RBI Financial Stability Report: There is good news and bad news, but where is the plan of action?

The Financial Stability Report is a very important document on the financial sector as it analyses threadbare the overall state of the various segments as well as highlights the risk-related issues that have been identified which can cause potential challenges. The level of interest normally has always tended to be in the direction of what the Reserve Bank of India (RBI) had to say about banks as this is the document that provides everything one wants to know about these institutions. This time, however, the expectation was more on how the RBI viewed the non banking financial company (NBFC) piece as the developments in this segment have caused considerable turbulence in the market.

The report does not disappoint and puts the current scenario in perspective. The main takeaway is that there is no need to panic. The RBI report, however, does not indicate the future likely action on its part but talks of what has been done to assuage the market.

Let us look at banks first. The FSR is happy with the state of the banking system as the gross non performing asset (NPA) ratio is 9.3 percent for all banks as of March 2019 and is likely to come down to 9 percent by March 2020. More importantly, the asset recognition process is completed and from now on the NPAs will be on new credit given and not legacy lending. This is good news. Also, banks are better capitalised today and public sector banks (PSBs) average of 12.2 percent is commendable and the support provided by the government has helped.

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The FSR also is praise for the banking system, especially PSBs for improving the Provision Coverage Ratio to 60.8 percent as against an average of 60.6 percent for the entire system. The growth in credit has picked up for PSBs which is a sign that they are on the road to normalcy. Therefore, the view on the banking system is sanguine and the fact that NPAs are under control means that the other parameters will only improve. Lower NPAs mean fewer provisions which in turn improve profits and removes pressure from the net worth and hence further demand for capital. This virtuous chain can be improved upon in the coming years as long as the quality of assets is maintained.

The report points out that the problem areas in terms of NPAs still remain metals, mining and engineering where the ratios are above 25 percent while construction, gems and jewelry and auto follow next with ratios of 21.8 percent, 21.5 percent and 18.4 percent respectively. It will need to be seen as to how the new norms of dealing with stressed assets by the RBI work out for these sectors. The RBI has also indicated that the recovery rate for the cases under the IBC is around 40-45 percent which is definitely better than the ratios of less than 20 percent which were the norm prior to the implementation of the IBC.

Representational image. Reuters.

The NBFC discourse is more of an eye-opener as the FSR highlights first their importance in our financial system. Around 70 percent of their liabilities are raised from the public and their size of Rs 28.8 lakh crore compared with the banking assets size of roughly Rs 140 lakh crore, and hence is around 20 percent that of the latter. This can give us an idea of the importance of this sector as it reaches out to several corners where probably banks are less interested.

The RBI’s assessment is three-fold. The first part pertains to how it views the sector. The view given is that in general the well-run NBFCs have no problem and are progressing smoothly. However, those which started off with a fundamental asset/liability managment (ALM) mismatch are the ones which have faced a series of challenges. The answer is really more regulation which involves putting structures in place which are already in progress.

The second part of the story pertains to their share in some of the loan segments which is both impressive but also worrisome. Now, if one combines the NBFCs and HFCs and compares their joint share in certain loan segments with that of banks, it is fairly impressive. For auto loans, the share is 30 percent while for home loans, it is higher at 44 percent. In the case of loan against property, it is 53 percent and for personal loans 15 percent. Quite clearly, they are as important as the banks when it comes to providing finance to the household segment.

The worrisome part is that their delinquency rates tend to be higher. For auto loans, it is 4.6 percent against 2.9 percent for the industry average. In case of home loans, as against 1.7 percent for the industry NBFCs had 3.9 percent and HFCs 1.7 percent. For loans against property, it was highest at 5.1 percent (3.5 percent for industry). Therefore, there is definitely need for the NBFCs to hone their skills here and some high degree of introspection is required given that these ratios are much higher.

The third part of the story relates to the contagion effect which is something that requires attention. It is pointed out that given the size of the housing finance companies (HFCs), they tend to be the largest of the NBFCs. Now their combined strength makes them comparable to the banks, which means that any major shock or failure can also have far-reaching implications for the financial system, especially banks as they can be affected. This has already been witnessed in case of the mutual funds industry which has been affected by their investments in paper issued by the NBFCs. Their dominance in the corporate bond market is well-known and the progress here too will be impeded in case of such a shock and surveillance is the way out to ensure that the NBFCs continue to grow in a disciplined and secure manner.

In short, the system is fairly stable but the risks need to be recognised and worked upon to ensure smooth progress. We can expect more regulations and closer scrutiny in operation of both NBFCs and mutual funds which has already begun in a meaningful manner.

(The writer is chief economist, CARE Ratings)