Financial Stability Report: Write-offs improved asset quality

The reduction in gross NPA ratio was made possible by a write-off of bad debts rather than recoveries.

The Reserve Bank of India (RBI) tracks systemic risks through its Financial Stability Reports every half year. The report’s panoramic view of the financial landscape details not only how financial intermediaries and markets fared but also how they would fare under adverse conditions. It calculates two indicators — a Banking Stability Indicator (BSI) which is a weighted value of five factors, namely, soundness, profitability, efficiency, asset quality and liquidity, and tracks banking sector risk (the lower the indicator value, the greater the stability) and an overall financial system stress indicator or FSSI (higher value indicating greater stress).

More Stable

In its latest report of June 2023, the BSI continued to improve on the back of higher profitability and asset quality. Interestingly, liquidity contributed the most risk to overall stability which may seem counterintuitive given credit risk and profitability issues. But perhaps this is reflective of the times when even well-capitalised, profitable banks with low non-performing assets (NPAs) have been shaken by liquidity pressures. The other indicator, FSSI, is more comprehensive, covering five financial market segments (equity, foreign exchange, money, government debt and corporate debt) and three intermediary segments (banks, NBFCs and MFs). It considers 39 risk factors spread across nine markets and sectors. The report says that overall stress in the financial system eased in Q4 of 2022-23 though equity markets witnessed some stress in the aftermath of the banking turmoil in a few advanced economies.

The report’s main focus is banks, which are the biggest constituent (over 75 percent of the financial system) and also its largest provider and user of funds. Ordinarily, financial systems are considered stable if banks can pay their debts and pass regulatory capital tests. On this score, there have been no bank failures even when gross non-performing assets (GNPA) ratios were in high double digits in the past. A few banks did get into trouble but those were due to frauds or scams, rather than a failure to meet repayment obligations. Overall, the sector seemed stable — the GNPA ratio had fallen sharply (from 11.5 percent in 2018 to 3.9 percent in 2023), return on assets (RoA) rose from a negative -0.2 percent in 2018 to 1.1 percent in March 2023 and capital to risk-weighted assets ratio (CRAR) reached a record high of 17.1 percent in March 2023. But what needs to be noted is that the reduction in the GNPA ratio was to a large extent made possible by a write-off of bad debts rather than recoveries. Write-offs formed nearly 29 percent of the gross NPAs as of March 2023. Likewise, the improvement in profitability of banks during 2022-23 was helped in no small measure by lower provisioning as much as by higher lending rates.

But the RBI is sanguine about the future. Stress test results done by it revealed that banks were well-capitalised and could absorb macroeconomic shocks over a one-year horizon. Under the baseline scenario, the aggregate CRAR of 46 major banks was projected to slip from 17 percent in March 2023 to 16.1 percent by March 2024. In a medium-stress scenario, this could go down to 14.7 percent and to 13.3 percent under severe stress, which was still above regulatory mandates. The GNPA ratio under the baseline scenario of all SCBs could improve to 3.6 percent while under medium stress and severe stress scenarios, it could rise to 4.1 percent and 5.1 percent, respectively.

Risk Aversion High

While these are very acceptable numbers, a few points need to be noted. First, there has been a high degree of risk aversion by banks in preferring retail loans to corporate loans. It is not unlikely that capex spending and infrastructure projects involving the private sector could come up for bank finance in future. Secondly, recoveries, even post-IBC, have been poor and the improvement in asset quality came about largely through write-offs. Finally, increased provisioning for bad loans, which could come about, both from the new expected loss-based regulations or from increased NPAs, could dent profitability and CRAR ratios in future.

The two non-bank segments, NBFCs and mutual funds (MFs) also made good progress. The credentials of NBFCs remained robust, with CRAR at 27.5 percent and GNPA ratio of 4.3 percent in March 2023. Even under a severe shock scenario, the capital-adequacy ratio of sample NBFCs was expected to fall only to 23.5 percent. But the problem with this sector is its high dependence on funding from banks and MFs that not only lend but also subscribe to their commercial paper (CPs) and bonds.

Though not under RBI’s purview, MFs figure in the RBI report because they are the second largest suppliers of funds (next to banks), investing mostly in NBFCs, corporates and even banks. In fact, their exposure to the financial sector, under both their equity and debt schemes, is significant, which makes them susceptible to financial sector risks. This is why SEBI mandated asset management companies to carry out stress tests of all open-ended debt schemes (except overnight schemes) every month to evaluate the impact of various risk parameters, namely, interest rate risk, credit risk, liquidity risk and redemption risk faced by such schemes on their net asset values. Stress was found to exist in the case of 14 mutual funds, though in terms of schemes, only 24 out of a total of 295 schemes exhibited stress.

Overall, the RBI believes that banks have sufficient capital buffers to withstand moderate to severe adverse macroeconomic circumstances. Network analysis also indicated that contagion risks and solvency were reduced.

SA Raghu is a columnist who writes on economics, banking and finance. Views are personal, and do not represent the stand of this publication.