Finance Minister Nirmala Sitharaman recently asked scheduled commercial banks to avoid long-term, high-risk funding to prevent a recurrence of the non-performing assets crisis caused by asset-liability mismatches. The FM advised lenders to focus on mobilising deposits, retail lending, and supporting medium-term projects. She advised them to follow the example of institutions like the National Bank for Financing Infrastructure and Development which are better equipped to handle long-term financing.
This is not the first time the government has expressed concerns over the long-term, high-risk lending practices of Indian lenders. In November last year, Sitharaman called on lenders to exercise prudence, echoing the Reserve Bank of India’s (RBI) advice to adhere to core banking principles. Her recent statement comes amid increasing scrutiny of risky lending practices, as the rapid rise in loans, depleting deposits, and high exposure to certain asset classes raise concerns about the stability of Indian banks.
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Lessons from international banking failures
Despite these warnings, lenders have shown a greater appetite for risk. With a volatile global economic climate, a thorough review of the Indian banking system is necessary to avoid potential crises. The vulnerabilities of the banking system became apparent in March 2023, when several mid-sized US banks, including Silicon Valley Bank (SVB) and Signature Bank, collapsed due to sudden customer withdrawals. These banks had invested heavily in long-term securities to earn higher interest rates, leading to a liquidity crisis. The collapse of Credit Suisse in Europe further amplified fears of a global banking contagion.
A recent survey by the Federation of Indian Chambers of Commerce and Industry (FICCI) and the Indian Banks’ Association (IBA) warned that Indian lenders may face liquidity issues as credit growth outpaces deposit growth. Top bankers identified raising deposits as a priority to match loan growth and maintain low credit costs. Fitch Ratings also cautioned Indian banks to be careful with their lending, even though their financial performance has improved.
NPA ratios at multi-year lows
The NPA ratio of scheduled commercial banks dropped to a multi-year low of 2.8%, and the net NPA ratio stood at 0.6% in March 2024. Despite these improvements, experts advise lenders to focus on extending profitable loans that do not expose them to excessive risk.
Bank loans grew by 16% in FY 2024, significantly higher than the 8% CAGR over FY15-FY22. However, Fitch Ratings highlighted the lower transparency in Indian banks’ retail lending data as a risk factor, noting that Indian lenders often provide less information on loan-to-value ratios, borrower debt serviceability, and recovery rates compared to their Asian counterparts.
Banks: Risk-taking and RBI safeguards
Certain banks have displayed excessive risk-taking behaviour in the past, which hurt their financial performance during economic downturns. While government-owned banks were particularly vulnerable, private banks also faced challenges. Fitch Ratings previously advised lenders to strike a careful balance between increasing lending for revenue generation and avoiding high-risk practices.
The RBI has introduced several measures to mitigate risks in the banking sector, including improvements in governance, risk management, and reporting standards. In November 2023, the central bank raised risk weights for certain loan categories to build capital buffers and imposed business restrictions on entities with supervisory concerns.
The RBI is also focused on managing risks from the non-banking financial company (NBFC) sector, which accounts for over one-fifth of the overall banking system. The past failures of large NBFCs, such as IL&FS, SREI Infra, and Dewan Housing, highlighted the systemic risks posed by asset or liability vulnerabilities. Bailing out these large institutions imposes significant costs on the financial system, further underscoring the need for cautious lending practices.
As Indian banks continue to navigate a complex financial landscape, the calls for prudent lending are more important than ever. The lessons from global banking failures and the warnings from both the government and regulatory authorities should guide banks in balancing growth with financial stability, ensuring that India’s banking sector remains resilient amidst uncertain economic conditions.