'Banks facing asset quality pressures'

The present economic downturn throws up asset quality challenges for Indian banks that could swiftly impact non-performing loan (NPL) ratios. Asset quality pressures have been building up in certain sectors, starting with unsecured consumer loans in 2007 and spreading to SMEs, while corporates' cash flows came under pressure in 2008, said Fitch Ratings in its report 'Indian Banks-Annual Review and Outlook', on Friday.

The deterioration should however be orderly, given the sector diversity of the loan portfolio and barring a collapse in domestic demand and industrial activity. The systemic reported gross NPL ratio (which stood at 2.3% at end-December 2008) may not significantly exceed 5% in the next 12 months to early 2010 even after adjusting for problem loans that are restructured during this period.

Any short-term damage over the next 12 months should therefore be manageable from a systemic perspective though the ratings of banks with concentrations to the vulnerable sectors--including commercial real estate, textiles and other export-led sectors or those with already weak profitability and capital cushion may face downgrades. Meanwhile, several Indian banks' international ratings are either linked with that of the sovereign or are at the sovereign ceiling, and may be affected should there be a revision in the sovereign ratings.

In the special report, Fitch notes that the 8.5% aggregate tier-1 ratio for the Indian banking system comprises almost entirely of common equity that provides some comfort during the downturn; the government has also announced it will ensure minimum capital adequacy ratio of 12% for all government banks.

External sources for common equity have however dried up and if the loan growth remains higher than the internal capital generation for banks tier-1 capital- would erode. This is indeed likely, given that internal capital generation has been between 10-15% for most banks and may fall as profitability comes under pressure from rising loan loss provisions and costs; this is even as loan growth could remain between 15-20%, despite being tempered by caution and the economic slowdown, given the primary role that banks play in credit intermediation in India.