Financial Services

Financial stability report – stormy clouds or sunshine ahead? 

Amid a gloomy global and domestic macroeconomic environment, the Reserve Bank of India (RBI) released the fifth issue of its biannual financial stability report (FSR) on June 28, 2012. The FSR highlights the RBI’s views on macro prudential surveillance of the Indian market, potential risks to the financial stability and suggested corrective action. In the following sections, we have summarised the key findings of the report and their key implications for the banking sector in India.


The FSR by RBI points towards the declining economic growth and risks that could impact the growth in near future. On one hand, the global sovereign debt crisis and the continuing problems in some of the advanced economies would impact India’s economic growth and on the other hand, various domestic factors including widening current account and fiscal deficit, high food inflation, moderation in private and government consumption and investment demand are expected to weigh down on the domestic growth. Though there is a little respite in view of relatively low international crude oil prices, risks to inflation still remain high in terms of suppressed fuel prices, high subsidies and weak monsoons.


As per the FSR by RBI, the Indian banking sector is unlikely to be impacted significantly directly by the Eurozone crisis as domestic banks which dominate the sector (with approximately 92 percent of the sector’s assets), have practically no exposure to the Eurozone countries. The only direct impact could be on some specialised types of financing such as structured long term finance, project finance and trade finance which are extended to some of the European players. The crisis has also impacted India’s exports reducing the credit off-take. Further, the foreign investments from Eurozone (besides other countries) have come down resulting in volatility in currency and equity markets.


Demonstrating the overall slowdown in the Indian economy, both credit and deposit growth in the banking sector decelerated during FY12. Credit growth of the scheduled commercial banks (SCBs) at 16.3 percent y-o-y in FY12 was lower than 22.6 percent y-o-y credit growth in FY11. Deposit growth stood at 13.7 percent y-o-y in FY12 as compared to 17.7 percent y-o- y in FY11. Comfortable capital adequacy positions of banks would enable them to remain resilient to credit, market and liquidity risks and withstand macroeconomic shocks. However, the disparate growth in deposit vis-a-vis credit has led to an increased dependence on borrowed funds, especially short-term funds, along with growing short-term maturity mismatches in the balance sheet of banks which might lead to liquidity risks in future1.


The slowdown in credit growth was more prominent in the priority sector, real estate and infrastructure segments which account for approximately 60 percent of the banks’ credit. The credit deceleration was most noticeable among public sector banks (PSBs) while the old private sector banks recorded a robust credit growth of 24 percent 1. The FSR by RBI highlights the need to carefully monitor the trend of retail and real estate sectors-led growth in credit among the old private sector banks to avoid concentration risk. However, on the positive side, the overall slowdown in credit growth led to a marginal improvement in SCBs’ capital to risk weighted asset ratio (CRAR) from 13.5 percent as at September 2011 to 14.1 percent as at March 20121.



Growth Rate of Bank Credit to Select Sectors




The Financial stability Report by RBI states that the Indian banks‘ soundness and profitability indicators improved from September 2011 levels but deteriorated as compared to March 2011. The SCBs have registered healthy profits during FY12, though the growth rate of earnings has decelerated relative to FY11. During FY12, return on assets (RoA), return on equity (RoE) and net interest margin (NIM) of SCBs have declined marginally.


The FSR by RBI has also made an insightful observation into the quality of capital ratios calculated across geographies and even banks within a jurisdiction. As Basel norms provide overall guidelines leaving considerable flexibility for individual regulator to customize the norms, there are significant variations among the definition of capital and risk weighted assets warranting a closer look at the capital ratios of banks worldwide.


In India, SCBs have witnessed a significant increase in their risk weighted asset (RWA) density (proportion of RWAs to total assets) with significant variations across banks. It indicates the increasing risk being taken by the banks and raises concerns over the quality of their capital ratios. Further, the limited progress made by banks to implement advanced approaches of Basel II also increases the concerns over the risk management of Indian banks. The FSR by RBI also mentions that the most of the Indian banks will migrate to Basel III comfortably with relatively better capital adequacy position. However, there could be challenges as additional capital need could impact cost of capital and return on equity of the banks especially for short term. The concerns around the availability of a sufficient quantum of ‘liquid’ assets under liquidity norms and the impact of such requirements on domestic financial markets have also been raised in the FSR.


