What the RBI’s Financial Stability Report reveals about the banking sector

Source: The post is based on the article “What the RBI’s Financial Stability Report reveals about the banking sector” published in the Indian Express on 5th August 2022.

Syllabus: GS 3 Issues and Challenges Pertaining to the growth and development of the Indian Economy; Investment

Relevance: Bank reforms, regulatory reforms, Infrastructure Investment related reforms

News: Recently, the RBI released its latest Financial Stability Report (FSR) which talks about the health of the Indian Banking System.

What were the findings of the report?

The RBI has stated that the banking system is healthy, considering the stress of the previous decade. The two key indicators clearly demonstrate the progress in the banking system:

(1) The Bank’s financial situation has been improved by successive waves of recapitalization. Therefore, banks have written off most of their bad loans. Therefore, they brought down their gross non-performing loans (NPAs) from 11% of total advances in 2017-18 to 5.9% in 2021-22.

(2) Due to the above said financial turnaround, the banks have the space to resume their business of extending credit.

Why the improvement in banks’ financials is a glass half-full picture?

(1) It is still unclear whether the banking system is healthy enough to finance the strong economic recovery or GDP growth. There are various factors behind it:

(a) Over the last decade, banks have increasingly shifted away from providing credit to industry or financing investment. Now, banks are lending more to consumers. For example, the share of industry in total banking credit has declined from 43% in 2010 to 30% in 2020, and consumer loans have increased from 19% to 29%.

(b) Most of the industry credit/loan has been extended to the smaller firms or MSMEs. For example, due to the credit guarantee scheme in the wake of the pandemic, the loan growth for MSMEs has gone up from 3 percent in 2020 to 31 percent in 2022.

(3) There has been little lending for private sector investment for infrastructure creation. Most of this went for public sector capital expenditure. Much of the lending to the private industry has been in the form of working capital loans, necessitated by the increase in commodity prices.

Why is there so little lending for investment by large firms?

There has been a situation of risk aversion on the part of firms and banks in terms of private sector investment:

On the demand side, private sector investment has been sluggish for nearly a decade after the boom-and-bust of the mid-2000s. The firms have little reason to expand their production facilities.

On the supply side, most of the bank loans given during the period 2004-09 for large infrastructure projects turned bad, leading to high levels of NPAs. Therefore, banks were unable to extend credit for a decade.

Thus, even when their health improved, they remained wary of lending to large-scale industrial projects, preferring instead to shift to smaller-scale and less risky consumer lending.

Why has the perception of risk aversion not changed even during the post-pandemic recovery?

There is still no framework that will reduce the risk of private sector investment in infrastructure.

The banks do not have a reassurance that in case the NPA problems do develop, the problem will be resolved expeditiously. The Insolvency and Bankruptcy Code has been plagued by delays and other problems.

Now, there are other issues like heightened global macroeconomic uncertainty, growing geopolitical tensions, and uncertain recovery prospects of India’s domestic economy.

A healthy balance sheet of the banking sector is necessary, but not sufficient for economic growth.

What should be done?

Both banks and firms have to be willing to take on the risk of investment in industry and infrastructure.  

Deep structural reforms should be introduced to the infrastructure framework, the resolution process, and management processes at the banks themselves.

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