The banking conundrum: Balancing credit growth vs credit risk

A constant dilemma that banks face is the choice between credit growth and simultaneously mitigating credit risk while maintaining asset quality. The pandemic’s adverse aftereffects have hit business sentiments owing to higher uncertainty, impacted business cash inflows, delayed customer payments – all of which has added pressure to liquidity concerns and pushed banks to the corner. To ease the immediate burden on banks’ books, RBI has issued policy guidelines related to loan restructuring and asset classification norms. In consideration of factors like high liquidity and adequate capitalisation in the banking system, continued efforts by banks to fortify their digital banking frontiers and economic activity returning to normalcy, one can expect a recovery for India’s banking sector in 2021.

At a glance: India’s banking sector (source: IBEF)

• Indian banking sector broadly comprises 12 public sector banks, 22 private sector banks, 46 foreign banks, 56 regional rural banks, 1485 urban cooperative banks and 96,000 rural cooperative banks 
• Number of ATMs: 209,110(Aug 2020) 2021e: 407,000 
• Asset size of banks in FY20: US$ 2.52 trillion
• CAGR (FY16-20) of bank credit was 3.57%, total credit touched US$ 1,698.97 billion in FY20 
• CAGR (FY16-20) of deposits was 13.93%, swelled to US$ 1.93 trillion by FY20. 
• Credit to non-food industries as of Oct 2020 was Rs. 102.80 lakh crore (US$ 1.38 trillion)

Data in charts:

RBI’s timely intervention 

Recognising the challenges posed by the pandemic, RBI announced a 6-month moratorium applicable to all lending institutions with respect to term loans. This reduced the immediate impact of absorbing a potential NPA shock on the banks’ books, providing a respite.

Source: Deloitte (pg 2)

Subsequently, banks have been allowed to undertake a one-time loan restructuring related to pandemic-caused stressed assets with partial conversion of debt to equity and extensions, resulting in a moratorium extension for the next two years. This is a much-needed step in the right direction towards bolstering the asset quality of banks, in the absence of which, CRISIL estimates that the NPAs would have hit a steep two-decade high of 11.5% by the end of FY21.  

‘’Micro, small and medium enterprises (MSMEs), which have been substantially affected by the pandemic-led disruptions, have also got relief in the form of a three-month extension in the existing restructuring scheme, i.e. till March 31, 2021. The major beneficiaries, though, will be sub-Rs 500 crore corporate exposures and retail exposures, which were earlier expected to see the highest increase in NPAs in percentage terms. The debt at risk in these segments – or loans at risk of slipping into NPAs this fiscal unless restructured by banks – is a sizeable Rs 3 lakh crore.’’- CRISIL Ratings

The IBC (insolvency and bankruptcy) proceedings related to assessment and closure of stressed assets have been stopped until FYE2021. All of these measures have relaxed recognition of asset quality concerns on the banks’ books in the short to medium term. However, since the real position of NPAs and doubtful assets would be fully ascertained only in the long-term, this is a cause for uncertainty. A recent S&P report(Nov 2020) expects the banking sectors’ non-performing loans to increase to 10-11% of gross loans for FYE 2022, a spike from 8% as on 30 June 2020.

Source: S&P (pg 91)

Budget 2021-22 too has inserted relevant provisions for Stressed Asset Resolution by establishing a New Structure:

‘’The high level of provisioning by public sector banks of their stressed assets calls for measures to clean up the bank books.  An Asset Reconstruction Company Limited and Asset Management Company would be set up to consolidate and take over the existing stressed debt and then manage and dispose of the assets to Alternate Investment Funds and other potential investors for eventual value realization.’’- Nirmala Sitharaman, Finance Minister, Budget speech

A stabilisation in asset quality would ultimately pave the way for improved credit and earnings growth. 

The credit offtake dynamics

In the throes of the pandemic, several small business units and SMEs were thrown off-guard and struggled to maintain sufficient cash flows and realise profits. This translated into subdued demand for loans. This situation is evident from RBI data that points to a loan contraction of 5.3% in FY2021, compared to a 4.4% contraction in FY2020 for MSMEs. Further, credit growth till Oct 2020 was lower than 6%, compared to 9% in the previous year. In the wake of the prevailing conditions, it would be prudent for banks to enhance internal credit-quality assessment systems to zero-in on quality borrowers. A recent IBEF report (Jan 2021) summarizes the key performance indicators related to growth in credit and deposits (in absolute terms).

Source: IBEF

The Government’s timely liquidity support by way of emergency credit line guarantee scheme as well the uptick in economic activity is expected to result in higher credit growth in FY22, with lower-than-expected loan restructuring requests from borrowers. ICRA’s revised loan structuring estimates stand at 2.5-4.5% of advances as against the earlier 5-8%. 

All of this would spell good news for the banking sector, which can expect credit growth to touch pre-Covid levels by FYE22.

ICRA’s analysis summarizes the actual and expected performance of FY20, FY21 and FY22e:

Banks adopt a ‘wait and watch’ mode in lending

The banking system is awash with liquidity with a surplus of INR 6.21 lakh cr as of 1 Jan 2021. RBI data indicates that this situation of surplus liquidity has been the status quo since the past 19 months. This is also due to the bank deposits inflow exceeding that of bank credit outflow. CARE Ratings opines that bank deposits grew by 6.7% as against credit growth of 1.7%, during Mar-Dec 2020. Clearly, banks are adopting a ‘better safe than sorry’ approach with respect to credit. While this might contain further credit risk in the short to medium term, the strategy might not be productive in the long-term whereby banks would be deprived of growing their earnings from interest income. The below chart highlights a comparison between the loan recoveries and write-offs by banks:

Source: ET

Conclusion: Banks’ flight to safety

With the overhang of stressed assets and higher provisioning, many banks have adopted a risk-averse approach towards credit with a focus on enhancing collection efficiency. The cautious approach to lending has extended to sectoral credit portfolios, with reduced disbursals to certain critical industries and MSMEs accessing loans at higher interest rates. 

The new Normal mandates that banks hit the reset button with regard to credit practices. It would do well for banks to overhaul their systems and credit models to leverage upon data analytics and technology towards building a robust credit portfolio with adequate safeguards and early-warning signals to identify exceptions and red flag credit deterioration. Collaboration with fintech players to widen credit penetration and strengthening underwriting processes would help revive credit growth.