Hidden Stress Points In Banks – Insights From Financial Stability Report

Financial stability is a necessary condition for sustainable growth. The Reserve Bank of India’s latest Financial Stability Report provides a comprehensive assessment of the strength and resilience of India’s financial system. 

While domestic risks to financial stability appear largely contained, near-term global risks have increased. This is due to escalating trade tensions, particularly stemming from the Trump administration’s reciprocal tariffs, prolonged geopolitical conflicts, a likely slowdown in global growth, and potential spillovers to emerging market economies. 

Elevated public debt, climate risks, exchange rate and asset market volatility, and frequent disruptions in capital flows are also contributing to global uncertainties.  

Despite scheduled commercial banks exhibiting robust capital, decadal-low non-performing assets, handsome liquidity buffers, and an increasing provision coverage ratio, certain pressure points warrant constant monitoring by regulators and stakeholders. 

These are: a. slowdown in credit growth, b. pressure on net interest margin, c. asset quality of unsecured credit, d. large loan write-offs, e. elevated credit growth to MSMEs, particularly micro enterprises, and f. rise in non-housing retail loans to households. 

The latest FSR, on closer reading, reveals concerns that are less visible at first glance. These include:

Credit growth
As the banks were flush with funds and deposit growth was close to the credit growth, the slowdown of credit growth was not a supply-side problem. Instead, the sluggish demand for credit was primarily due to deceleration in India’s real GDP growth from 9.2% in 2023-2024 to 6.5% in 2024-2025, which is well below India’s potential growth of 7.5%. 

Moreover, non-financial corporates reduced their dependence on bank lending by heavily borrowing from abroad and mobilising ₹15.7 trillion from the primary capital market in 2024-25 compared with ₹11.8 trillion in the previous year. Incidentally, the debt-equity ratio of non-financial corporates has fallen from 63% cent in 2021-2022 to 40% in 2024-2025. As bank lending rates remained elevated, India’s corporates found equity financing cheaper, particularly when the secondary market was buoyant. 

Hopefully, corporate demand for credit will increase in 2025-2026 as new investments kick in following an elevated level of capacity utilisation (75%) at the macro level. Furthermore, banks are expected to pass on the benefits of the recent accommodative monetary policy to corporates by reducing lending rates expeditiously.

Net Interest Margin
During the last two years, the yield on assets of banks remained stable at around 8.6%, while their cost of funds increased from 4.5% to 5.7%. This resulted in the NIM to fall from 3.8% to 3.5% at the system level. The pressure on the NIM has been due to a decline in the share of low-cost CASA deposits in total deposits from 43.5% in 2021-2022 to 37.3% in 2024-2025, amidst increasing shares of both term deposits and Certificates of Deposit. 

As the share of floating-rate loans has been rising in recent years, the easy monetary policy will put downward pressure on lending rates almost immediately. Hence, the pressure on NIM will continue until the cost of deposits is reduced. 

Asset Quality of Unsecured Credit 
Asset quality has improved in recent years, with gross NPAs declining to a decadal low of 2.3% in 2024-25 at the system level. A major contributing factor in reducing gross NPAs has been large write-offs, particularly by private sector banks. 

A deep dive into asset quality showed that both gross NPAs and stressed advances were above 6% in the case of agriculture. When the agriculture sector was performing reasonably well, the high delinquency rate could be attributed to possible diversion of such advances, including the misuse of the Kisan Credit Card, the bulk of which may be unsecured. 

Following RBI’s regulatory restrictions, although unsecured credit growth moderated significantly during the last two years, it remained above the industry average. The asset quality of unsecured credit continued to be a major concern, following very high fresh slippages by private sector banks. 

Loan Write-offs
Since 2015, scheduled commercial banks have been under regulatory pressures to increase the provision coverage ratio and reduce NPAs through a stringent asset quality review. It is worth examining how large NPAs disappeared from the balance sheets of banks. Several factors contributed to the significant reduction of NPAs. 

Notable among them include large write-offs, conversion of credit to investment, such as the credit to state-owned power distribution companies, sale of credits to asset reconstruction companies, resolution/ restructuring under the Insolvency and Bankruptcy Code, and recovery of loans from liquidation and other means. 

Since 2015, the total write-off has exceeded ₹16 trillion, followed by the acquisition of stressed assets by ARCs at over ₹11 trillion, and resolution plans approved under IBC at over ₹8 trillion, with claims admitted at over ₹14 trillion. 

Post write-offs, recovery was hardly 16%, while the portfolio-level recovery across all tools remained 30-35%. While DISCOM bonds still sit on the balance sheet of banks, the stressed assets of ARCs reflect a shift in the burden of NPAs from one set of balance sheets to another. Regulators are expected to refrain from any forbearance regarding NPA management. 

Similarly, banks should endeavour to maintain a clean balance sheet for smooth intermediation.

MSME Loans
Notwithstanding moderation, credit growth to MSMEs at 14.1% in 2024-25 was above the industry average of 10.8%. Consequently, the share of MSME credit in total non-food credit went up steadily to 17.7% in 2024-2025. Within scheduled commercial banks’ total MSME credit outstanding, 49% was dispensed to microenterprises, followed by 31% to small enterprises and 20% to medium enterprises. 

The stress assets of the microfinance sector within MSMEs remained elevated at above 6%. This would pose a serious problem of defaults, leading to disruption of fresh lending to this sector.

Non-Housing Retail Loans to Households 
The behaviour of Indian households is changing in the 21st century. Although they are the biggest net savers, Indian households’ outstanding debt-to-GDP ratio has been rising steadily from a little over 34% in 2018-2019 to 41.9% by December 2024. 

For the emerging market economy as a whole, this ratio has fallen from 53% in 2020-2021 to 46.6% by December 2024. Nevertheless, it remained well above the debt-GDP ratio for Indian households. Although the debt-GDP ratio of Indian households is not alarming, the rise in non-housing retail loans to households, primarily meant for consumption--about 55% of total household borrowings-- is a major concern. This has adversely impacted the net financial savings of Indian households, which nosedived from 6.9% in 2014-2015 to 5.1% in 2023-2024. 

More important is the composition of household assets, which has changed from bank deposits to equity and investment. The proportion of household financial assets held in banks declined from 46.3% in 2018-2019 to 40.6% in 2023-2024. In contrast, the share of equity and investment surged from 15.7% to 22.4% during the same period, other components remaining broadly unchanged. 

More risk-taking by households embeds the seeds of defaults in the case of large downward corrections in asset prices, which is more likely due to stretched valuations of more than two-thirds of listed equities, which are trading above their benchmarks. Incidentally, the June Financial Stability Report has reported that Indian households have the largest exposure to highly volatile microcap equities compared to mutual funds and foreign portfolio investors. 

Bankers should be careful while providing non-housing consumer loans to households, as the probability of such loans being partially diverted to the equity market cannot be ruled out. 

(These are the author’s personal views.)