BANKING IN INDIA: SYSTEMIC RISK AND HOW TO ADDRESS IT
This article analyses the Reserve bank of India’s Financial Stability Report with regard to the systemic risks faced by the banking sector in India.
MEASURES OF BANKING STABILITY
The RBI reports that the risks to the banking sector have increased since June 2012 and that all major risk dimensions captured in the Banking Stability Indicator (BSI), which measures the expected number of banks that could become distressed given that at least one bank becomes distressed, show increase in vulnerabilities in the banking sector. The BSI takes into account individual bank’s probabilities of distress besides embedding banks’ distress dependency. Therefore, the indicator exhibits larger and nonlinear increases than the Probabilities of Distress of individual banks. The analysis of RBI uses network tools to assess impact of contagion due to risk of credit concentration. The spread in the banks’ toxicity indices during the current period is more divergent than the spread observed during the financial crisis. This means that the ability to transmit the distress to other banks has diverged. The spread among the banks’ vulnerability indices is lower than the spread observed during the financial crisis, indicating that rise in the vulnerability of SCBs has become more broad-based. The vulnerability levels are however significantly lower than the levels observed during the crisis.
RISK DUE TO INTERCONNECTEDNESS
Financial contagion refers to a scenario in which small shocks, which initially affect only a few financial institutions or a particular region of an economy, spread to the rest of financial sectors and other countries whose economies were previously healthy, in a manner similar to the transmission of a medical disease. At the domestic level, usually the failure of a domestic bank or financial intermediary triggers transmission when it defaults on interbank liabilities and sells assets in a fire sale, thereby undermining confidence in similar banks. The current analysis of the central bank captures contagion effects under different conditions– stressed credit and interest rate scenarios. These stressed conditions lead to losses in capital due to additional provisioning requirements. If the loss is large enough to cause distress to one or more banks, there will be further losses due to the contagion effect brought about by the distressed banks. The extent of contagion will however be proportional to the importance of the distressed bank in the network. Hence if the distressed bank occupies a central position in the banking system, then the credit environment will be stressed and lead to contagion losses to other interconnected banks which will be substantial. The total loss to the banking system due to the stressed conditions will thus be the summation of the percentage loss caused by the stressed conditions, and the percentage contagion losses due to distress in one or more.
The analysis also shows that the total loss to the banking system after taking into account contagion losses could exceed losses due to the direct impact of the stressed conditions alone. For example, let us consider a scenario where NPAs have doubled. This could cause an initial loss of about 14% of the total capital whereas the total loss to the system would be about 40%, the additional loss being due to contagion effect. These risks will need to be taken into consideration while assessing the impact of credit and interest rate shocks on the banking system.
CORPORATE DEFAULT
It goes without saying that the failure of a corporate borrower or group causes a direct loss to the banking system to the extent of the banking system’s exposure to the borrower or group. The extent of failure varies depending on the degree of the loss given default of the borrower or group. The total loss to the banking system from the failure of the corporate borrower or group will then typically be distributed across banks in proportion to their individual exposures to the group. If, in the case of one or more banks, the loss is large enough to cause distress to the bank, then there will be further losses to the banking system due to the contagion. This is a great source of concern and steps should immediately be taken to impose limits on the exposures taken by banks. In this regard, guidance may be taken from the Basel Committee which in a consultative document on “Supervisory Framework for Measuring and Controlling Large Exposures – Consultative Document”, published in March 2013, has proposed that the threshold defining large exposure should be set at 5 per cent of a bank’s eligible capital base and that the large exposure limit may be fixed at 25 per cent of Tier 1 capital (as against the currently used total capital). In India currently, the exposure ceiling limits are 15 percent of capital funds in case of a single borrower and 40 percent of capital funds in the case of a borrower group. The capital funds comprise of Tier I and Tier II capital.
SOLVENCY AND LIQUIDITY RISKS
A bank typically has both positive and negative net lending positions against other banks. In the event of failure of such a bank, both solvency and liquidity contagion will happen concurrently. The business model of many banks involves performing the financial intermediation role known as maturity transformation – on the whole, channelling collective funds obtained through shorter term borrowing into longer term loans and investments. This creates a maturity mismatch between the dates on which the bank’s liabilities fall due for payment and the dates on which it can call for repayment of its assets. This makes banks’ funding models inherently unstable. Confidence in a bank’s solvency is what sustains this business model. Depositors and other lenders roll over their loans to the bank, or other lenders replace them, when they are confident that the bank will continue to be solvent and viable. On the other hand, fear about the future solvency of the bank may provoke expectations of delayed repayment or non- The key issue for banks is that in practice any signalling of uncertainties about their solvency or liquidity may undermine confidence in their ability to repay their debts and trigger a run on the bank.
When a failing bank becomes insolvent it impacts all its creditor banks. At the same time it starts to liquidate its assets to meet as much of its obligations as possible. This process of liquidation generates a liquidity contagion as the trigger bank starts to call back its loans. The lender/creditor banks which are well capitalised will survive the shock and will generate no further contagion. On the other hand, liquidity risk is a primary source of risk to banks and may quickly translate into solvency risk and those lender banks whose capital falls below the threshold core capital ratio of 6 per cent will trigger a fresh contagion. Similarly, the borrowers whose liquidity buffers (for the analysis, excess CRR, excess SLR, available MSF and available export credit refinance are considered as liquidity buffers) are sufficient will be able to tide over the stress without causing further contagion. But some banks may have to call back certain assets (for the analysis, only short term money market asset have been assumed to be callable) after exhausting its liquidity buffers to address the liquidity stress. This process of calling in short term assets will again propagate a contagion.
