After a rough ride in 2020, India’s banking system faces a litmus test this year

Cleaning the mess.
Cleaning the mess.
Image: REUTERS/Danish Siddiqui
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When the spread of Covid-19 was on the verge of hurting the Indian economy in early 2020, the central bank quickly moved to protect the country’s banking system. The Reserve Bank of India (RBI) provided relief to banks as well as borrowers by offering the option of halting loan repayments for six months (March-August). It slashed the repo rate to a record low, and opened up a special credit line for banks to encourage them to lend more. It also allowed lenders to restructure some loans.

All these steps gave much-needed temporary respite to India’s banking system. While the moratorium on loan repayments protected them against the shock of rising bad loans, the availability of cheap credit flushed the banking system with liquidity.

But these moves have merely kicked the can down the road, and the moment of reckoning could arrive in 2021. The RBI, in its latest report (pdf), warned that “as policy support is rolled back, the impact of the Covid-19 pandemic may dent the health of the banks.” With 40% of overall outstanding loans in the financial system under moratorium till August, the central bank said that “data on gross non-performing assets (GNPA) of banks are yet to reflect the stress.”

It basically means that the money that some borrowers were unable to repay, but were protected by the moratorium, would have to be recognized as bad loans.

Further aggravating the bad loans issue is an impending order from India’s supreme court. It asked banks, temporarily, not to declare defaulters as non-performing assets (NPAs). “Asset quality is a significant concern for banks this year,” observes Karan Gupta of India Ratings. “The restructuring of loans and the SC order will have a huge impact on how the bad loans scenario pans out in 2021.”

Indian banks face a surge in bad loans

According to credit ratings agency S&P Global, Indian banks’ NPA to loan book ratio (the amount of bad loans as a percentage of outstanding loans) is expected to shoot up to 10-11% by March 2021 from 7.6% in September 2020. “Forbearance is masking asset problems arising from Covid-19,” says Deepali V Seth Chhabria, a banking analyst at S&P Global. “With loan repayment moratoriums having ended, we expect to see a jump in NPAs.” There would have been more bad loans till now if there hadn’t been a supreme court order or central bank moratorium, she adds.

But even before Covid-19 dented borrowers’ ability to pay, Indian banks were reeling from a spate of corporate defaults over the last five years. To mitigate the effect of rising NPAs, the banks went on a lending spree. “The banking way of handling NPAs is typically by increasing lending. As the book size increases, the older NPAs become smaller in terms of percentage of book value and can be written-off,” explains Dr Vidhu Shekhar, assistant professor of finance at Bhavan’s SP Jain Institute of Management and Research in Mumbai.

Attempting a similar strategy this time around could backfire in the current weak economic environment. Also, the demand for credit is weak because the lockdown severely dented companies’ top lines as well as individual household incomes.

Balancing credit growth and risk

Experts believe that the effects of the Covid-19-led slowdown are still visible and hence, lenders need to be cautious of expanding their loan books too quickly in the current economic environment.

The challenge facing banks is not merely to stop the surge of NPAs, but also to be cautious while doling out loans in 2021. “One must remember that Covid-19 still remains an uncertain threat so the key challenge for banks would be to grow prudently. How banks handle Covid-19 will be key to addressing the issue of bad loans,” says Rajiv Mehta, lead analyst (institutional equities) at Mumbai-based brokerage firm Yes Securities.

In absence of demand from corporates, retail banking products like credit cards, personal and home loans were driving India’s credit growth over the last three years. But these categories, which were especially valuable to fast-growing private banks, are also witnessing subdued demand now. Retail and services loan growth has sharply fallen from the highs of 30% in March 2019, the RBI report states.

Small banks in deep trouble

With the banking system staring at the double whammy of weak credit growth and rising NPAs, smaller lenders are bracing for the worst. Last year was extremely tough for small banks in India, with a couple—Lakshmi Vilas Bank and CKP Co-operative Bank—even going bust. Defaults and a weak economic environment have clearly shaken confidence in smaller institutions.

With the specter of insolvencies looming at the start of pandemic-led lockdown, there was a flight of deposits from small banks to bigger ones. And the situation might not improve for these small lenders anytime soon.

“The smaller the bank size, the greater the possibility that even a small chunk of big accounts turning bad can take it down,” Shekhar says. “This will also mean that the smaller banks will be extra cautious in making new loans, and thereby will have slow book growth.”

So, while the small lenders face an uphill task, even the bigger ones will face fire in what seems to be yet another difficult year for India’s beleaguered banking sector.