NBFC sector stress to have impact on banks' recovery: Fitch

Systemic stress across India’s non-bank financial companies (NBFCs) would deal a significant setback to the banking sector’s recovery, reversing recent improvements in performance, pressuring Viability Ratings (VRs) and posing solvency risks to state-owned banks with the thinnest buffers, Fitch Ratings has cautioned.

India’s NBFC sector has been under pressure from tight financing conditions since the default of Infrastructure Leasing & Financial Services in late 2018.

Banks’ exposure to NBFCs reached 7.4 per cent in FY19, up from 5.3 per cent at FY end (FYE) 14. Fitch cautioned that the more extensive linkages between banks and NBFCs have raised contagion risks in the event that the NBFC sector suffers a crisis.

"We assume that 30 per cent of the NBFC exposure becomes non-performing. We view this as close to a worst-case scenario, but the figure also reflects the proportion of the sector that we believe is characterised by riskier business and financial profiles.

"We also assume 30 per cent of property exposure becomes non-performing, and that economic knock-on effects lead to an extra 10 per cent of personal, credit card and consumer durable loans and 2.5 per cent of corporate loans becoming non-performing," said Fitch analysts Saswata Guha, Tania Gold, Dan Martin, and David Prowse.

The analysts estimated that the banking system’s gross non-performing loans (NPL) ratio would rise to 11.6 per cent by FYE21 from 9.3 per cent at FYE19, compared with their baseline expectation of a decline to 8.2 per cent.

"We would expect the recovery process to become even more protracted in such a difficult environment, although banks would resort to writing off some of the legacy bad loans in order to manage their NPL stock, as has generally been the case so far," they opined.

Losses and capitalisation pressure

Bank losses would add to existing capitalisation pressures, particularly at the state banks. Fitch estimated that banks are already $7 billion short of the capital required to meet a 10 per cent weighted average common equity Tier 1 (CET1) – the level that we believe would give them an adequate buffer above regulatory minimums. The gap would rise to about $50 billion by FYE21 under the stress scenario.

In reality, it is unlikely that banks would be in a position to maintain that level of capital, and many would struggle to stay above the regulatory minimum of 8 per cent that is set to apply from end-March 2020, the agency added.

Fitch estimated that the aggregate weighted-average CET1 ratio would fall by 350 basis points to 7.5 per cent in our stress scenario, leaving a system-wide aggregate shortfall of about $10 billion to meet the regulatory minimum. The shortfall at state banks would be larger, as the agency expects large private banks to remain generally above the minimum.

Most banks’ ability to issue capital would be limited in a stress scenario, which would put the onus on the government to address capital shortfalls – especially since the state banks have already offloaded considerable assets to boost capital levels, assessed the analysts.

"Our sovereign team would not expect a capital injection of $10 billion (or 0.4 per cent of GDP), on its own, to put significant pressure on India’s sovereign rating (BBB-/Stable)," they said.

State-owned banks with VRs (viability ratings) in the ‘b’ range would face heightened solvency risks if fresh equity is not injected, while those in the ‘bb’ category could breach the minimum regulatory additional Tier 1 (AT1) threshold of 5.5 per cent CET1, triggering compulsory AT1 write-downs.

This would lead to significant downward rating actions on the VRs of Fitch-rated banks – in some cases to as low as ‘f’, signifying failure, the agency said, adding that the Issuer Default Ratings for support-driven issuers would only be affected if the ability of the sovereign to provide timely support was undermined.

"The tough market environment is likely to persist, at least in the near term, and will test the resiliency of other NBFCs.

"The most vulnerable are likely to be those that operate with higher leverage and weaker asset-and-liability (ALM) maturity profiles, and that face higher concentration risks. Typically, this includes wholesale and housing finance companies," said the global rating agency.

According to a stress test conducted to examine the potential impact on banks of the NBFC sector pressures developing into a broad crisis, the agency estimated that the scenario would leave banks with an aggregate shortfall of $10 billion to meet regulatory minimums, and $50 billion below the level that it believes would provide an adequate buffer.

Seeking to measure the relative vulnerability of Indian banks’ weak capital and earnings buffers in such a scenario, Fitch analysts believe the most plausible trigger would be several large defaults in the real estate development sector, caused by aggravated liquidity risks and weak sales.

NBFCs were an important source of financing for real estate in recent years, with banks pulling back from the sector. Developers are now facing liquidity pressures as NBFCs have also begun to shy away from the sector, showing reluctance to refinance maturing debt of even large, proven developers.

The agency cautioned that large property defaults would result in losses for direct NBFC creditors, and would pose significant contagion risks for the rest of the sector, testing system-wide liquidity.

NBFCs source 55-65 per cent % of their total funding from debt instruments, with about 10-13 per cent coming in the form of short-term commercial paper. Much of their lending is long term, especially in the case of wholesale and housing finance companies, resulting in weak liquidity profiles.