Further, insolvent banks with toxic assets are unwilling to accept significant reductions in the price of the toxic assets, but potential buyers were unwilling to pay prices anywhere near the face value of loans. With potential sellers and buyers unable to agree on prices, the markets may freeze with no transactions occurring. The contagion from both the solvency and liquidity side will stabilise when the losses are fully absorbed by the system with no further banks coming under duress.
ASSET QUALITY
Non Performing Assets (NPAs) of the banking sector need to be tackled on a priority basis to ensure that they do not grow to alarming proportions. The RBI has revealed that the banking system is facing a high tide of bad loans. The gross non-performing assets (NPAs) in the financial system will rise to 4.6 per cent by September 2014 from 4.2 per cent in September 2013. The amount of recast loans touched an all-time high of 10.2 per cent of the overall advances as of September 2013. The state-run banks will be the worst-affected, the report said, pegging the gross NPAs for public sector banks at 4.9 per cent by March 2015. It projected the gross NPAs for private banks at 2.7 per cent in the same period.
Asset quality continues to be a major concern for Scheduled Commercial Banks (SCBs). Before 2008, asset quality of SCBs was improving. The Gross Non-performing Assets ratio had declined sharply from 12.0 per cent as at end March 2001 to 3.5 per cent as at end March 2006 and thereafter this ratio was flat till March 2011. The Gross Non-performing Assets ratio has been persistently rising since then. The Gross Non-performing Assets ratio as well as the restructured standard advances ratio has increased. The total stressed advances ratio rose significantly to 10.2 per cent of total advances as at end September 2013 from 9.2 per cent of March 2013.
Among the bank-groups, the public sector banks continue to have distinctly higher stressed advances at 12.3 per cent of total advances, of which restructured standard advances were around 7.4 per cent. Five sectors— infrastructure, iron & steel, textiles, aviation and mining— have a high level of stressed advances. At system level, these five sectors together account for around 24 per cent of total advances of commercial banks and around 51 per cent of their total stressed advances. As per the report, the following table lays out the share of stressed advances for the top five stressed sectors:
Sector |
% of Total Advances |
% of Stressed Advances |
Infrastructure |
14.7 |
30.3 |
Iron and Steel |
4.7 |
9.2 |
Textiles |
3.4 |
7.4 |
Aviation |
0.5 |
3.5 |
Mining |
0.6 |
0.8 |
One of the major reasons behind this accelerated credit growth could be the competitive credit disbursal under the past PLR regime and surplus available with banks for credit due to sharp decline in the statutory liquidity ratio from 30.5 per cent of total assets as at end March 2005 to 22.6 per cent as at end March 2008. In addition, the push for infrastructure projects, many of which was not cleared later on, also resulted in accelerated growth in Gross Non Performing Assets since 2006.
The stressed advances of medium and large sized industries (including large projects) account for 16.3 and 17.1 per cent of total advances to the respective segments, whereas, in the case of ‘micro & small’ sized industries stressed advances were around 8.2 per cent of the total advances to the segment. The services sector has also been registering similar trend but their stressed advances ratio is lower than that of industries. Medium and large segments of both industries and services taken together have stressed advances ratio around 14.5 per cent of total advances in that segment and in the case of public sector banks they are around 17 per cent followed by old private banks at 13.6 per cent. Though the share of medium & large segments to total loans is the highest for foreign banks around 74 per cent, the level of stressed advances in this bank-group is only 4.2 per cent. The share of medium & large segments to total loans is the second largest for the public sector banks and they also have the highest stressed advances in this segment.
From the macro stress tests on credit risks, the Gross NPA ratio of all SCBs can be expected to rise to around 4.6 per cent by September 2014 from 4.2 per cent as at end September 2013, which may subsequently improve to 4.4 per cent by March 2015 if the macroeconomic conditions improve. Whereas, if the macroeconomic conditions deteriorate further, the GNPA may rise further and under severe stress conditions, it could move up to 7.0 per cent by March 2015. Under such severe risk scenario, the system level CRAR of SCBs could decline to 11.1 per cent by March 2015, but still remain above the regulatory requirement of 9 per cent.
The central bank is implementing a repository of non-performing loans but that may not slow down the pace of creation of fresh non-performing loans. All this may mean that banks will ultimately have to take a haircut to resolve the issue. In case of projects with a longer useful life, the haircut may be less, but for shorter duration projects, the haircut will be large. Further there may be the need to recapitalize several banks.
NON DEPOSIT TAKING SYSTEMATICALLY IMPORTANT NBFCs
Capital to risk-weighted assets ratio (CRAR) norms were made applicable to NBFCs-ND-SI with effect from April 2007, in terms of which every systemically important non-deposit taking NBFC is required to maintain a minimum capital, consisting of Tier-I and Tier- II capital, of not less than 15 per cent of its aggregate risk-weighted assets. The aggregate CRAR of the ND-SI NBFC sector stood at 28.4 per cent for the quarter ended September 2013 as against 27.4 per cent in the corresponding quarter of 2012. The gross NPA ratio of the ND-SI sector stood at 3.5 per cent for the quarter ended September 2013 as against 3.1 per cent for the same quarter in the preceding year.