India’s banking sector requires significant attention

During 2007-2009, while the United States and most of Europe were engulfed in a devastating financial crisis, the Indian financial sector was largely untouched. During those years, Indian households and companies were not as indebted as the American ones, nor were Indian financial institutions transacting derivatives or securitisations as American financial institutions were. Now almost ten years later, global investors should be turning their attention to the very indebted Indian corporations and to the troubled Indian banking sector.

After years of increasing GDP growth in India, which encouraged banks to lend to India’s corporations, the Indian industrial sector is now among the most heavily indebted globally. There should be concerns about the companies’ ability to manage cash flows to meet their bank loan repayments.

An important development to monitor is Prime Minister Narendra Modi’s unexpected November 2016 announcement to introduce demonetisation. This demonetisation entails withdrawing 500 and 1,000-rupee bank notes; this means removing from circulation 86% of India’s currency. The purpose of demonetisation is to encourage Indians to pay taxes and to reduce money laundering and terrorism financing. For the moment, demonetisation has been moving very slowly. However, demonetisation could have an adverse effect of worsening companies’ liquidity, which in turn would worsen banks’ non-performing loan portfolios. Unfortunately, the Reserve Bank of India estimates that Indian banks have about $133 billion in stressed assets after years of excessive lending.

Analysis in the IMF’s Global Financial Stability Report shows that the Indian banking sector is in a weak position in comparison to other emerging economies in terms of bank capital available to sustain unexpected losses on its assets. In particular, Indian banks have a significant amount of non-performing loans, made primarily to the industrial sector.

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Additionally, a 7 May 2017 note by analysts at credit rating agency Moody’s highlighted the low levels of capital at public sector Indian banks. Their common equity Tier I ratios range from 7.24% and 9.97% of risk weighted assets. While these levels are slightly above the minimum recommended 6% by the international banking standard setter, the Basel Committee on Banking Supervision, if the Indian economy had a significant credit or market crisis, these levels would be insufficient for the banks to sustain unexpected losses. Fitch estimates that the sector will need $90bn of new capital by 2019 to meet Basel III capital adequacy norms.

Adding to the woes of the Indian banking sector was a mid-May 2017 McKinsey consulting report stating that “the total stressed assets of Indian banks, including restructured loans, have now outstripped the combined net worth of the sector”.

It is not just public banks that are troubled; private sector banks are also facing non-performing loan challenges. Recent news that Yes Bank, ICICI Bank, and Axis bank have higher levels of non-performing loans than had been initially published, will certainly increase concerns about the truthfulness and accuracy of banks’ financial reporting; the banking shares’ price decline certainly shows investors’ concerns.

For the moment, if India’s banks condition worsens, its impact on banks in other countries is likely to be limited. In the US, for example, as of the end of 2016, US banks had about $69 billion in exposures to Indian corporates and financial institutions; this is almost a 30% decrease from a peak of $84 billion in the first quarter of 2015. India is the fifth largest emerging market counterparty to US banks after Mexico, Brazil, China, and South Korea, in descending order by counterparty size.

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The seriousness of India’s non-performing loans portfolios, however, must remain the top priority for the bank supervisory side of the Reserve Bank of India. In remarks to the Federation of Indian Chambers of Commerce and Industry in Mumbai at the end of April, Deputy Governor of the Reserve Bank of India, Viral Acharya stated that “Undercapitalised banks could be shown some tough love and be subjected to corrective action, such as the revised Prompt Corrective Action (PCA) guidelines recently released by the Reserve Bank of India.” The PCA would mean that there would be no further growth in deposit base and lending for the worst-capitalised banks. “This will ensure a gradual ‘run-off’ of such banks and encourage deposit migration away from the weakest public sector banks to healthier public sector banks and private sector banks. It is not rocket science to figure out where the growth potential in our banking sector lies and deposit growth should be allowed to reflect that.”

It is critical that Reserve Bank of India bank examiners be given support and encouraged to keep a close eye on India’s banks. If banks start to fall apart due to bad loans, there would be significant damage to India’s GDP. One need only look at the fact that even after almost a decade since the financial crisis, its pain is still felt by millions of people globally, who have not been able to recover from the long lasting effects that come with bank crisis.

Mayra Rodríguez Valladares is managing principal of New York based MRV Associates. You can follow her on Twitter @MRVAssoc.

 

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