RBI Das asks banks to build capital buffers, stress test their books

Saturday, Jul 11, 2020


MUMBAI – Reserve Bank of India Governor Shaktikanta Das today said a recapitalisation plan for public sector banks and private banks has become necessary, as the expected rise in bad loans due to COVID-19-related hit to economic activity would also lead to erosion of capital. 


Speaking on the second day of the State Bank of India virtual conclave, Das said RBI had asked all banks, deposit taking entities and non-deposit taking entities with asset size of over 50 bln rupees to conduct stress tests to ascertain the impact of the pandemic on their balance sheet, asset quality, liquidity, profitability and capital adequacy for 2020-21 (Apr-Mar).


"Based on the outcome of such stress testing, banks and non-banking financial companies have been advised to work out possible mitigating measures including capital planning, capital raising, and contingency liquidity planning, among others. The idea is to ensure continued credit supply to different sectors of the economy and maintain financial stability," Das said. 


Banks have been asked to conduct such stress tests on Jun 19, while non-bank lenders have been asked to do so on Jul 1.


The suggestion from RBI governor on capital planning and linking it to stress tests comes just days before the Financial Stability Report is due for release. The report is normally issued twice in a year–at the end of June and December–but the central bank had given financial entities more time to provide some data, which is why the June report is yet to be released.


The Financial Stability Report for June is awaited as it will provide details on Reserve Bank of India stress tests on financial institutions and their ability to deal with shock scenarios such as COVID-19 through capital buffers.


On Friday, Cogencis had reported quoting a finance ministry official that the government is unlikely to infuse funds into public sector banks before the next financial year staring April as a clear picture on stressed assets may emerge only after the Jan-Mar quarter.


As per Das, between 2015-16 and 2019-20, the government infused 3.08 trln rupees into public sector banks, and this coupled with RBI's revised framework on resolving stressed assets, helped combat the overhang of such loans on banks and enabled an improvement in their capital position.


As per provisional numbers provided by Das, scheduled commercial banks' capital adequacy ratio stood at 14.8% on Mar 31, up from 14.3% a year ago while public sector banks' capital adequacy was 13.0%, up from 12.2% a year ago.


Although well above capital requirements, there have already been announcements by most large private banks and non-bank finance companies, and a few state-owned banks such as SBI that they are looking to raise capital in the near future.


Das claimed the financial system had entered the pandemic in a "much improved" position due to the regulatory and supervisory initiatives taken by RBI, including a more streamlined approach to supervision and regulation within the central bank. These steps also helped strengthen credit discipline and reduce credit concentration.


Citing data, Das said gross non-performing asset ratio and net non-performing asset ratio of scheduled commercial banks stood at 8.3% and 2.9% on Mar 31, repectively, down from 9.1% and 3.7%, a year ago. Provision coverage ratio of these banks had also improved to 65.4% in March, from 60.5% a year ago, which indicated "higher resiliency in terms of risk absorption capacity".


Additionally, Das said profitability of scheduled commercial banks had also improved during this year.


But, Das added that while its actions had helped cushion banks from the immediate impact of the pandemic on banks, the medium-term outlook is "uncertain" and would depend on the COVID-19 curve.


"Policy action for the medium-term would require a careful assessment of how the crisis unfolds. Building buffers and raising capital will be crucial not only to ensure credit flow but also to build resilience in the financial system," he said.



However, Das noted that the trend was divergent when compared to non-bank finance companies, with gross and net non-performing assets of such lenders at 6.4% and 3.2% on Mar 31, respectively, up from 6.1% and 3.3% a year ago. Weakness in asset quality was also reflected in their capital adequacy declining to 19.6% in 2019-20, from 20.1% a year ago.


"While the NBFC sector as a whole may still look resilient, the redemption pressure on NBFCs and mutual funds need close monitoring. Mutual funds have emerged as major investors in market instruments issued by NBFCs, which is why the development of an adverse feedback loop and the associated systemic risk warrants timely and targeted policy interventions," he said.


Das cited the rising share of banks lending to non-bank finance companies and housing finance companies, and the continued crunch in market-based financing faced by these lenders as another area that needs to be carefully watched.


In the absence of a full legal mechanism that helps resolve stressed financial companies, Das said some amendments had helped it deal with the problems at Dewan Housing Finance Corp Ltd through takeover of operations by an administrator and tracking them carefully.


