Banks are stressed: What do we do?


A day after the Reserve Bank of India (RBI) released its biannual Financial Stability Report, outlining the “significant challenges” being faced by Indian banks, 31 of 33 big banks in the US cleared the final round of the Federal Reserve’s annual stress tests, signifying the resilience of the US financial system.

Only one of the largest banks of the US—Morgan Stanley—got a conditional passing grade and two others, Deutsche Bank AG and Santander Bank NA, both US subsidiaries of European banks, failed. In the previous year too, the duo did not qualify.

The stress tests essentially gauge whether the banks in the US with at least $50 billion in assets each have enough capital, management bandwidth and other safeguards to survive a financial crisis.

Ahead of the stress tests results on 29 June, the Fed had said that all big banks would be able to make it through a recession. Since the global financial crisis in the aftermath of the collapse of the US investment bank Lehman Brothers Holdings Inc. in September 2008, the banks have been directed to create a cushion of large capital against likely losses from a recession or any other developments that shock the market. The 29 June statement has also outlined areas where the Fed expects further improvement next year.

The RBI stress test, on the other hand, indicates that risks to the banking sector increased significantly in the second half of 2015-16, driven by deteriorating asset quality and lower profitability. Indeed, the financial system is resilient but it could become vulnerable if the macroeconomic conditions deteriorate sharply.

Saddled with bad assets, the banks are expected to remain risk-averse and not lend money to corporations; besides, in the absence of adequate capital, their ability to lend will also be impacted.

Simply put, Indian banks are caught in a vicious cycle: They are not willing to lend for fear of adding to bad assets; this dents their interest income and profitability; and that, in turn, further erodes their ability to lend as they are not able to plough back profits to bolster their capital.

The credit growth of Indian banks slowed to 8.8% in March 2016 from 9.4% in September 2015; the growth in deposits too declined from 9.9% to 8.1% during this period.

The gross non-performing assets (NPAs) as a percentage of advances rose to 7.6% from 5.1% and, overall, the proportion of stressed advances rose to 11.5% from 11.3%. After setting aside money, the net NPAs of banks rose sharply, from 2.8% to 4.6%, between September and March. On every parameter, the state-owned banks are in a far worse shape than their private peers.

In March, the top 100 borrowers accounted for almost 28% of credit to all large borrowers and little over 16% of Rs.75.3 trillion bank credit. They also accounted for more than one-fifth of the gross NPAs of the Indian banking system.

The RBI stress test suggests that gross NPAs of the banking system may rise to 9.3% by March 2017 “under a severe stress scenario”. For the state-owned banks, it could be as high as 11%. Higher bad assets will force banks to set aside more money, dent their profitability, and they would need capital infusion to be able to support the demand of loan from the corporate borrowers.

Unlike the US Federal Reserve, which identifies the banks that fail the stress tests, the Indian banking regulator does not expose individual banks and rightly so, as this could lead to a run on a bank with a large number of depositors rushing to withdraw money simultaneously, due to concerns about the particular bank’s solvency. In such a scenario, the money kept by a bank with RBI in the form of cash reserve ratio as well as the government bond holding—which could be liquidated to generate cash—may not be enough to cover the deposit withdrawals. RBI prefers to talk in terms of number of banks at risk and not who they are. For instance, stress tests on banks’ credit concentration risks, it says, is significant for eight banks, accounting for a little over 12% of advances, and they may end up having capital less than what they require.

Since 2010 when the first signs of stress were seen, the government has pumped in Rs.67,734 crore capital to keep the public sector banks running. It has agreed to infuse an additional Rs.70,000 crore even as the state-owned banks will have to raise over Rs.1 trillion from the markets to meet their capital requirements. Media reports suggest that the finance ministry has already finalized the plan for the first round of capital infusion of around Rs.10,000 crore. After pumping in Rs.25,000 crore in 21 state-owned banks last fiscal year, the government has committed to offer Rs.25,000 crore capital to these banks in the current year and another Rs.10,000 crore each in 2018 and 2019.

For the big US banks and their investors, the annual stress tests are extremely critical as those who pass the grade are entitled to pay dividends and buy back stocks from their shareholders. In the Indian context, such a test still largely remains an academic exercise as the government seems to believe in a perpetual unconditional bailout theory.

In the thick of global financial turmoil, the US Treasury announced a Troubled Asset Relief Program, or TARP, of up to $700 billion to save its privately managed banks from the so-called subprime mortgage crisis. Most of this amount has been invested, loaned or paid out by the Treasury and the banks have returned more in the form of interest, dividend and fees. The band-aid approach that India follows will keep the system alive but one cannot expect a turnaround till such time the government accepts that capital infusion is just one of the tools and it needs to do more to revive the weak banks. Meanwhile, wary of corporate credit, now they are chasing retail loans; the trend will continue till they burn their fingers.

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