Markets may be ignoring the NPA risk

New measures encourage lending to areas having a high probability of defaults

The RBI’S new measures to tackle the second Covid wave seem to have lifted sentiment in the financial sector — temporarily, at least. The key points of the governor’s statement can be summarised as follows.

Global economic activity seems to be picking up but the second wave has put the brakes on a fast domestic recovery. The next few months are likely to be bad and the central bank will do what it can to support life and maintenance of livelihood through a difficult period.

Banks can lend ~50,000 crore more for healthcare-related activities, and these will be treated as priority sector loans. These will be subsidised by the RBI in the sense that banks can place the equivalent of the “Covid loan book” in the reverse repo at a more advantageous rate of interest.

Small finance banks (SFB) and microfinance institutions (MFIS) will be allowed to tap a new ~10,000crore line of credit, which will be made available at the repo rate. Moreover, lending to MFIS via the SFB route will be considered a priority sector. In addition to this, lending to the MSME sector will be encouraged by exempting such loans for CRR calculations.

Restructuring of sticky small loans (with an exposure limit of ~25 crore) under the Covid Resolution 2.0 framework will be allowed until September 2021. Banks also have the discretion to review loans, which have already been restructured, and to extend the period of moratorium or remaining tenor. They may also review the sanctioned working capital limits.

The MSME sector is one of the areas of very high distress. MFIS also deal with low-income groups, where distress is high due to the loss of livelihoods for millions during the extended lockdowns of 2020. The central bank’s actions are partly prompted by humanitarian considerations.

But the chances are a high percentage of the new Covid and SFB loans will turn non-performing, and so will a sizeable proportion of newly restructured loans. Moreover, these new NPAS will not be recognised as such, which means investors will not receive a clear picture of bank balance sheets until this phase ends.

The RBI conducts stress tests to gauge the likely level of NPAS in its biannual Financial Stability Report (FSR). In December 2020, the FSR estimated gross NPA could rise to 14.8 per cent of banking assets under the “severe stress” scenario.

This was well before the second wave became apparent and the underlying assumptions about GDP growth recovery, credit disbursal, etc, were more optimistic then. It may be safely assumed that banking will indeed move into the “severe stress” scenario. But the new measures will allow them to defer full recognition of NPAS by restructuring and it also encourages lending to areas, which have a high probability of defaults. This means investors will not receive a transparent picture.

The banking sector can contain many time bombs. That creates problems for the disinvestment programme, which includes ambitious plans of selling and merging PSU banks. The surge in banking stocks after the governor’s speech bumps up valuations and increases the chances of a severe correction at some stage.