According to the FSR by RBI, the strain on asset quality remains elevated with gross non-performing asset (NPA) ratio for SCBs increasing to 2.9 percent as at March 2012 (2.4 percent at March 2011). Net NPA ratio stood at 1.3 percent as at March 2012, as against 0.9 percent as at March 2011. The increase in NPAs was largely led by priority sector, retail and agriculture. The following table illustrates the sector-wise share of NPAs.



Sector-wise gross NPAs of SCBs



Gross NPA ratio

Share in Banking system
credit (%)
Share in banking System
NPA (%)
Priority Sector 4.4 30.6 47.8
Retail 2.8 18.5 18.3
Agriculture 4.6 10.3 18.2
Micro and Small Enterprises 4.8 9.8 17.9
Real Estate 1.7 16.7 9.7
Iron & Steel 3.2 3.8 4.7
Textile 4.4 2.7 4.5
Infrastructure 0.6 11 2.5

Source: Financial Stability report, June 2012, RBI


As per the FSR by RBI the position is not alarming yet and strong capital adequacy position of Indian banks provides some comfort, ensuring that the banking system remains resilient even in the unlikely contingencies. But the increasing divergence in growth rate of credit and NPAs (credit growth of 16.3 percent and NPAs growth at 43.9 percent as at end March 2012) has widened in the recent period and could put further pressure on asset quality in the near term. The slippage ratio increased to 2.1 percent as at end March 2012 from 1.6 percent at March 2011 emphasizing the asset quality concerns and the need for proactive management of NPAs by banks. During FY12, the quantum of restructured accounts also increased, surpassing both credit growth and growth rate of gross NPAs1.


The FSR by RBI makes some interesting observations around the increasing systemic importance of some large Indian banks. It argues that the maximum possible loss to the banking system due to the failure of the ‘most connected’ bank has risen from 12 percent of the capital of the banking system to over 16 percent in 2011. The average loss caused by the failure of the three ‘most connected’ banks has also increased during the same period. The situation warrants more rigorous micro prudential supervision of these ‘most connected’ entities. Besides closer supervision, this could prompt the regulator to come up with the guidelines on the holding company structure for banking conglomerates.


In the insurance space, the non-life insurance industry grew by 23.2 percent y-o-y during FY12, as against a growth of 22.4 percent y-o-y during FY11. The life insurance industry showed a decline of 9.2 percent y-o-y in the first year premium collected in FY12, against a growth of 15.1 percent y-o-y in FY11. Currently, Indian insurance sector is not consistent with Solvency II regime and as a first step the regulator Insurance Regulatory and Development Authority (IRDA) has set up a Committee to examine the solvency regime in select jurisdictions and to make its recommendations on the Solvency II regime in India2.


The FSR by RBI states that, despite a few negative indicators, asset quality in particular, the financial sector of India stands sound and resilient. With healthy leverage levels banks continue to be well capitalised.




Though the risk to financial stability has aggravated due to global risks and domestic macroeconomic conditions, the financial system of the country remains healthy led by inherent strength of the domestic economy, well capitalized banks and their ability to withstand liquidity pressures.


The RBI’s second systemic risk survey also revealed the same trend. The stakeholders are concerned about the evolving global risks and a couple of domestic factors but at the same time remained confident about the stability of the domestic financial system though the level of confidence was low from the previous survey. Also, the results of a series of stress tests to study the impact of adverse macro-financial shocks showed that the Indian banking system remained resilient even under extreme stress scenarios.




1. Financial Stability Report, June 28, 2012, RBI
2. Financial Stability Report, June 28, 2012, RBI


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