Talking Point. The RBI and systemic risk

For about five years now, the RBI has been publishing the Financial Stability Report which studies financial system risks having a bearing on the economy. The December 2015 report carries forward the theme of increased risks from the banking system. The RBI calculates a Banking Stability Indicator and tracks banking sector risk using its movements — higher the indicator value, lower the stability. The Indicator has been on the decline since 2010. It combines the impact of five factors — soundness, profitability, efficiency, asset quality and liquidity.

That the stress on the banking sector has been on the rise is well known. What is interesting here is what factors are causing this stress. Intuitively, one would expect asset quality to be the key factor, but according to the methodology applied in the report, liquidity and profitability pose bigger risks. This ties in with the fact that while the non-performing asset (NPA) ratio can be managed through sales to asset reconstruction companies and debt restructuring, liquidity pressures do not go away, which is the real problem of bad loans. This is so because banks deal in financial assets and it is the orderly flow-back of assets rather than profits that sustains them.

Gross NPAs rose from 4.6 per cent to 5.1 per cent of total advances between March and September, indicating no end in sight to the problem. A greater concern is the pipeline of stressed assets (gross NPAs plus restricted standard loans), though marginally lower at 11.1 per cent, represent NPAs-in-waiting. The RBI seems to believe that it is the excessive leverage that is telling on banks.

But according to the Ministry of Corporate Affair’s database covering nearly 20,000 non-government and non-financial companies, the overall leverage has been 30-40 per cent; even small and mid-size companies had leverage ratios of less than 100 per cent. This is not so significant considering the RBI’s own classification of leveraged (debt-to-equity ratio >2) and highly leveraged (debt-to-equity ratio >3) companies. It is the skewness of the data that is the issue — five sub-sectors, namely mining, iron & steel, textiles, infrastructure and aviation, which together constituted 24 per cent of total advances from banks as of June 2015, contributed to 53 per cent of the total stressed advances. These are all old-sector core industries requiring large capital outlays and long gestation periods — hardly a recipe for bank lending, given their short asset-liability profiles and preference for short-term profitability and retail focus. This is a historical legacy (especially for public sector banks), caused by the demise of specialised term lending institutions.

In an earlier report, the RBI had opined that banks have been found wanting in project appraisal competencies and cautioned them on relying overly on outsourced project appraisals.

There is further skewness; the top 100 large borrowers account for nearly 18 per cent of total bank credit and the contribution of this segment to overall GNPAs has shot up from 0.7 per cent to 3.1 per cent between March and September. It is, therefore, clear why the problem refuses to go away and also why there is urgency about pushing through the Insolvency & Bankruptcy Bill.

In spite of falling profitability and rising NPAs, banks managed a capital to risk weighted assets ratio (CRAR) of 12.7 per cent. But the RBI warns against complacency. Several stress tests carried out for credit risk revealed that extreme movement in NPAs would seriously jeopardise CRAR and profitability.

Interestingly, the liquidity stress tests scenarios to test banks’ ability to meet a run on their deposits using only their liquid assets showed that they were able to withstand the pressure of the assumed sudden withdrawals by depositors with the help of their statutory liquidity ratio (SLR) investments. This probably explains why banks invest in SLR securities beyond required levels.

The writer is an independent consultant