The Reserve Bank of India's diagnosis of the Indian banking sector's health, contained in its recently released Financial Stability Report, the fourth in the series, is an odd mix of frankness and coyness in almost equal measure.

It is quite blunt when it reports on the economy and its future outcomes. But it shies away from the implications of the current state of banking assets, taking comfort in the sovereign guarantee that has bound public sector banking to a level of protection that, at times, could and has become stifling.

The RBI submits banks to various stress tests; some of these show banks buffeted and rocked by strains that have become more than apparent in the economy, the most noteworthy of which is severe credit risk that has already led to significant spurts in “bad loans”.

The RBI identifies retail, infrastructure, especially power, and priority sectors as vulnerable spots where bank credit is fast losing its value.

At some point in its report, the RBI assures the reader that banks can handle the perceptible increase in non-performing assets; so far, the sector has remained “resilient” and if push comes to shove, enough capital can be raised to make sure none go under.

RBI skips around issues

This is where the RBI plays coy. If banks have been resilient so far, it is because of several reasons. For one, interest-based business accounts for the most part of bank incomes; even for private sector banks that have made significant forays into fee-based services.

In other words, the low risk profile of banking buffers Indian banks, unlike their foreign counterparts, from the warp and woof of complex fee-based business ventures that often cross the line into speculative activity.

For another, Indian banks and, especially public sector ones that count for more than 70 per cent of banking activity, are protected by a government that still owns more than 50 per cent of their shares.

That traditional patronage, long decried by free-market (and freewheeling) economists as counterproductive, is now enjoying a brisk comeback in Europe and the US and not without reason.

NPAs outpace credit

Despite these assurances, “asset quality” risks remain. “In fact,” says the RBI, “the deterioration in asset quality has been identified as the risk with the highest probability of occurrence…”

Gross non-performing assets (NPA) ratio of scheduled banks increased from 2.3 per cent end-March 2011 to 2.8 per cent end-September 2011, while the net NPA ratio has increased from 0.9 per cent to 1.2 per cent between that period.

More telling than these figures is the fact that with a growth rate of 30.5 per cent, NPAs have outpaced credit expansion of 19 per cent between March and September.

Here's the RBI's take on this: “Despite the recent spurt in NPAs, the impairment levels in Indian banks compare favourably with the banking sectors in both the major advanced countries as well as peer economies.”

The chicken egg syndrome

That is hardly an inspiring comparison, much less a handy guide to the value of banks as lubricant for the growth engine.

To gauge that value, consider the dichotomy between NPA and credit expansion in the light of this prognosis: “The industrial sector, in particular, may get adversely impacted by lower demand, infrastructural constraints and higher cost of both external and internal credit.”

Lower demand? The RBI informs us that all three components — private and government consumption and investment — are falling and holds that an upturn in the economy “hinges on resuscitation of domestic demand especially for investment growth.”

You couldn't ask for a blunter prescriptive diagnosis. But here's where the ‘chicken and egg' scenario kicks in.

With the economy's demand ‘driver' as good as dead (in need of “resuscitation”), why should banks lend to, say, power, or roads or even to the priority sector that, in more ideal conditions could ignite final consumption demand?

The fear of mounting NPAs (which as the RBI informs us exceeded credit growth between March and September 2011) would be a powerful deterrent for bankers; and if they do not lend business suffers.

So even if interest rates begin their slow descent, rising risk aversion will offset any beneficial advantages of cheaper credit.

One thing is clear: in the event, “pressure on asset quality” of banks will ease.

(This article was published on December 26, 2011)
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