Fitch revises outlook on Indian banks’ operating environment to “stable” from “negative”

Fitch Ratings has revised its outlook on Indian banks’ operating environment (OE) to “stable” from “negative”, as it believes the ongoing recovery of the country’s large and diversified economy will support sustainable business growth for banks.

The receding risk of further pandemic-related disruption has also lowered financial performance risks.

“These factors underpin the current OE score of ‘bb’, which is two notches above the implied category score of ‘b’,” the global rating agency said.

Fitch expects India’s economy to outperform peers and forecast real GDP growth of 8.4 per cent for FY22 and 10.3 per cent for FY23.

The agency expects stable medium-term earnings for public sector banks (PSBs), as near-term improvements are balanced by the unwinding of regulatory forbearance from the financial year ending March 2023 (FY23).

It observed that forbearance has suppressed PSBs’ immediate capital requirements by deferring recognition of stress, giving banks time to build capital buffers.

Fitch assessed that large private banks will gain market share, as their much better capitalisation can sustain higher loan growth, backed by solid retail franchises, a diversified business mix and stable funding.

“We regard SBI as the most competitive of the State banks in light of its dominant franchise, vast reach and relative pricing power. This should partly offset some of its capital constraints.

“However, most State banks are likely to see an erosion of market share due to their moderate capital buffers limiting loan growth, a lack of pricing power and weak management execution,” opined the agency.

Government’s support

Fitch noted that banks will also benefit from forbearance measures in the interim, such as State-guaranteed emergency funding and the option to restructure loans.

“This should limit risks to asset quality and earnings and give banks time to build capital buffers before risks to asset-quality re-emerge once forbearance starts to unwind from 2023,” the agency said in a peer review of major Indian banks.

Fitch expects the staggered unwinding of unrecognised stressed loans to generate moderate asset-quality pressure starting in FY23. Private banks should fare better than state banks due to greater earnings headroom, it added.

“Our negative outlook on ICICI’s asset quality reflects its higher exposure to vulnerable segments and loans under forbearance than at peers.

“SBI and Bank of Baroda are at less risk than other State banks, but a lack of pandemic-related provisions could pose challenges,” the agency said.

Stress in MSME and retail

The agency expects the bulk of stress to come from granular loan segments, mainly micro and medium-sized enterprises (MSMEs) and retail.

Fitch believes that substantial growth in retail loans and exposure to MSMEs and vulnerable corporate sectors have created risks that are not captured in the improving impaired loan ratios due to regulatory forbearance.

The agency expects underwriting to be eventually tested with the gradual unwinding of the unrecognised stress post FY23.

“This is likely to occur alongside a gradual rise in risk appetite across banks in response to the economic recovery – as indicated by a moderate revival in credit growth. This will result in greater risk density from multi-year lows,” it added.

The agency noted that there would be some stress from pandemic-affected corporate segments, such as hospitality and travel, but it sees corporate loans as less vulnerable due to the risk aversion exhibited by banks in recent years.

Fitch opined that risks are lower in retail loans due to a high share of secured loans, but banks with greater exposure to unsecured loans, loans to self-employed and low-income borrowers may face challenges.

It regards MSMEs as the most vulnerable segment, while corporate loans are more resilient due to a protracted period of deleveraging, coupled with India’s economic recovery.

“State banks’ greater risk appetite is reflected in high exposure to the vulnerable sectors, but we think the share of corporate loans could increase, supported by the infrastructure and construction sectors in light of the government’s strong focus on infrastructure spending.

“However, banks are likely to be cautious, considering the large losses incurred in the past from such financing,” the agency said.

Earnings revival

Fitch expects earnings and profitability to recover at most banks by FY23, driven by falling loan-impairment charges (H1 FY22 system average: 1.2 per cent of loans, FY21: 1.7 per cent), as forbearance will limit fresh loan impairments.

Pressure should also be offset by improving recoveries from impaired loans, while earnings are supported by adequate pre-provision profit (H1 FY22: 3.6 per cent, FY21: 3.5 per cent) thanks to stable net interest margins and operating costs.

“Waning forbearance is likely to pressure profitability, but we expect average operating profit/risk-weighted assets to remain commensurate with banks’ current earnings and profitability scores,” the agency said.

Fitch observed that the earnings of private banks should continue to outperform that of PSBs, supported by higher pre-provisioning income buffers.

“This is driven by private banks’ more profitable loan mix and greater diversification of their income base. Any rise in loan impairment charges after forbearance unwinds, should be somewhat offset by robust loan growth and rising fee income amid steady cost/income ratios,” said the rating agency.

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