BICRA Highlights

Banks in India are exposed to high economic risks despite relatively moderate private sector debt in the economy partly due to low-income levels. A weak legal framework for creditors in India substantially accentuates risks facing lenders. We see good growth prospects for the Indian economy over the next couple of years, but macroeconomic headwinds remain a key risk to the country's economic recovery. We believe that the banking sector's credit losses and nonperforming assets are heading towards long term average after unwinding of stresses in the banking system in the past four years. Economic recovery should restrain the imbalances in the next two years.

The Indian banking sector's funding profile remains a strength. Banking regulations are broadly in line with international standards although the financial regulator has a mixed record of preventing problems. Weak governance and transparency also undermine the institutional framework for the banking sector. We consider that directed lending by the government and the presence of many government-owned banks distort competition. We expect earnings of Indian banks to continue to improve as credit costs normalize.

Economic and Industry Risk Trends

The economic risk trend for the banks operating in India is stable. The ongoing economic recovery should help bring down the credit losses close to cyclical lows in the next two years. A continued rebound could ease imbalances or credit risks facing banks. In contrast, downside risks could emerge if the improving trend in the economy reverses and the slowdown is much more severe or prolonged than our current forecasts, or if we expect a significant increase in banks' nonperforming loans (NPLs) and credit losses.

We view the trend for industry risk for Indian banks as stable. We anticipate that the banking sector's funding profile will remain its strength. Strong deposit growth due to a high savings rate should offer efficient banks room to grow. India's institutional framework and competitive dynamics are likely to be stable over the next two years. We expect large banks to continue to gain market share and consolidate the industry. Competitive dynamics for the banking industry could worsen if the risk-adjusted profitability doesn't sustain at its improved levels in the next two years.

Economic Risk  |  7

Economic resilience: Low-income levels underscore economic risks for the banking system

Banks operating in India remain exposed to high economic risks in a low-income economy with GDP per capita that we estimate at slightly less than US$2,300 in fiscal 2022 (year ended March 31, 2022). In the medium term, we expect India to continue to achieve strong real GDP growth, well above the median for peers at a similar income level (see chart 1). Following the peak in COVID-19 cases around mid-last year, the Indian economy has embarked upon a solid recovery, well supported by improved consumer and business confidence. The ongoing broadening out of the recovery suggests that permanent costs are likely to be lower than previously estimated. The economy has been gradually stabilizing after COVID-19-related shocks in 2020 but it will take a while to fully recover, in our view. Moreover, despite sound growth prospects, India is likely to remain a low-income economy in the medium term.

Chart 1

We expect real GDP growth to remain healthy in medium term, despite some downside risk. Our projections for strong post-pandemic growth are predicated on the country's constructive structural trends, including healthy demographics and competitive unit labor costs. However, the crisis in Ukraine has increased the downside risk to our forecast for the current fiscal year. Our macroeconomic outlook is predicated on an average Brent crude price of US$85-US$90 per barrel in fiscal 2023. Should market prices of key commodities remain higher than our forecast for a longer period, this could weigh on our economic growth and current account projections, while adding to inflation risks.

India faces significant weaknesses in its macroeconomic policy flexibility. These weaknesses do not currently detract from the economic resilience in relation to the banking industry. Nevertheless, persistent fiscal deficits at the state and central government levels, combined with a large general government debt stock and high interest burden, constrain fiscal policy flexibility, in our view. Reforms that spur investment and job creation will be important determinants of India's ability to maintain its strong economic recovery momentum over the next few years.

The Reserve Bank of India (RBI) has made substantial progress in lowering inflation since 2015, when it introduced a medium-term inflation target band of within 2 percentage points of 4%. CPI inflation has generally remained within the central bank's boundaries in recent years. However, year-on-year (y-o-y) CPI inflation exceeded this target range for the third straight month in March 2022, surging to nearly 7%. Sustained inflation pressures above the RBI's target could pressure the central bank to normalize its accommodative monetary policy stance more quickly. On May 4, 2022, the RBI in an off cycle meeting hiked its policy repo rate for the first time since 2018 and cash reserve ratio, citing near-term inflation risk.

