Mounting Concentration Risk Could Test Indian Banks, says Fitch Ratings

August 23, 2011:

Fitch Ratings says that the growing single-name concentration risk in Indian banks could result in more volatile non-performing loan (NPL) ratios than those seen during the last 10 years. Most of this growth since 2008 is attributed to infrastructure loans that should likely continue till 2012-2013 before hitting a sectoral cap.

Single-name concentration as measured by "20 largest exposure / equity" was above 100% at end-March 2011 for all 24 government and private banks rated by Fitch in India. The ratio was higher than 200% for 15 banks, with the highest at 453% for one government bank. For more details, please see the report "Indian Banks: A Health Check. Greater Resilience Post-2008, but Mounting Concentration Risk" available at or by clicking on the link above.

The top 20 credits extend loans to highly rated domestic corporates and to the infrastructure sector, where credit risk is historically low. For example, infrastructure loans have some of the lowest NPL ratios in Indian banks' portfolio. Fitch however notes growing concerns due to delays in project implementation, increased cost of raw material linkages and growing exposure to state electricity utilities with weak credit profile. The risk of NPL spikes could therefore be high for some banks.

Credit losses from any such NPL spike could be manageable, given the critical need for infrastructure in the country and expectations of policy support to avoid a crisis in the sector. Further, the long-term commercial viability of existing infrastructure projects is expected to remain on course with significantly higher NPL recoveries than the average recovery expectation (30%-50%) for secured NPLs in India.

On the positive side, resilience of Indian banks has increased, as reflected in a higher Tier 1 ratio and improved loan-loss reserves at end-June 2011 compared with 2008. The average Tier 1 ratio for the banking system was 10.3% in 2011, up from 9.1% at end-March 2008, and comprised mostly core common equity (over 90% of tier 1 capital). The improvement was also across the board: for example, Tier 1 ratio was above 8% at end-June 2011 for all Fitch-rated Indian banks, with the notable exception of State Bank of India ('BBB-'/'Fitch AAA(ind)'/Stable). In comparison at end-March 2008, 12 banks had a Tier 1 capital ratio of below 8%, including two that were below 6%.

Pre-impairment operating income benefitted from a cyclical uptrend in net interest margin (NIM) in FY11 (ended March 2011), along with an improved mechanism in the "base rate" to pass on rate hikes. Banks' operating margins were therefore generally higher in FY11 than in FY08-FY09. While margins are likely to narrow in FY12, Fitch expects them to remain sufficiently robust to absorb credit costs.

Fitch notes that funding remains driven by customer deposits, which is a traditional strength. In March 2011, a few mid-sized government banks sharply increased their borrowings through certificates of deposit to fund their above-average loan growths. While refinancing risks on such borrowings are generally low for government banks, the high refinancing costs in a rising interest rate regime would likely squeeze NIM during Q2FY12 and Q3FY12.

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