The year 2021 will be a litmus test for the Indian banking system. here’s why

When the spread of Covid-19 was poised to hurt India’s economy in early 2020, the central bank acted swiftly to protect the country’s banking system. The Reserve Bank of India has relieved banks as well as borrowers by offering the option to halt loan repayments for six months (March-August). He cut the repo rate to a record low and opened a special credit line for banks to encourage them to lend more. It also allowed lenders to restructure some loans.

All of these measures have given a much-needed temporary respite to the Indian banking system. While the moratorium on loan repayments shielded them from the shock of rising bad debts, the availability of cheap credit flooded the banking system with liquidity.

But these measures have only thrown the box down the road, and the moment of judgment could come in 2021. The RBI, in its latest report, warned that “as political support is undone, the impact of the Covid-19 pandemic could harm banks’ health.” With 40% of overall outstanding loans in the financial system under moratorium until August, the central bank said “data on gross banks do not yet reflect stress”.

This essentially means that money that some borrowers were unable to repay, but were protected by the moratorium, should be recognized as bad debt.

An impending order from the Supreme Court of India further aggravates the problem of bad debts. He asked banks, temporarily, not to report defaulters as non-performing assets. “Asset quality is a major concern for banks this year,” observes Karan Gupta of India Ratings. “The loan restructuring and the SC order will have a huge impact on how the bad debt scenario plays out in 2021.”

Indian banks face rising bad debts

According to rating agency S&P Global, Indian banks’ NPA to loan book ratio (the amount of bad debt as a percentage of outstanding loans) is expected to reach 10% to 11% by March 2021, up from 7, 6% in September 2020. “Forbearance masks asset issues resulting from Covid-19,” said Deepali V Seth Chhabria, banking analyst at S&P Global. “With the end of loan repayment moratoriums, we expect to see a jump in NPAs.” There would have been more bad loans so far had it not been for a Supreme Court order or a central bank moratorium, she adds.

But even before Covid-19 took a toll on borrowers’ ability to pay, Indian banks were reeling from a string of corporate defaults over the past five years. To mitigate the effect of rising NPAs, banks went on a lending spree. “The banking way of dealing with NPAs is usually to increase lending,” says Dr. Vidhu Shekhar, assistant professor of finance at SP Jain Bhavan Institute of Management and Research in Mumbai. “As the size of the book increases, older NPAs become smaller in terms of percentage of book value and may be written off.”

Attempting a similar strategy this time could backfire in the current weak economic environment. In addition, demand for credit is weak as the lockdown has severely affected business turnover as well as household income.

Balancing credit growth and risk

Experts believe that the effects of the slowdown caused by Covid-19 are still visible and therefore lenders should be cautious and avoid expanding their loan portfolios too quickly in the current economic environment.

The challenge facing banks is not only to stop the surge in NPAs, but also to be cautious when lending in 2021,” said Rajiv Mehta, Principal Analyst (Institutional Equities) at Yes Securities, a Mumbai-based brokerage firm. “How banks handle Covid-19 will be key to solving the bad debt problem.”

In the absence of business demand, retail banking products like credit cards, personal and home loans have been driving credit growth in India over the past three years. But these categories, which were particularly valuable to fast-growing private banks, are also seeing moderate demand today. Growth in retail and service loans fell sharply from highs of 30% in March 2019, the RBI report said.

Small banks in big trouble

As the banking system faces the double whammy of weak credit growth and rising NPAs, small lenders are preparing for the worst. Last year was extremely difficult for small banks in India, with a couple – Lakshmi Vilas Bank and CKP Co-operative Bank – even going bankrupt. Defaults and the weak economic environment have clearly shaken confidence in small institutions.

With the specter of insolvency looming at the start of the pandemic-induced lockdown, there was a flight of deposits from smaller banks to larger ones. And the situation may not improve anytime soon for these smaller lenders.

“The smaller the size of the bank, the more likely it is that even a small group of large accounts that go bad can delete it,” Shekhar said. “It also means that smaller banks will be extremely cautious in making new loans, and therefore will have slow book growth.”

So while smaller lenders face an uphill battle, even the biggest will face fire in what looks to be yet another tough year for India’s beleaguered banking sector.

This article first appeared on Quartz.

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