Table 1

Economic imbalances: Imbalances are normalizing as the economy recovers

We consider that banks in India remain exposed to intermediate risk of a significant increase in credit losses. Nevertheless, in our base case, we see the credit losses and nonperforming assets heading towards cyclical lows after unwinding of stresses in the system in the past four years. Economic recovery--including improved consumer and business confidence, healthy GDP growth, and falling unemployment--should restrain the imbalances in the next two years. We project the banking sector's weak loans declining to 5%-5.5% of gross loans by early 2024 (see chart 2). Likewise, we forecast the credit costs for fiscal 2022 to fall to the lowest in seven years and recover further up to fiscal 2024. This would make credit costs comparable to that of other emerging markets and to India's 15-year average.

Chart 2

After two years of tepid loan growth, credit demand is reviving in line with a higher-speed economy. In the next two years, we expect private sector debt to grow broadly in line with the nominal GDP. Given the underpenetrated retail-loan market, this segment will continue to drive loan growth. Corporate loans will pick up more slowly, however, and they will remain driven by working-capital needs. Larger corporates should also commence capital expenditure (capex) in the next one year, which will further support growth in private sector debt. We believe capex-related growth will accrue to the banking sector only with a lag.

We expect low interest rates, tax concessions by state governments, and the continued economic recovery over the next 12-18 months to improve demand for residential property. We estimate that inflation-adjusted real estate prices will rise marginally on a national level over the next 12-18 months.

We expect India's current account to experience progressively larger deficits over the next few years. Though we expect these deficits to be manageable, substantially higher energy prices could drive the shortfall higher, particularly if those price levels are maintained over an extended period. India's sound external metrics have strengthened its foreign exchange reserves in recent years. The government's limited external debt position also moderates currency and capital flight risk, in our opinion. We project India's narrow net external debt position, a measure of the economy's net foreign indebtedness, to remain in surplus for the next four years, supported by favorable current account developments and continued net foreign direct investment inflows.

Table 2

Credit risk in the economy: Legal framework weaknesses exacerbate credit risks

Banks in India are exposed to very high credit risks despite relatively moderate private sector debt in the economy partly due to low-income levels. In addition, the weak legal framework for creditors in India substantially accentuates risks faced by the lenders. Delay in resolution of NPLs has contributed to the sizable level of stressed assets. We estimate that the banking sector's weak loans will remain high in the next two years despite an improving trend. Formation of the incremental NPLs should slow down and recoveries of NPLs should gain momentum.

We forecast private sector debt to remain at about 75% of GDP, with rising household debt likely to offset a deleveraging corporate sector. India's credit-to-GDP ratio is much lower than that of some other large countries such as China (see chart 3). However, at the same time the income levels as measured in per capita GDP is also the lowest. Bank loans to the household sector form about 28% of banking system loans, up from 20% five years back. Indian banks' loan books are generally diversified. None of the nonretail segments account for more than 10% of loans (except agriculture, which is well diversified). Commercial real estate and construction exposures are limited, respectively about 2.5% and 1.1% of the total loans. We consider that regulation and policy help in limiting and managing single name and foreign currency exposures.

Chart 3

Micro and small and midsize enterprises (MSMEs) account for about 15% of the Indian banking sector's total advances as of March 31, 2021. Despite the government's emergency credit guarantee plan for new loans to MSMEs, this sector remains more exposed to an economic slowdown. Moreover, as the moratorium on principal repayments ends, some MSMEs at the margin could turn delinquent.

Residential mortgages form about half of the total lending to households. We consider this segment to be low risk reflecting the banks' focus on prime customers and regulatory ceiling of 80% loan-to-value (for loans over Indian rupee (INR) 3 million). There has been a rise in the proportion of self-employed borrowers and non-prime borrowers in the past few years. However, good availability of data via credit bureaus has contributed to a general credit discipline.

Unsecured personal loans and credit card debt could also contribute to incremental NPLs; together these debts account for about 11% of loans in the banking system. With an economic pick-up, residual stress for small and midsize enterprise and retail sectors should start abating.

