A sustained improvement in the financial performance of Indian banks bodes well for the sector’s intrinsic risk profiles, according to Fitch Ratings.
Fitch believes there is further upside in bank performance and that this could persist for longer than it had initially expected, with Covid-related risks largely in the background and a steady improvement in bank balance sheets over the past three years, in part due to forbearance.
The credit rating agency said the sustained easing of financial-sector risks could support a higher operating environment score but this will depend on its assessment of various factors, such as medium-term growth potential, borrower health and loans under regulatory relief, rather than just near-term bank performance.
There is also a risk that continued strong loan growth may lead to selective or incremental increases in risk appetite, while net interest margin compression and higher credit costs post-wind-down of regulatory forbearance could still weigh on financial profiles.
Also read: RBI issues final guidelines on interest rate risk in banking book
Viability Rating
Fitch said any Viability Rating upgrades would consider whether financial profile improvements are sustainable and exceed any additional risks taken.
The agency observed that Banks in the ‘b’ Viability Rating category have a weaker record than higher-rated peers and would also need to demonstrate reduced balance-sheet risk or better management of risk profiles before an upgrade would be considered.
The agency emphasised that risk profiles and capitalisation remain as the most likely reasons for keeping assigned Viability Ratings below implied levels.
Also read: India Inc gravitating towards multiple banking
Even if banks’ Viability Ratings were upgraded by one notch, it would not affect their Issuer Default Ratings, which remain underpinned by expectations of sovereign support.
The agency observed that the pace of asset quality and profitability improvement has exceeded its expectations, while capital buffers are broadly in line with its projections.
Loan ratio
The sector’s impaired-loan ratio declined to 4.5 per cent in 9MFY23 from 6 per cent at FY22. This was nearly 60 basis points (bps) below Fitch’s FY23 estimate.
The agency noted that increased write-offs have been a key factor but higher loan growth, supported by lower slippages and improved recoveries, have also played a role.
Also read: Bank of Maharashtra tops list of public sector lenders in loan growth, asset quality
Fitch expects a further improvement by FYE23, although banks still face the risk of asset-quality pressure associated with the unwinding of loan forbearance in FY24.
Fitch said the sector’s improving provision cover (9MFY23: 75 per cent, FY22: 71 per cent) also supports banks’ ability to withstand risks, although private banks are significantly better placed than state banks due to their lower impaired loan ratio of 2.1 per cent, against state banks’ 5.6 per cent.
Credit costs
Sound economic momentum has contributed to a further drop in credit costs to 0.95 per cent at 9MFY23, as per Fitch’s estimate, compared with 1.26 per cent at FY22.
Lower credit costs were the primary factor driving an improvement in return on assets to 1.1 per cent in 9MFY23, outpacing Fitch’s FY23 estimate of 0.9 per cent, although earnings also benefited from higher-than-expected loan growth and improving net interest margins.
Also read: India Ratings revises MFI sector outlook to ‘improving’ from ‘neutral’
Fitch said Banks have a reasonable tolerance to absorb pressure from credit costs and margin normalisation, without affecting its FY24 profitability forecasts.
The agency assessed that pre-impairment operating profit at private banks, at 4.5 per cent of loans, offers greater headroom than the 3 per cent at state banks and supported private banks’ return on assets of 1.9 per cent, which far exceeded state banks’ 0.7 per cent.
Pressure on capital
Fitch observed that sustained high loan growth, accompanied by rising risk density, could pressure capital.
The sector’s common equity Tier 1 (CET1) ratio rose by around 54 bps in 9MFY23 to 13.3 per cent, alongside a 460 bps drop in the net impaired loans/equity ratio to 9.6 per cent.
Also read: Banking mergers in India have been beneficial to the banking sector: RBI paper
While the drop shows that unexpected risks to capital are easing, state banks’ CET1 ratio of 11.5 per cent – although improved over prior years – could be more at risk in a downside scenario than private banks’ significantly higher 16.3 per cent, per Fitch Ratings analysis.
Private banks also demonstrate better access to the equity capital market, reflected in state banks’ limited equity raising, preference for hybrid capital instruments and dependence on government recapitalisation.