A big question mark on financial stability

Away from the immediate concerns on growth and currency management in the light of the withdrawal of (old) currency notes of Rs.500 and Rs.1,000 (the so-called specified Bank Notes, or SBNs), recently released report by the Reserve Bank of India points to some deeper concerns, particularly in India’s financial sector.

On the one hand, India’s macroeconomic conditions broadly remain stable and resilient with considerable moderation in CPI inflation. And though the growth impetus has slackened recently, there is a positive undercurrent of growth moving to a higher trajectory. The current account deficit remains modest. A deceleration in worker remittances and software services has posed some concerns. In sum, against the fragile domestic imbalances witnessed in most of the emerging market economies, the outlook on growth and macroeconomic stability for India can be said to be favourable.

However, developments in the financial sector tell a different story. The banking stability indicators as set out in the recently released Financial Stability Report of the RBI depict some serious concern. The report highlights the elevated risks in the banking sector emanating from “continuous deterioration in asset quality, low profitability and liquidity”.  That’s a triple whammy made worse by the upheaval caused by the withdrawal of SBNs, and adds new complexity to a situation that was already spiralling out of control.   

The RBI’s 74-page Financial Stability Report has delved into the soundness and resilience of the banking sectors. The soundness of the banking sector has been analysed and assessed taking in to account the performance in terms of business growth. Resilience is captured through standard models of sensitive analysis by studying varying macroeconomic shocks.

Consider some of the findings of the report.  The asset quality of the banks has deteriorated further with Gross Non Performing Advances ratios (GNPAs) increasing to 9.1 per cent from 7.8 per cent between March and September 2016, pushing the overall stressed advances ratio to 12.3 per cent from 11.5 per cent during the same period.

The credit quality of large borrowers (having aggregate fund based and non-fund based exposures of Rs. 50 million and more) has deteriorated considerably. The system level credit  risk of  the banking sector against macroeconomic stress revealed that the GNPA in the base line scenario may increase to 9.8 per cent by March 2017 and further to 10.1 percent by March 2018.

Furthermore, capital to risk weighted asset ratio(CRAR) for the public sector may continue to be lowest at around above 11 per cent by March 2017 and less than 10 per cent by March 2018, an indication of just how much the public sector banks (PSBs) are undercapitalised.

The macro stress also revealed that the provisioning and capital adequacy for the banks and particularly PSBs need to be further enhanced from the present level of 5.8 per cent for PSBs. While there is a persistence of subdued business growth, at the system level, pubic sector has lagged the private sector.

There has been a contraction of system level profit after tax (PAT) due to higher growth of risk provision but the PSBs recorded losses. The sectoral credit risk as evident from the macro test revealed that iron and steel sector is expected to record the highest GNPAs. The report said banks in general may withstand liquidity shocks with their high quality liquidity assets (HQLA) and SLR investments.

The experience of 2008 financial and economic crisis suggests that deteriorating financial stability is a potential threat to growth and macroeconomic stability. Therefore, post-crisis the world over, the authorities have focussed attention on financial stability through tightening regulatory reforms to address the structural issues associated with financial sector in general and banks in particular.

Indian authorities also contemporaneous with the global developments further strengthened the banking regulatory framework through a series of measures. However, on account of weakening of banking stability indicators and higher levels of impairment, the banking sector is expected to remain risk averse. Furthermore, due to the emphasis of the banking system on the cleaning up of the balance sheets, there is likelihood that the capital position of the banks could be inadequate to support higher credit growth.  This development could work as a cog in the wheel for effective transmission of monetary policy to the real sector via interest rate and credit channel.

The findings of the Financial Stability Report when perused in conjunction with the Report on Trend and Progress of Banking released by the RBI divulge serious concerns for the banking sector in terms of indicators of profitability based on Return on Assets (RoA) and Return on Equity (RoE), particularly for PSBs with RoA of minus 0.20 per cent and RoE of minus 3.47 per cent during 2015-16. Another important aspect is the slow recovery of NPAs.

The latest data released by the RBI on the outstanding credit of the banking system for September 2016 revealed that there has been a reduction in the bank credit to industry and credit to agriculture increased marginally. The weighted average lending rate (WALR) declined marginally to 11.26 per cent.

The banking system witnessed a unprecedented stress and reputational risk post demonetisation, from November 08, 2016 till now. Thus, the business growth of the banking sector would have shown a significant slackening since September 2016 though data for this will follow with a lag..

One is not sure whether the stress test of the financial stability report captures any scenario like demonetisation on the banking business model, profitability and liquidity. Anecdotal evidence suggest that the banking business has come to a standstill in terms of credit growth.  The   management of excess liquidity due to the receipt of SBNs remains a severe challenge.

While writing the foreword for the financial stability report, the RBI Governor has mentioned that withdrawal of SBNs will impart far reaching changes going forward. He mentioned that this is expected to transform the domestic economy in due course in terms of greater intermediation, efficiency gains, accountability and transparency through increasing adoption of digital modes of payments. 

This view from the inside stands in sharp contrast to the views of the highly respected former governor, Dr. Y V Reddy, who has mentioned that he would not have accepted the recommendation of the government on demonetisation because of institutional and reputational risks.

What all this points to is a big question mark on the financial stability of the Indian economy.

(Dr. R K Pattnaik is Professor, SPJIMR.  Jagdish Rattanani is Editor, SPJIMR. Views are personal)