The Insolvency and Bankruptcy Code, 2016 (IBC) tilted the balance of power toward lenders. However, progress on resolution is still slow. Recovery process is still long, and several large cases are yet to be resolved. The resolution process is hit because of ongoing litigations to settle various points of law. The government has been taking steps to further improve the IBC process. For example, it recently amended the IBC act to make available a pre-pack resolution window for MSMEs, which could speed-up insolvency resolution while maintaining business continuity so that the asset value is preserved. Likewise, India is also in the process of establishing a "bad bank", which will buyout some of banking system's nonperforming loans. But the progress on these measures remains slow and the effectiveness needs to be seen.

Table 3

Industry Risk  |  5

Institutional framework: Governance and disclosure issues heighten risks

Banks operating in India face high risk institutional framework, in our view. India's banking regulations are broadly in line with international standards, in our opinion. That said, we believe that weak governance and transparency undermine the institutional framework for the banking sector. In addition, we view the RBI, which also functions as the banking regulator, as moderately free from political influence.

The RBI has a mixed record of preventing problems in the banking sector, in our view. The RBI has facilitated market driven solutions such as mergers with the larger banks to prevent contagion risks from distressed banks. However, holders of additional Tier 1 and tier-2 banks in weak private sector Indian banks have suffered losses when these banks faced problems.

The RBI regulates only banks and nonbank finance companies (NBFCs) including housing finance companies. Other regulators oversee other financial intermediaries such as insurance companies and mutual funds. In recent years, the government has been strengthening the scope of RBI's regulation, and its supervisory powers. RBI has also enhanced its regulation and reporting for NBFCs. For example, it has introduced more granular liquidity management requirements.

We consider that the Indian government and the RBI support fintech development and competition. The authorities encourage collaboration with other industry players toward this shared goal. That said, the central bank is also performing a balancing act by taking measured steps in fintech regulation to maintain financial stability in the sector.

Competitive dynamics: Distortions impair some banks' ability to price for risk

Banks operating in India face high risk competitive dynamics, in our view. We consider the risk appetite of Indian banks to be adequate. We expect the structure of the Indian banking industry to remain stable with large banks dominating and gaining market share for at least the next two years. The entry barriers for banks continue to be high. The regulator has granted full banking licenses to only two banks in the past 10 years. Nevertheless, we consider that directed lending and the presence of many government-owned banks distort competition.

Government-directed lending to certain "priority" sectors forms about 40% of total loans. However, the government only broadly defines the priority sectors and does not directly influence banks' credit decisions. Priority sectors include residential mortgages, agriculture, export-oriented companies, social infrastructure, renewable energy, and small companies. We consider that such directed lending generally interferes with the allocation and pricing of credit in an economy. In addition, banks in India are required to invest 18% of their net demand and time liabilities in government securities; effectively financing a significant part of government deficit, which is a drag on banks' interest margins.

Many banks and nonbank financial institutions operate in India, leading to a fragmented industry structure. However, an underpenetrated financial market offers good growth prospects to the better performing banks.

Public sector banks (PSBs) dominate the industry, and account for about 63% share of customer deposits. Since 2017, the government has reduced the number of PSBs to 12 from 27, and it plans to further reduce this to five banks. In the budget for fiscal 2022, the government mooted a plan for privatization of two PSBs. We expect this process would require legislative changes, and it should improve system efficiency in the longer term. Consumer and commercial finance companies (fincos) play an important role in credit delivery in India, accounting for about a quarter of the loans. Despite higher funding costs than banks', many of the larger fincos are very profitable with overall return on assets of 1.5%-2% in the past three years. Their earnings benefit from lower operating costs than banks', strong niche positions, and an absence of regulatory drag on margins.

Despite rapidly growing fintech participation, digital disruption poses a relatively low risk to the top-tier banks in India, in our opinion. Many banks have been quick to embrace new technologies to cater to a vast and growing, young, technologically savvy customer base. We believe that India's top-tier private-sector banks and SBI are well-placed to leverage technological advancements.

