Loans to small and medium-sized enterprises (SMEs) continue to pose risks to the asset quality of the banking system as the segment is most vulnerable to rises in interest rates, ratings agency Moody’s Investor Services said.
However, the credit growth will be supported by the underlying growth potential in the economy. The credit demand will be supported from corporate sector and continue to stay strong as higher inflation will drive working capital requirements.
Companies will turn to domestic banks to meet their financing requirements at lower costs. This will help sustain recovery in credit growth, which started in FY23, at around 15%.
“Still, loans to SMEs continue to pose risks to banks’ asset quality because this segment is the most vulnerable to rises in interest rates,” the report said.
The banks are safe on corporate and retail lending on improved underwriting systems. The asset quality of corporate loans have improved significantly as banks have tightened their underwriting criteria and is the best-performing segment in banks’ loan books over the past two years, the agency said.
While retail loans have also performed well despite covid pandemic-induced stress for individuals, helped by improvements in banks’ underwriting.
“We maintain a stable outlook for India’s (Baa3 stable) banking system,” it said.
The gains in net interest margins (NIM) will be limited and not proportional to increases in interest rates because funding costs will rise faster than loan rates. The moderation in NIM will come from tight liquidity conditions, forcing banks to increase their deposit rates. Banks’ funding and liquidity have tightened in the past year because they have drawn down on deposits and liquid assets they have accumulated during the pandemic to support credit growth.
The systemic liquidity coverage ratio declined to 136% in September from a peak of 173% in September 2020 but the agency does not expect it to fall much further because banks are seeking to maintain buffers over the 100% regulatory minimum. However, deposit competition will increase leading to increases in funding costs.