According to ratings agency Moody’s Investor Services, loans provided by banks to small and medium-sized enterprises (SMEs) remain a risk to the asset quality of the banking system, as the segment is the most susceptible to interest rate increases. However, the credit growth of the banking sector will be driven by the growth potential of the economy, with credit demand expected to continue to be strong due to higher inflation driving working capital requirements, leading companies to turn to domestic banks for financing at lower costs. This will help sustain the recovery in credit growth, which has remained at around 15% since FY23.
Moody’s report indicates that while corporate and retail lending by banks have improved significantly on the back of improved underwriting systems, loans to SMEs remain a cause for concern. Despite the covid pandemic-induced stress on individuals, retail loans have performed well due to improvements in banks’ underwriting, while the quality of corporate loans has also improved significantly. However, SME loans remain the most vulnerable to interest rate increases, as they could impact the creditworthiness of small businesses.
Moody’s maintains a stable outlook for India’s banking system, as gains in net interest margins (NIM) are expected to be limited and will not be proportional to increases in interest rates, as 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. The funding and liquidity of banks have tightened over the past year due to the pandemic, as they drew down on deposits and liquid assets to support credit growth.
The systemic liquidity coverage ratio, which declined to 136% in September from a peak of 173% in September 2020, is not expected to fall much further as banks maintain buffers over the 100% regulatory minimum. However, deposit competition is likely to increase, leading to higher funding costs.
While the credit growth of the banking sector is expected to remain strong, the continued risk of SME loans could impact the asset quality of the banking system, particularly in the face of interest rate increases. Moody’s maintains a stable outlook for India’s banking system, but warns that gains in net interest margins will be limited, with the banking system expected to face tight liquidity conditions in the coming months, leading to higher funding costs.
