Banks are expected to remain largely resilient to the cyclical downturn as increases in loan loss reserves and common equity injections in 2014 will likely help maintain adequate defenses. These factors underline the stable outlook for the Indian banking sector for 2014, even as it continues to face credit quality pressures from loan concentration, borrowers' overleverage and the prevailing economic slowdown.
In a base case scenario, ROA of government banks will continue to trend 15bp-20bp lower than the long-term average of 0.9%-still adequate to absorb rising credit costs without impacting capital for most banks. Corporate borrowers however have limited resilience to further shrinkage in profit margins. While a pick-up in real GDP growth may improve cash flows from mid-2014, any failure in this revival and further increase in interest rates may result in a wave of failed restructuring that may test the profits of a broader base of government banks and some of the weak private banks.
Regulatory measures are forcing banks improve loan loss reserves on restructured loans and exposures to corporates with large unhedged forex liabilities. These are expected to boost the total loan loss reserves (specific and general) of the banking system to nearly 70% of gross NPLs on a sustained basis from the current level of 63%; this will also improve the cyclical resilience of banks. The removal of provisioning forbearance on restructured accounts from FY16 will improve reserves further.
Capital ratios are expected to remain intact even as profits remain weak due to continued injections by the government. The government has often reiterated its commitment to ensure that its banks are adequately capitalised under the Basel III regime, which helps support the long-term issuer ratings of public sector banks. The government's support stance was proven during the 2008 global financial crisis and remains unchanged. This provides crucial comfort to creditors, which could weaken if the timeliness of such support is compromised.
Banks' funding profile improved in 2013 on the back of subdued loan growth, but remains vulnerable due to the lack of adequate long-term liability products to fund the growing residential mortgage and infrastructure loan portfolios. This weakness was exposed in 2012 when refinancing pressure diluted the transmission of monetary easing and allowed only an average 40bp reduction in base rate as against a 125bp reduction in the repo rate.