This was coupled with steps to improve engagement with stakeholders to get non-bank lenders to strengthen risk management and liquidity management frameworks. 


Das said, initially, RBI was closely monitoring 50 large non-bank lenders, with the list being expanded to 100 such lenders, along with ongoing monitoring of non-bank lenders with certain identified weaknesses. 



Expanding on the theme of need for better supervision of financial entities, Das said RBI had attempted to put in place systems and structures that helped to "identify, assess and proactively mitigate or manage the vulnerabilities amongst financial institutions". Towards this, the apex bank was creating a more holistic approach to regulation and supervision.


"The unified approach is aimed at addressing the growing size, complexities, and inter-connectedness amongst banks and NBFCs. It is also aimed at effectively addressing potential systemic risks that could arise due to possible supervisory or regulatory arbitrage and information asymmetry," he said.


Das said the supervision framework had been designed to ensure better focus on risky institutions and practices, along with deploying appropriate tools and technology to achieve supervisory objectives and enhance the capability to conduct horizontal or thematic studies across supervised entities on identified areas of concern.


A key aspect that has helped during this lockdown when physical supervision has been affected is that RBI strengthened its off-site surveillance mechanism to identify emerging risks and assess vulnerabilities in supervised entities in a timely manner to take action effectively. He added that there is an effort to further strengthen supervisory market intelligence capabilities.


Das said this offsite systems would help "smell the distress", if any, and effectively initiate pre-emptive actions, as it relies more on macro and micro variables that are more analytical and forward-looking. The aim is to identify vulnerable sectors, borrowers as well as supervised entities.


He cited the example of handling of weak institutions, with specific emphasis on YES Bank, where a successful reconstruction was achieved through a public-private initiative led by State Bank of India.


Das said the aim of YES Bank resolution, when a marked-based effort failed, was to intervene when the net worth was still positive, with the greater picture on safety of depositors and financial system in mind.


In the case of Punjab & Maharashtra Co-operative Bank, where till recently RBI had limited powers of regulation, Das said efforts were underway with all stakeholders to reach a workable solution as losses are "very high" and almost 50% of deposits have been eroded.


With more powers over these banks now, Das said efforts were on to move towards a risk-based, and pro-active supervisory framework that will identify weaknesses early.


Das admitted that despite efforts taken so far, there was always scope for improvement to address issues that may emerge in the medium to long-term, and RBI would focus on creating a supervisory approach that helps the ability of financial institutions to identify, measure and mitigate these risks. The first step will be to strengthen internal defences within supervised entities, while the greater focus would be on identifying early warning signals and initiating corrective action.


He said RBI was now focusing more on the causes of weakness at banks than symptoms that are usually poor asset quality, lack of profitability, loss of capital, excessive leverage, excessive risk exposure, poor conduct, and liquidity concerns, which often blend together.


However, the cause of these weaknesses are generally inappropriate business model, inappropriate governance functions, poor decision-making by senior management and misalignment of internal incentive structures with external stakeholder interests, he said.


This is why RBI has heightened its supervisory scrutiny over these areas along with improving compliance, risk management and internal audit function, as supervised entities tend to ignore these aspects often due to their focus on business aspects.


RBI issued a discussion paper on corporate governance in commercial banks to align Indian norms and practices with those prevalent globally. Das said the paper focuses on separating ownership from management, as owners focus on the return on their investment while the management should focus on protecting the interest of all stakeholders.


Das said these principles of good governance, and board of director-led scrutiny would be extended to large-sized non-bank finance companies in "due course".



Das said with COVID-19 following just a decade after the global finance crisis, the probability of risk events that shock the financial sector had now moved to less than once-in-a-decade from once-in-a-lifetime events.


This meant that minimum capital requirements that have been calibrated based on historical data due to such events may no longer be considered sufficient to absorb such losses.


"Meeting the minimum capital requirement is necessary, but not a sufficient condition for financial stability. Hence, it is imperative that the approach to risk management in banks should be in tune with the realisation of more frequent, varied and bigger risk events than in the past."


Paraphrasing famed playwright Oscar Wilde, Das said being caught unprepared in the face of a shock may be regarded as a misfortune, but to be caught unawares more than once may be a sign of carelessness.  End


Reported by T. Bijoy Idicheriah

Edited by Mainak Moitra


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