While India’s financial system remains stable, concerns over banks’ asset quality remain, according to the Reserve Bank of India in its latest Financial Stability Report (FSR).

The report said the banking stability indicator (BSI) worsened between September 2016 and March 2017 due to a deterioration in asset quality and profitability.

The indicator represents the five dimensions of soundness, asset-quality, profitability, liquidity and efficiency.

In its previous report, which was released in December 2016, the BSI had similarly flagged the elevated risks to the banking sector (in the March and September 2016 period) due to continuous deterioration in asset quality, low profitability and liquidity.

According to the latest FSR, the macro stress test indicates that under the baseline scenario, gross non-performing assets (GNPAs) of scheduled commercial banks (SCBs) may rise from 9.6 per cent in March 2017 to 10.2 per cent by March 2018. GNPAs were at 9.2 per cent in September 2016.

In the case of a severe stress scenario, the RBI warned that “a severe credit shock is likely to impact capital adequacy and profitability of a significant number of banks.”

Large borrowers The share of large borrowers (aggregate fund-based and non-fund based exposure of ₹5 crore and more) both in SCBs’ total loans portfolio as well as GNPAs came down between September 2016 and March 2017, the report said. Large borrowers accounted for 56 per cent of gross advances and 86.5 per cent of GNPAs of SCBs, whereas the top 100 large exposures accounted for 15.2 per cent of gross advances.

Credit flow Banks’ share in the flow of credit to the commercial sector, which was around 50 per cent in 2015-16, declined sharply to 38 per cent in 2016-17.

In his foreword to the report, Deputy Governor NS Vishwanathan said: “Retrenchment of credit by public sector banks is partly offset by non-banking finance companies (NBFCs), mutual funds and the capital market but they cannot fully substitute for banks in a bank-based financial system like ours. Hence, steps to restore the health of the banks assume urgency.”

Credit discipline While the central bank has activated prompt corrective action (PCA) to stem the slide in the banking system, the Deputy Governor underscored that nothing can replace credit discipline and appreciation of the sanctity of commercial contracts in order to ensure a robust financial system.

“Thus, additional focus has to be on strengthening the internal governance framework of financial entities and observance of market discipline.

“This will have a salubrious impact on financial intermediation, whereby assumption and sharing of risks is based on risk capacity and not on herd instinct or accounting and regulatory dispensations,” said Vishwanathan.

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