Rise in bad loans, credit shocks can wipe out a quarter of India’s banking capital and this is dangerous

The Reserve Bank of India (RBI) has warned the Indian banking system is at the risk of losing a quarter of its capital, if the bad loans and credit stress continued.

The RBI, in its half-yearly Financial Stability Report (FSR), stated that if top borrowers default, the extreme stress will dent the state lenders the most.

The bad loans have been on a rise since March, but the RBI also mentioned the banks were well positioned to face liquidity risks.

As per the report, the Banking Stability Indicator (BSI) shows that the risks to the banking sector have sharply increased since the publication of the previous FSR, adding a trend analysis of BSI suggests that stability conditions in the banking sector which started deteriorating in mid-2010 have now worsened significantly.

The report also says that not only state lenders but non-banking finance companies, insurers, mutual funds will also be hurt.

The report underlined the gross bad loans may jump to 9.3% of the total from 7.6% in March under extreme stress and the state-run lenders may be worst hit with gross NPAs rising to 11% by March 2017 from 9.6% in March 2016.

While the overall economic slowdown is being blamed for the surge in bad loans, the share of big borrowers was disproportionately higher, it said. Large borrowers' share of gross bad loans jumped to 86.4% from 83.4% of the total and their share of total loans increased to 58% from 56.8% in September 2015, it said.

"While concerns emanating from the significant concentration of large exposures in banks books are justified in the current milieu, the challenge is to shift a part of the resource allocations to bond financing without impacting aggregate allocative efficiency and economic welfare," the report said.

It stated the weak finances may keep banks from expanding credit, needed to fund investment as the government seeks to boost economic growth.