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Key Takeaways from RBI's Latest Financial Stability Report (FSR)

Jan 6, 2022 7:33 AM 5 min read

Last week, the RBI released the latest iteration of its biannual Financial Stability Report (FSR).

The FSR (link) reflects the views of the Central Bank on risks to financial stability and the resilience of the financial system. This time around, the RBI has highlighted that Indian banks have fared better than expected during the pandemic.

But the regulator has also warned that with global economic recovery losing momentum with resurfacing lockdowns, rising Omicron infections, supply disruptions and bottlenecks, elevated inflationary levels, and shifts in monetary policy stances, the near-term outlook remains fraught with risks.

Let’s begin with the banks.

Up, Down, and Up Again

Various measures by GoI and the RBI - such as the loan recast scheme, the loan moratorium facility, the ECLGS, the bad bank, PSB reforms, and, of course, the IBC - have managed to bring down lenders’ gross NPA ratios (which peaked at 11.5% in March 2018) over recent years and also limited the inadvertent spike in bad assets during the pandemic.

The RBI report says gross NPAs have continued their downward trajectory. As of March 2021, bad loans stood at 7.3%, down from 8.2% last March Moreover, provisional data points to a further moderation this year, down to 6.9% at the end of September 2021. To add to this, the 2021 edition of Trends and Progress in Indian Banking shows a 10x jump in bank profitability, from ₹10,911cr ($1.46bn) in 2019-20 to ₹1,21,998cr ($16.36bn) in 2020-21.

These are encouraging numbers, but lest we forget - about ₹10Lcr ($132.21bn) worth of stressed assets remain in the system. And with lockdowns back and inflation on the upside, the economy had entered more uncharted territory.

The Central Bank has added that the asset quality improvement is due to lower slippages but also due to write-offs - lenders wrote off ₹2.08Lcr ($27.89bn) of bad loans during this period - and fiscal and monetary measures. Given that these measures are temporary and that recoveries through all channels - Lok Adalats, debt recovery tribunals, the SARFAESI Act, and the IBC - have actually declined from 22% (of the total amount involved) in 2019-20 to 14.1% in 2020-21, a spike in bad loans is expected in 2022.

The regulator’s stress tests predict that bad loans could jump to 8.1% by September 2022 under a baseline scenario (10.5% for PSBs and 5.2% for private banks) and to 9.5% overall under a severe stress scenario.

However, the FSR argues that all 48 lenders that have been a part of the study have sufficient capital, both at the aggregate and individual levels, to maintain minimum regulatory capital and weather both scenarios at the same time. (The capital adequacy ratio, presently at 16.6%, may drop to 15.4% under the baseline scenario and to 13.8% under the severe stress scenario.)

The RBI also said that lenders' increasing reliance on the retail segment to grow their loan books faces headwinds as (1) delinquencies increase in the consumer finance portfolio, and (2) the new credit segment suffers a slowdown.


Fintech Fever

Speaking of assets gone bad, loan repayment delays and defaults have spiked up in the burgeoning fintech space.

Delinquency levels have risen from 1.82% of loans sanctioned by fintechs in September 2020 to 4.56% in September 2021. This number was much higher than the same for private banks (2.23%) and NBFCs and HFCs (3.77%), and slightly lower than PSB delinquencies (5.03%). And in all these categories, fintech and digital lending is the only lending that has registered an uptick in defaults.

A bad loans crisis in the nascent fintech segment would be a headache regulators could do without right now, especially so considering that the sector is an underregulated one.

The FSR has highlighted that “digitalisation of financial services can…bring in its wake various risks such as greater reliance on third-party service providers, misselling of financial products, breach of data privacy, unethical business conduct, and illegitimate operations”.

As such, the Central Bank has said it recognises the need for a regulatory and supervisory framework “to ensure orderly development of the fintech sector and address the associated issues” and towards that end it is “in the process of consolidating all fintech-related work under one umbrella”.


Crypto Clampdown

The regulator reiterated its stance that private cryptocurrencies “pose immediate risks” to customer protection, anti-money laundering initiatives, and combating the financing of terrorism.

The RBI argued that they are “prone to frauds and to extreme price volatility, given their highly speculative nature” while “longer-term concerns relate to capital flow management, financial and macro-economic stability, monetary policy transmission and currency substitution”. It added that the rapid growth of decentralised finance (DeFi) is “geared predominantly towards speculation and investing and arbitrage in crypto assets, rather than towards the real economy”.

While the Central Bank’s crypt-hesitancy is old news, it assumes increased significance in light of the ongoing discussions to formulate a law regulating or banning private digital coins as well as on whether or not to develop a Central Bank Digital Currency (CBDC). The regulator has no qualms about the latter at least.


Miscellaneous Matters

The RBI also highlighted various regulatory measures taken over the past year, such as the Prompt Corrective Action (PCA) Framework for NBFCs, the Retail Direct Scheme for investing in G-Secs, the Integrated Ombudsman Scheme, the Financial Inclusion Index etc.

The FSR also again took note of the "disconnect" between the stock market and the real economy. It was noted that Indian equities were trading at rich valuations and that the stock market rally had continued unabated - not counting last two weeks' volatility - even as broader economic metrics remained on shaky ground.

Also highlighted was the increasing participation in day-trading, IPOs, futures, and options of retail investors, "whose shareholding in companies listed on the NSE has increased from 6.4% in December 2019 to 7.1% in September 2021, in value terms".

The possibility of requiring “additional provisioning at early stages of impairment to internalise the costs imposed by delay in resolution of assets under the IBC” was also mooted (lenders are likely to frown on this suggestion).

The Central Bank also expressed doubts over whether the Union Government would be able to limit the fiscal deficit at 6.8% this FY, considering that the latter has already moved the second supplementary demand for grants worth ₹3.73Lcr ($50bn) despite an 83% uptick in net tax revenue.

The FSR reports that NBFCs are now better-positioned to withstand credit or liquidity squeezes, even though infrastructure finance companies (IFCs) are in the red. And even as SCBs stage a steady recovery, cooperative lenders in semi-urban and rural areas are witnessing greater asset quality stress, particularly since the Second Wave hit.


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