The true strength of India’s banking sector was evident after the global financial crises. India’s financial system withstood the contagion largely because banks were very well regulated at home and because they were lucky that they were not so well integrated with the western financial system. Last month ECB authorities said they were conducting fresh stress tests for banks, especially in EU economies, which are on the brink of a sovereign debt default. Indeed, much of the toxicity is still hidden in the system. In contrast, Indian banks have not only remained stable but have grown impressively since 2008. The banking sector led the stock market recovery after the global markets came in a bear grip late 2008. However, of late, there is some perceived macro risk to India’s banking sector emerging from higher government borrowings, tighter liquidity environment and persistent inflation. The Union budget has sought to address these concerns by keeping a tight control on budgeted expenditure. However, the outcome of such efforts would depend on some critical factors such as benign oil prices, good monsoons, etc, which the finance minister himself readily admits.
At present banks do face some challenges in the form of liquidity shortage in the system tending to become a structural issue. Liquidity problems combined with an inflationary environment could reduce credit growth and affect margins; in a rising interest rate environment, there could be losses in bond portfolios. And, of course, the threat of rising loan losses exacerbate because of the combination of the circumstances mentioned above. The problems are not insurmountable, though, and an economy growing at 8.5-9% would provide the way out of these incipient problems. Ultimately, steady GDP growth is a panacea for many of these ills. The banking sector reflects a growing economy like no other sector does. Typically, the RBI’s credit growth target of 20% is linked to a nominal GDP growth assumption of about 14 -15%.
If credit grows at 20% a year, then the overall banking assets should nearly double every four years. That means banks will need additional capital of about Rs 4