What will happen to the Indian banking system if it faces severe stress from the economy? Though non-performing assets (NPAs) will shoot up and capital adequacy ratios (CRARs) will fall, the banking system could still be able to reasonably withstand the pressure, reveals the stress test conducted by the Reserve Bank of India.

NPAs arise when bank customers stop servicing their instalments beyond a specified grace period (usually 90 days), thereby giving rise to stress. And, CRARs indicate the quality of capital that banks hold with them, which enables them to ward off stress.

“These stress scenarios are stringent and conservative assessments under hypothetical severely adverse economic conditions and should not be interpreted as forecasts or expected outcomes,” the RBI clarified.

However, if the risks of a severe contraction in GDP growth, a higher fiscal deficit and inflation spiralling, were to materialise, the banking system’s assets could come under a spot of bother.

In such a scenario, the gross non-performing asset (NPA) ratio of banks could increase to 6.3 per cent of total advances from about 4.5 per cent at end-September 2014.

This stress test takes into account only the performance of scheduled commercial banks — public sector, private, and foreign banks.

“Under such a severe stress scenario, the system level CRAR of SCBs could decline to 9.8 per cent by March 2016 from 12.8 per cent in September 2014,” the RBI said in its yearly Financial Stability Report.

Sector-wise, it could be the engineering sector that could possibly account for the highest share of NPAs — 12 per cent of total advances. This could be followed closely by the cement sector at 10.6 per cent of total advances.

Provisions The RBI said that the current level of provisions of various bank groups — public sector, private, and foreign banks — as a proportion of their respective total advances were at 3.2 per cent, 1.9 per cent and 3.9 per cent, respectively, as of September 2014.

Among the bank groups, the RBI added that the public sector banks had the highest expected loss at 3.2 per cent of their total advances as of September 2014.

“Though they may meet the expected losses under baseline scenarios they are likely to fall short in terms of having sufficient provisions to meet expected losses (EL) under adverse macroeconomic risk scenarios,” the central bank added.

The RBI’s bank-wise estimation of expected and unexpected losses shows that 20 banks, with about 29.8 per cent in total advances of select 60 banks, were unable to meet their expected losses with the existing provisions.

Also, only two banks are expected to see higher unexpected losses than the total capital.

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