Significant increase in interest rates over the past 18 months will adversely impact the asset quality and profitability of banks in India, according to credit rating agency Crisil.

Banks’ gross non-performing assets (NPAs) ratio is expected to increase to nearly 3 per cent by March 31, 2012, from 2.3 per cent a year ago.

The pressure on asset quality is expected to arise primarily because of weakening debt servicing ability of the corporate sector, especially the small and medium enterprises (SME) segment. The banks’ migration to system-based recognition of NPAs will also result in higher NPAs over the near term, the agency said.

Further, limited ability of banks’ to pass on further increases in funding costs to borrowers may result in a sharp decline in their return on assets (RoA) to below 1 per cent in 2011- 12 for the first time in five years, Crisil said in a report.

Sectors with weak demand-supply scenario, intense competition, and high leverage will be the most impacted. The uncertain global environment can add pressure on the export-driven sectors,

“In a scenario of prolonged high interest rates, banks’ retail advances segment may also see some delinquencies over the medium term,” said Mr Pawan Agarwal, Director, Crisil Ratings.

So far, banks have been passing on increases in funding cost to their borrowers and this has enabled them to maintain their net interest margin (NIM) at around 3 per cent. Consequently, they reported a healthy RoA of about 1.1 per cent in 2010-11, despite higher provisions for pension liabilities.

The rating agency said banks will have limited room to pass on any further increases in funding costs to borrowers. This will result in the banks’ NIM reducing to less than 3 per cent, and RoA dipping to around 0.95 per cent in 2011-12.

“Despite deterioration in banks' asset quality and pressures on profitability, their comfortable capitalisation covers asset-related risks,” said Mr Suman Chowdhury, Head, Crisil Ratings.

Banks' overall capital adequacy ratio was around 14 per cent as on March 31, 2011. Moreover, banks' capital coverage for net NPAs is expected to remain adequate, at nearly nine times, as on March 31, 2012.

Bad tidings

Return on assets to fall below 1 per cent for the first time in five years

Banks will have limited room to pass on any further increases in funding costs to borrowers

Banks' retail advances segment may also see some delinquencies over the medium term

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