The Reserve Bank of India on Thursday cautioned that banks face the prospect of a rise in non-performing loans, particularly in their small and medium enterprises (SME) and retail portfolios, especially as regulatory relief is wound down.

The RBI’s latest Financial Stability Report (FSR) noted that banks remained relatively unscathed by pandemic-induced disruptions, cushioned by regulatory, monetary and fiscal policies.

The report reflects the collective assessment of the Sub-Committee of the Financial Stability and Development Council (FSDC-SC) on risks to financial stability.

“Within the domestic financial system, credit flow from banks and capital expenditure of corporates remain muted.

“While banks’ exposures to better rated large borrowers are declining, there are incipient signs of stress in the micro, small and medium enterprises (MSMEs) and retail segments,” the report said.

The FSR underscored that the demand for consumer credit across banks and non-banking financial companies (NBFCs) has dampened, with some deterioration in the risk profile of retail borrowers becoming evident. Subdued credit growth in a low-interest rate scenario could impact banks’ net interest income levels, it warned.

Stable NPA ratios

The gross and net NPA ratios of banks remained stable during the second half of 2020-21, at 7.5 per cent and 2.4 per cent, respectively, in March 2021. As at September-end 2020, the ratios had been 7.5 per cent and 2.1 per cent, respectively.

On the other hand, special mention account (SMA) ratios, which reflect incipient stress, deteriorated, the report said.

The report said banks must prepare contingency strategies to deal with segment-specific asset quality pressures, especially when regulatory reliefs get rolled back.

Per the FSR, macro-stress tests for credit risk show that scheduled commercial banks’ GNPA ratio may increase from 7.48 per cent in March 2021 to 9.80 per cent by March 2022 under the baseline scenario and to 11.22 per cent under a severe stress scenario.

Stress tests also indicate that SCBs have sufficient capital, both at the aggregate and individual level, even in the severe stress scenario.

Monitor MSME, retail loans

As banks and other financial institutions have resilient capital and liquidity buffers, balance-sheet stress remains moderate in spite of the pandemic, the report said. But it emphasised a close monitoring of MSME and retail credit portfolios. This calls for banks to shore up their capital position when favourable market conditions prevail, it added.

“The banking sector will be required to specifically guard against adverse selection bias while being alive to the credit demand from productive and viable sectors.

“In the most optimistic scenario, the impact of the second wave should be contained within the first quarter of the year, while frictional inflation pressures work their way out over the first half of the year,” the FSR said. The report said financial intermediaries need to internalise these expectations into their outlook while staying on guard against potential balance-sheet stress with sufficient capital and liquidity buffers and governance structures.

Govt borrowings

Referring to the surge in the government’s market borrowings, with a significant share of public debt being absorbed by banks, the FSR noted that going forward, however, their absorptive capacity may be circumscribed by the likely expansion of bank credit as economy recovers.