We expect bank earnings to return to 1% ROAA next year, after many few years of subdued earnings (see chart 4). Lower-credit costs, a pick-up in loan growth, and rising interest rates should help in the turnaround. Sales of NPLs to bad banks could also lead to one-off gains and provide an upside to banking system's profitability.

Chart 4

Table 4

Systemwide funding: Strong deposit franchise supports funding

Banks in India face low funding risks. Customer deposits predominantly fund banks in India, and a large proportion of deposits are from households. Consequently, Indian banks have a low reliance on cross-border funding or domestic debt capital market. Indian banks' wide branch networks, the country's high domestic savings, deposit insurance, and sizable retail customer base support banks' deposit franchise, in our view. The perceived safety of bank deposits, and an increase in the bankable population due to rising income levels and favorable demographics, should support deposit growth over the next few years.

Banking system funding should remain predominantly through stable deposits. During the pandemic, deposit growth has remained robust and in line with the past 10-year trend at about 12% per year due to precautionary savings in the face of high uncertainty. On the other hand, loan growth was subdued leading to improvement in the credit-to-deposit ratio to about 70%. We expect deposits to grow at similar levels as credit for the next couple of years.

We view the domestic debt capital market in India to be moderately broad and deep. The market is active for issuance of high-investment-grade bonds with medium- to long-term maturities.

The government and central bank offer a range of conventional and non-traditional policy tools to support bank funding, if needed. The RBI uses tools such as the liquidity adjustment facility, market stabilization scheme, open market operations, and relaxation on investments under statutory liquidity facility (government security holdings). During the global financial crisis in 2008, and also during the COVID-19-related slowdown, the RBI provided liquidity to the financial system through special repo windows. It did that by allowing temporary use of statutory liquidity ratio securities, and by creating a special purpose vehicle that could raise funds from the RBI against government securities to meet requirements of some fincos.

Table 5

Peer BICRA Scores

We believe banks in India face higher economic risks than some peer banking systems due to the country's relatively low income levels and higher credit risk. Banks in India are exposed to very high credit risks despite relatively moderate private sector debt in the economy partly due to low income levels. In addition, the weak legal framework for creditors in India substantially accentuates risks faced by the lenders. On the other hand, we expect the imbalances to normalize as the economy recovers.

India has a superior funding profile than many peer banking systems. Core customer deposits form a high proportion of funding in the system. However, India's institutional framework is weaker than some of its peers' due partly to poorer transparency and governance challenges.

Table 6

Government Support

We believe the Indian government is highly likely to intervene directly and rescue systemically important banks, if needed. There is a record of the government injecting capital into weak PSBs (when needed) and facilitating mergers of financially distressed banks with stronger banks. The government has historically not allowed commercial banks to fail by swiftly stepping in, when needed.

We expect government support to systemically important banks to continue. This is because banks play a key role in the economy, particularly in providing funding to priority sectors. Bank depositors also form a large political constituency. Furthermore, government-owned banks dominate the Indian banking system. The majority ownership also puts a moral obligation on the government to proactively maintain the health of banks, in our opinion.

In 2018, the government withdrew a parliamentary bill related to resolution framework for financial firms. The bill included a proposal to bail-in deposits, which was opposed by many stakeholders including the public.

Table 7

Related Criteria

• Banking Industry Country Risk Assessment Methodology And Assumptions, Dec. 9, 2021
• Financial Institutions Rating Methodology, Dec. 9, 2021
• Environmental, Social, And Governance Principles In Credit Ratings, Oct. 10, 2021
• Sovereign Rating Methodology, Dec. 18, 2017
• Country Risk Assessment Methodology And Assumptions, Nov. 20, 2013

Related Research

• Banking Industry Country Risk Assessment Update: April 2022, April 26, 2022
• Economic Outlook Emerging Markets Q2 2022: Growth Slows Amid Higher Commodity Price Inflation, March 29, 2022
• India, March 3, 2022
• Asia-Pacific Banks Outlook 2022: The Long And Winding Road (To COVID Recovery), Jan. 25, 2022
• As India's Banks Grow Again, Will Old Mistakes Return?, Nov. 29, 2021