Money & Banking

Covid will leave banking system with capital shortfall of at least $15 billion over two years: Fitch

Our Bureau | | Updated on: Jul 01, 2020

Non-performing loans of banks could spike in the next two years, the global credit rating agency Fitch said

Capital requirements could soar to $58 billion in FY22 if economic contraction is worse than expected, says ratings agency

The economic disruption caused by the coronavirus pandemic is likely to harm Indian banks’ balance sheets and financial performance for at least the next two years, particularly for state-owned banks, which are most vulnerable, cautioned Fitch Ratings.

This will leave the banking system with a capital shortfall of at least $15 billion. Further, non-performing loans (NPLs) could spike in the next two years, the global credit rating agency said.

According to Fitch, a moderate stress test reveals that the Indian banking system is likely to require recapitalisation of around $15 billion in the financial year ending March 2022 (FY22) to meet minimum regulatory capital norms (of 8 per cent).

This recapitalisation will help the banking system meet a 10 per cent weighted-average (WA) common equity Tier 1 (CET1) ratio — the level that Fitch believes would provide an adequate buffer above regulatory minimums

“However, capital requirements would soar to around $58 billion (in FY22) under a high-stress scenario should the economic contraction be more severe than we expect,” the agency said.

Per the agency’s assessment, state (-owned) banks are likely to account for the bulk of the capital shortfall, as large private banks should stay above the minimum requirements, despite some capital erosion in a high-stress scenario.

Holding back loan growth

“ is doubtful if banks are in a position to maintain such a high level of capital, given the sovereign's constrained fiscal position.

“We therefore expect many banks to hold back on loan growth or resort to balance-sheet contraction, as seen in previous crises, to stay above the 8 per cent regulatory minimum that is to apply from end-September 2020,” Fitch said.

According to the agency, state banks are also under tremendous pressure to support distressed sectors, both within and outside the government's announced stimulus measures. This ultimately puts the onus on the government to address capital shortfalls, as it expects banks to otherwise display high risk aversion in the absence of adequate recapitalisation.

The agency said private banks are under less pressure due to their better capitalisation, although they are also at risk of capital erosion. However, they have been more proactive issuers of equity and are less likely to breach minimum regulatory capital ratios under our high-stress scenario.

Impaired loans set to rise

Fitch expects the banking sector’s impaired loan ratio to increase by around 450 basis points (bps) over the next two years (FY21-FY22) under its moderate-stress scenario, while the high-stress scenario sees the ratio doubling. One basis point is equal to one-hundredth of a percentage point.

The expected peak in FY22 under moderate stress is roughly 140 bps above the previous peak of 11.6 per cent seen in FY18. What this means is the impaired loan ratio could peak to 13 per cent in FY22.

The impaired loan ratio rises by around 800 bps (to 19.6 per cent) under high stress.

Fitch believes that a large proportion of bad loans are likely to be recognised in FY22 due to regulatory forbearance, including the 180-day moratorium on the recognition of impaired loans, in place until September 2020.

The agency also expects recoveries to weaken significantly, owing to falling collateral values and the one-year regulatory suspension of new bankruptcy proceedings. This is likely to pressure banks’ loan loss cover ratio (FY20 estimate: 68 per cent) as banks play catch-up on legacy bad loans while fresh ones build up.

Fitch expects stress across most key segments. It said retail unsecured loans are particularly vulnerable, alongside loans to SMEs, which are likely to have experienced the most disruption to cash flow.

Reported loans under moratorium announced by banks thus far is broadly around 30 per cent of total loans, but it does not appear that banks are fully accounting for incipient stress by excluding partially serviced loans; for instance, where only one of three instalments has been paid.

Retail loans turning risky

The agency said the strategy of banks increasingly trying to diversify from corporate exposure towards the perceived safety of retail is now at threat, as evident from their scaling back incremental lending to retail.

Fitch believes that SME loans are also highly vulnerable. The government's stimulus measures provided SMEs with some equity support, but the bulk of the aid was in the form of credit extension, which risks further indebting the sector, it added.

The agency said structural challenges in many sectors, including tourism, real estate, auto and infrastructure, have been accelerated by the precipitous drop in consumption demand due to pandemic-related lockdowns, causing significant stress.

“We believe the stress (in the corporate sector) may take time to manifest due to support measures from authorities, which have postponed the problem rather than addressed it,” it added.

Published on July 01, 2020
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