Why RBI feels banks' asset quality 'may get dented'

The Indian financial system’s asset quality improved despite the pandemic, but it could be due to special dispensations by the regulator, and banks would likely see increased stress on their books once the schemes expire.

According to the annual trend and progress report of the Reserve Bank of India (RBI) released on Tuesday, the data available for this financial year so far indicate that banks’ bad debts have moderated while provision coverage ratios (PCRs), capital buffers as well as profitability indicators have improved relative to pre-pandemic levels.

“A closer look at granular data, however, reveals a more nuanced picture.

"Credit growth is muted, indicative of pandemic scarring on aggregate demand as also risk aversion of banks.

"Banks’ asset quality may get dented, going forward,” the central bank’s report said.

The gross non-performing assets in 2020-21 accounted for 7.3 per cent of total advances, down from 8.2 per cent the previous year.

The provisional supervisory data suggests a further moderation in the ratio to 6.9 per cent by the end of September 2021.

“The improvement was driven by lower slippages, partly due to the asset classification standstill.”

Public sector banks also reported net profits after a gap of five years.

The non-bank financial companies (NBFC) sector, too, “may have to grapple with higher delinquency as and when policy measures unwind,” the report said.

The special mention accounts (SMA) category has swelled in NBFCs as the dispensations come to a close, the RBI noted.

Small Finance Banks (SFBs), meanwhile, have shown structural problems as they suffer from concentration risk on both sides of their balance sheets.

Therefore, SFBs need to diversify their assets as well as their liability profiles.

“The governance culture in these banks needs improvement.

"High attrition levels, especially at top ranks, need to be addressed,” the report said.

The central bank said the pandemic brought about a shift in the adoption of digital technology, cybersecurity, and frauds to all stakeholders including regulators and supervisors are emerging as challenges.

The report also warned of bigtech firms lending “either directly or in partnership with regulated financial entities,” which could be difficult to regulate, and can potentially destabilise the financial ecosystem and hamper the competition.

Payments banks are already facing this competition.

Even as they are into basic banking services for the unbanked, they are “under constant pressure to innovate to maintain competitiveness, especially against BigTech players.”

As a result, their operational costs and investment needs are higher than other segments of the banking sector, affecting their profitability.

The capital to risk-weighted assets ratio (CRAR) of the banking system improved sequentially every quarter from the end of March 2020 to reach 16.6 per cent at the end of September 2021, driven by fresh capital and higher retained earnings.

Banks also maintained their capital conservation buffer at 2.5 per cent.

Importantly, the number of banks breaching the regulatory minimum requirement of CRAR (including capital conservation buffer) (10.875 per cent) declined to one during 2020-21 from three in the previous year.

Private companies have been net savers in the past three years, increasing their deposits with banks, while their credit offtake has remained anaemic.

The household sector’s deposits, at 64 per cent of the total, also picked up pace.

The share of large borrowal accounts, with exposure of Rs 5 crore or more, in total advances declined to 51 per cent at the end of March 2021 from 54.2 per cent a year ago.

Their contribution to total NPAs also declined in tandem from 75.4 per cent to 66.2 per cent during the same period.

However, the special mention accounts-2 (SMA-2) ratio, which signals impending stress, has risen across bank groups since the outbreak of the pandemic.

Frauds in the banking system declined in 2020-21 to Rs 1.38 trillion, from Rs 1.85 trillion a year ago.

Further, between April and September of fiscal 2021-22, banking sector frauds amounted to Rs 36,342 crore, compared with Rs 64,261 crore in the same period a year ago.

“An overwhelming majority of cases reported during 2020-21 in terms of number and amount involved related to advances, while frauds concerning card or internet transactions made up 34.6 per cent of the number of cases.”

Importantly, “there was a marked increase in frauds related to private banks both in terms of number as well as the amount involved.”

In the first half of 2020-21, private banks accounted for more than half of the number of reported fraud cases.

But the share of public sector banks continued to remain higher, “indicating predominance of high value frauds,” the RBI said.

The central bank digital currency (CBDC) should be designed properly before its introduction.

Whether CBDC would be issued directly by the central bank or through commercial banks, needs to be carefully weighed.

“Given its dynamic impact on macroeconomic policy making, it is necessary to adopt basic models initially, and test comprehensively so that they have minimal impact on monetary policy and the banking system,” the central bank said.

For the National Asset Reconstruction Company (NARCL) to succeed, risks to banks’ balance sheets should be clearly identified.

There should be transparent transfer pricing for sale of assets and independence and professionalism of the management of the new entity has to be ensured.

Climate change has also emerged as an “overarching concern” for the regulator.