A generous regulatory approach to stressed-loan restructuring will reduce incurred-loss provisioning and enable Indian banks to spread the related credit costs over a longer period of four years, resulting in a more manageable impact on profitability and capital, says Fitch Ratings. The regulatory forbearance has reduced the Indian banking sector's need for fresh core capital to meet minimum regulatory capital requirements, it says.
In a report, the ratings agency says, "Under our latest base case, we do not expect the banking system to require fresh equity capital to meet the minimum common equity Tier 1 (CET1) requirement of 8% until the financial year ending March 2025 (FY24-25). However, the sector would require $27 billion in fresh capital under our stress case, which incorporates less benign economic assumptions."
In 2020, Fitch had estimated higher system capital needs of $15 billion and $58 billion under moderate and high-stress scenarios for Indian banks. These stress tests had assumed recognition of asset-quality stress over two years.
"Our updated assessment, covering four years, reflects the role of regulatory forbearance in suppressing immediate capital requirements by deferring recognition of asset-quality stress and giving banks time to build capital buffers," it says.
According to Fitch, delayed International Financial Reporting Standards (IFRS) implementation means that Indian banks' capacity to make pre-emptive provisions is quite limited, guided by incurred instead of expected losses.
It says, "Deferred recognition of stress will thus dampen credit costs for Indian banks, supporting their capacity to generate capital internally through profits. This, coupled with continued delays in the full implementation of the Basel III capital conservation buffer, will contain capital needs for the banking sector, including the state banks, in our opinion."
However, the ratings agency says State-run banks in India would not require additional equity injections to meet minimum capital thresholds until FY24-25 under its base case. Still, their capital needs would increase if their loan growth is faster than it assumed.
State-run banks' CET1 ratios have increased by about 100 basis points (bps) in the past year, supported by a moderate amount of fresh equity raised since the second half (2H) of FY20-21 (H2FY20-21) and return to profitability.
"We expect more fresh capital for the state banks in FY21-22 (Rs200 billion was announced in the government budget in February this year) and their gradually improving earnings to support capital buffers at least for the next two years," Fitch says, adding "State capital injections will be pivotal to any recapitalisation efforts for state banks. They have had limited success with equity fundraising compared with private banks since the onset of the COVID-19 pandemic."
According to Fitch, forbearance does little to address underlying asset-quality problems but offers banks time to build up capital buffers against the eventual emergence of stress. However, Indian banks do not have a strong record of timely stress recognition.
It says, "Upside potential for viability rating (VRs) will be limited – particularly for state banks – in the current operating environment unless loss-absorption buffers improve substantially and are sustained after the end of forbearance, given our expectation that asset-quality stress will rise in the period to FY24-25."
"In our base case, we see state-owned banks meeting the minimum CET1 ratio requirement of 8% even in the absence of fresh capital from the government, but we expect them to lose market share. A meaningful weakening of their franchise, if likely to be sustained, or higher-than-expected stress could still adversely affect their intrinsic credit profiles and their VRs," Fitch added.
The ratings agency says it does not believe that the narrowing of capital gaps relative to its 2020 assumptions will create momentum for VR upgrades in the near term under its base case, as asset-quality stress will remain unresolved and capital buffers remain thin, particularly for State banks.
"Lower VRs would be more probable under our stress case, which would also likely warrant a lower operating environment score for India's banks," it added.