Fitch Ratings has revised down India’s real GDP for FY22 from 12.8 per cent to 10 per cent, underlining its belief that renewed Covid-related restrictions have slowed recovery efforts and left banks with a moderately worse outlook for business and revenue generation.

The challenges posed by the pandemic to Indian banks have increased due to a virulent second wave in the first quarter of FY22, the global credit rating agency said in its ‘Indian Banks 2021 Report Card’ report.

“Localised lockdowns during the second wave kept economic activity from stalling to levels similar to those during 2020 (Q1/April-June FY21 real GDP growth: -24.4 per cent), but disruption in several key business centres has slowed the recovery and dented our expectations of a rebound to pre-pandemic levels by FY22.

“Our moderately worse 2021 outlook for Indian banks factors in muted prospects for new business due to our expectation of weak corporate and consumer confidence, banks’ continuing high-risk aversion, and below-trend credit demand,” according to the report.

Bad loans to peak

Regulatory relief measures have postponed banks’ underlying asset-quality issues for now, but banks’ medium-term performance will be dented without a meaningful economic recovery, cautioned the global credit rating agency.

Fitch emphasised that continued relief measures aimed at Covid-affected segments (such as micro, small and medium enterprises, retail and contact services) played a crucial role in deferring recognition of problems with asset quality.

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Fitch expects impaired loans to peak after FY23 since stress is likely to manifest from the aforementioned pool over a fairly protracted time-frame.

“The impaired loans ratio of 7.5 per cent in FY21 was moderately better than our expectations. The ratio was supported by declining fresh bad loans as well as high levels of write-offs,” said Associate Director, Financial Institutions, and Saswata Guha, Director, Financial Institutions, in the report.

Asset quality

The agency said it remains cautious on asset quality, given renewed restrictions, medical exigencies and rising job losses.

The reintroduction of a restructuring scheme for retail, small businesses and MSMEs, together with a $20 billion increase in the ECLGS (Emergency Credit Line Guarantee Scheme) outlay, underscores the incipient stress as Indian banks potentially face another protracted asset recognition cycle similar to previous years, it added.

Fitch estimates that regulatory moratorium, Covid-specific restructuring, and state guaranteed refinance for MSMEs totalling around 10 per cent-plus of system loans had a significant role in suppressing stress.

The agency expects the suppression to continue in FY22 in the wake of new measures to deal with the second wave impact.

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The report’s authors opined that banks’ exposure to stressed MSME and retail borrowers could rise further with the increasing relief outlay, and is likely to compel banks – especially state-owned ones – to slow regular lending in the absence of adequate core capital cushions and weak contingency buffers.

Fitch estimates aggregate potential stressed loans to be highest among large state banks, at 11.9 per cent of loans, followed by mid -sized state banks at 9.3 per cent, after factoring in total exposure to MSMEs that have availed ECLGS, based on available bank disclosures.

The agency observed that most private banks have significantly lower impaired loans and a higher share of state-guaranteed ECLGS loans (2.2 per cent) than state banks (1.2 per cent) in FY21, but they also have more retail loans.

“We consider MSME and retail loans (especially unsecured and loans to low and moderate income borrowers) to be most at risk, although retail loans have performed better than our expectations so far,” the authors said.

Banks’ impaired loans ratio dipped to 7.5 per cent in FY21 (Fitch estimate: 7.6 per cent), from 8.5 per cent in FY20, despite weak loan growth.

This was mainly because of lower recognition of new impaired loans (FY21: 2.2 per cent of loans, FY20: 3.3 per cent), but also high loan charge-offs (FY21: 1.9 per cent, FY20: 2.3 per cent).

The report said sector loan-loss coverage has modestly improved (FY21: 68.9 per cent; FY20:66.2 per cent) with the increased provisioning of legacy bad loans.

However, contingency provisions were depleted in Q4 (January-March) FY21 as banks used them to cover moratorium loans that turned bad.

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The agency observed that state banks, with the exception of SBI (State Bank of India), have used up their relatively small Covid-related buffers while private banks retain slightly better contingency buffers (FY21: 0.5 per cent - 0.9 per cent of loans), but not material enough to deal with the stress caused by the pandemic.

Fitch said the Reserve Bank of India’s (RBI) recent regulatory directive has allowed banks to dip into floating reserves until FY22 but that alone may not provide much headroom unless banks are also allowed to dip into their standard reserves.

Market share

Fitch said Indian banks reported loan growth of around 5.5 per cent in FY21, moderately lower than 6.5 per cent in FY20.

However, public sector (state-owned) banks expanded by only 2.2 per cent – significantly below 9.6 per cent loan growth by private banks – as per Fitch’s estimate.

The authors underscored that private banks gained significant market share from public sector banks over the past decade as the latter have been hamstrung by higher impaired loans, larger losses and weaker capitalisation.

The government-led merger of state-owned banks has helped some to consolidate their market position, but Fitch believes state banks will continue to lose market share if they do not raise adequate capital to insulate against future stress and to support stronger growth.