The Reserve Bank of India’s (RBI) latest Financial Stability Report makes for disturbing reading, as it points to a new elephant in the room: The ‘contagion risks’ to the country’s banking system arising from the failure of one or more banks. The report has taken note of “three or four banks” featuring in the “inner core” of the inter-bank market over the last two years and, within them, two being consistently large net borrowers. While their names have not been revealed for obvious reasons, the RBI has assessed that in the event of these two banks going belly up, they would trigger the failure of nine other banks and wipe out a fifth of the core capital of the entire banking industry. It only goes to show the extent of interconnectedness between banks today, exposing them to the possibility of concurrent distress, especially in a scenario of falling growth or interest and exchange rate volatility.

The context of the RBI sounding a word of caution is hard to miss. That the current growth slowdown in the Indian economy has led to rising bank loan delinquencies is well established now. Gross non-performing assets (NPAs or loans where payments are due for 90 days or more) of commercial banks, which hovered around 2.3 to 2.4 per cent of outstanding advances between 2007-08 and 2010-11, rose to 2.9 per cent for the year ended March 2012. The subsequent six months have seen the ratio deteriorate further to 3.6 per cent. The picture worsens if one adds big-ticket loans to corporates that have been ‘restructured’ through reduction in interest rates, rescheduling of repayment periods, part-waiver of principal or interest, etc. Such restructured advances, technically not NPAs, have gone up from 3.5 per cent in 2010-11 to 4.7 per cent in 2011-12, and to 5.9 per cent as on September 2012. Taken together, it means roughly a tenth of bank loans are stressed to varying degrees.

The situation only reinforces the case for Indian banks to play to their traditional strengths: A funding structure largely reliant on domestic retail deposits, less prone to sudden withdrawals, high proportion of low-cost current and savings account deposits, and a diversified lending portfolio. The above strengths have been undermined in recent times, with bulk deposits forming over 50 per cent of the total liabilities of some public sector banks and the top 20 individual borrowers accounting for over a quarter of total credit exposure. These are testing times, indeed, for Indian banks, as the deterioration of asset quality from loans made during an unprecedented growth period increasingly manifests itself. While the rebuilding process will hopefully not be as prolonged as in the late 1990s — when the NPA ratio crossed 15 per cent — they might still benefit by going back to the basics, at least in respect of deposit taking and credit deployment.