratio (CRAR) of SCBs improved to 15.8% in September 2020 from 14.7% in March 2020, while their GNPA ratio declined to 7.5% from 8.4%, and the provision coverage ratio (PCR) improved to 72.4% from 66.2% over this period. Taking credit for the good show, RBI said that these improvements were aided significantly by regulatory dispensations extended in response to the Covid-19 pandemic.

Ground realities

Beyond the capital, provisioning, and bad loans of the banking system, RBI has touched upon some of the ground realities that the economy is witnessing lately. For one, RBI highlights that as a result of rising public commitments for mitigating the impact of the pandemic, fiscal authorities have started to witness revenue shortfalls. “The resultant expansion in the market borrowing programme of the government has imposed additional pressures on banks,” Shaktikanta Das pointed out in the RBI report.

Governor Das, praising RBI's proactive role, added that the borrowing programme has been managed smoothly so far, with the lowest borrowing costs in 16 years, along with the elongation of maturity. Further, Das went on to mention that the corporate sector has also raised substantial funds from financial markets amidst easy financing conditions, which have been mainly used for deleveraging and building up precautionary buffers.

Also, Das expressed hope that as growth impulses take root, the private sector capex cycle should revive as existing capacities get utilised and new capacities are added. “This will require the financial system to intermediate expanded growth requirements of Indian business,” he added.

RBI's FSR also highlighted that the growing disconnect between certain segments of financial markets and real sector activity—which the previous FSR had pointed out—has become further accentuated with abundant liquidity spurring a reach for returns. Within the financial market spectrum too, the divergence in expectations in the equity market, and in the debt market, has grown, both globally and in India. “Stretched valuations of financial assets pose risks to financial stability,” Das warned. “Banks and financial intermediaries need to be cognisant of these risks and spill overs in an interconnected financial system.”

Das admitted that we have been scarred by the pandemic, and the task ahead is to restore economic growth and livelihood. “Financial stability is a precondition for supporting this mission,” he pointed out.

At the systemic level, RBI's report reached out to banks, arguing that it wants the latter to prepare for any adversity by augmenting their capital bases, in order to support their own business plans and the broader economic recovery process in the post-Covid period. After all, the pandemic has altered behaviour and business models fundamentally.

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