High interest rates to impact Indian banks’ asset quality: Gross NPAs to rise to 3%, RoA to fall below 1% in 2011-12- Crisil

September 22, 2011:

Crisil believes that the significant increase in interest rates over the past 18 months will adversely impact the asset quality and profitability of India’s banks. The banks’ gross non-performing assets (NPAs) ratio is expected to increase to nearly 3.0 per cent by March 31, 2012, from 2.3 per cent a year ago. The pressure on asset quality is expected to arise primarily because of weakening debt servicing ability of the corporate sector, especially the small and medium enterprises (SME) segment. The banks’ migration to system-based recognition of NPAs will also result in higher NPAs over the near term.

Moreover, Crisil believes that the banks’ limited ability to pass on further increases in funding costs to borrowers may result in a sharp decline in their return on assets (RoA) to below 1 per cent in 2011- 12 for the first time in five years.

Says Mr. Pawan Agrawal, Director, Crisil Ratings, “The deterioration in asset quality will be driven primarily by slippages in the banks’ corporate and SME loans portfolios.” This will be caused by increasing interest rates, high input prices, and an expected moderation in economic growth. The sectors with weak demand-supply scenario, intense competition, and high leverage will be the most impacted. Also, sustainability of demand across industries, such as cement, automotive, construction, and textiles, will be a key monitorable for the credit quality of India’s corporate entities.

The uncertain global environment can add pressure on the export-driven sectors. Adds Mr. Agrawal, “In a scenario of prolonged high interest rates, the banks’ retail advances segment may also see some delinquencies over the medium term.” Overall slippages to NPAs for banks are expected to increase to around 2.5 per cent in 2011-12 from an average of 2.1 per cent over the past three years.

Despite the aforementioned risks, Crisil believes that gross NPAs will not significantly exceed 3.0 per cent over the medium term. This is because, despite some challenges, Crisil expects the Indian economy to grow at between 7.7 and 8.0 per cent in 2011-12. Moreover, over the years, the banks have strengthened their credit monitoring and collection mechanisms to mitigate delinquencies.

So far, the banks have been passing on increases in funding cost to their borrowers; this has enabled them to maintain their net interest margin (NIM) at around 3.0 per cent. Consequently, the banks’ reported a healthy RoA of about 1.1 per cent in 2010-11, despite higher provisions for pension liabilities. The banks will have limited room to pass on any further increases in funding costs to borrowers. This will result in the banks’ NIM reducing to less than 3.0 per cent, and RoA dipping to around 0.95 per cent in 2011-12.

Says Mr. Suman Chowdhury, Head, Crisil Ratings, “Despite deterioration in the banks’ asset quality and pressures on profitability, their comfortable capitalisation covers asset-related risks.” The banks’ overall capital adequacy ratio was around 14.0 per cent as on March 31, 2011. Moreover, the banks’ capital coverage for net NPAs is expected to remain adequate, at nearly 9 times, as on

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