The Reserve Bank of India's latest financial stability report (FSR) released on Tuesday painted a gloomy picture, saying India's banking sector remains stressed and the gross non-performing advances (GNPA) ratio is expected to rise further by the end of this financial year.

The quarterly report, an overall assessment of the stability of India’s financial system and its resilience to global and domestic risks, also noted that profitability of scheduled commercial banks (SCBs) declined but macro-stress tests indicate that their GNPA ratio may rise from 11.6% in March 2018 to 12.2% by March 2019. The system level capital to risk-weighted assets ratio (CRAR) may come down from 13.5% to 12.8% during the period. CRAR is the measure of a bank’s capital adequacy in terms of the riskiness of the assets (or loans) on its books.

On public sector banks (PSBs) under prompt corrective action framework (PCA PSBs), the RBI’s macro-stress tests suggest a worsening of their GNPA ratio from 21.0% in March 2018 to 22.3% by March 2019, with six PCA PSBs likely experiencing capital shortfall. “However, the capital augmentation plan announced by the government will go a long way in addressing potential capital shortfall, as also play a catalytic role in credit growth at healthier banks,” the RBI noted in its 17th FSR.

The RBI also flagged concerns about the profitability of weak banks worsening since September 2016 and said more efforts will be needed to improve their resilience.

The central bank  also said that the PCA framework  will help in improving the banking sector's health by addressing the vulnerabilities of weaker banks. “The PCA framework could help to mitigate financial stability risks by arresting the deterioration in the banking sector, so that further capital erosion is restricted and banks are strengthened to resume their normal operations. Furthermore, if undertaken promptly and well, governance reforms would not only improve the financial performance of banking sector but also help reduce operational risks,” the RBI added.

One of the FSR's worrying conclusions from the RBI’s sensitivity analysis is that a severe shock to the GNPA ratio could bring down the CRAR of as many as 20 banks, mostly public sector banks (PSBs), below 9%. At the same time, there is some  relief that the share of large borrowers in the SCBs’ total loan portfolios as well as their share in GNPAs declined marginally between September 2017 and March 2018. “In March 2018, large borrowers accounted for 54.8% of gross advances and 85.6% of GNPAs,” the RBI highlighted. “Top 100 large borrowers accounted for 15.2% of gross advances and 26% of GNPAs of SCBs.”

The RBI is cognizant of the fact that weak profitability of SCBs is a concern as low profits can prevent banks from building a cushion against unexpected losses and make them vulnerable to adverse shocks. The median return on assets (RoA) of SCBs came down further in March 2018, and there were several structural issues resulting in low profitability of SCBs, which included high loan loss provisions, debt overhang, increasing costs, and declining revenues.

The RBI also flagged concerns about the profitability of weak banks (14 banks with RoAs in the bottom quartile) worsening since September 2016 and said more efforts will be needed to improve their resilience. “Though such weak banks had higher pre-provisions operating profits (EBPT), the higher risk provisioning against NPAs on their balance sheets resulted in their low profitability,” the RBI said.

Under the RBI’s assumed baselines scenario, six PCA PSBs may have the minimum regulatory level CRAR of 9% by March 2019 without taking into account any further planned recapitalisation by the government. However, if macroeconomic conditions deteriorate, 10 banks may record CRAR below 9% under a severe macro-stress scenario. Under such a severe stress scenario, the system level CRAR may decline from 13.5% to 11.5% by March 2019, while under the baseline scenario, CRAR of SCBs may decline to 12.8%. Under such a severe stress scenario, six banks may have common equity Tier 1 (CET 1) capital to risk-weighted assets ratio below the minimum regulatory required level of 5.5% by March 2019. The system level CET 1 capital ratio may decline from 10.4% in March 2018 to 8.6% by March 2019 under the severe stress scenario. “The capital augmentation plan announced by the government will go a long way in addressing potential capital shortfall as also play a catalytic role in credit growth,” the RBI said.

Observers seem less worried now. A Kotak Institutional Equities’ report says the RBI’s FSR broadly reiterates their view that stress levels in the banking sector appear to be showing stable signs with no further deterioration in the underlying numbers. “We see FY19 as a very promising year on the resolution of bad loans,” says the report jointly authored by M.B. Mahesh, Nischint Chawathe, and Dipanjan Ghosh. With a bulk of the bad loans coming from the large corporate segment, most of these loans are now seeing a resolution through the insolvency code. “Our study suggests that significant progress has been achieved on the first list of RBI cases referred to IBC which we expect should see better progress from 2QFY18 as several cases are pending for clarification of the code at various courts,” the trio adds.

Clearly, one needs to join the RBI to hope that all will be well with the Indian banking sector.

Follow us on Facebook, Twitter & YouTube to never miss an update from Fortune India. To buy a copy, visit Amazon.