West Asia Shock Forces Banks Into a New Credit Risk Reality

The ongoing crisis in West Asia has introduced a new layer of uncertainty for India’s banking system, with risks likely to transmit through inflation, currency weakness, supply-chain disruptions and slowing economic activity. While the eventual magnitude of the stress remains difficult to quantify, the broad contours of the challenge are already visible.

Input costs are expected to rise, supply-side bottlenecks may intensify, and sectors dependent on imported commodities, fertilisers, and energy could face significant strain. Even agriculture, which has often cushioned the economy during periods of stress, may face disruptions if fertiliser and urea supplies tighten in the coming sowing seasons.

The combined effect of the West Asia crisis and the rupee’s depreciation against the dollar could push the economy into a period of medium-to-severe stress, affecting businesses and households unevenly.

In such an environment, banks become the principal transmission channel for economic stability. The uninterrupted flow of credit to productive sectors will be essential to prevent a sharper slowdown, even as banks themselves confront rising risks across liquidity, asset quality and profitability.

Importantly, the banking system is not entering this phase from a position of weakness. Asset quality, capital adequacy, provision coverage, profitability and return ratios have improved significantly over the past few years, placing banks in a stronger position to absorb shocks than during earlier crises. Yet, that strength could be tested if growth slows materially, repayment capacity deteriorates, and deposit mobilisation weakens amid rising inflationary pressures.

Flexible Surveillance
While liquidity pressures may emerge first, the more enduring challenge is likely to be credit risk. Liquidity coverage ratios remain comfortably above regulatory thresholds, and the RBI’s liquidity adjustment framework offers a near-term backstop. Structural asset-liability mismatches, however, cannot be corrected overnight. 

This places greater emphasis on credit monitoring and borrower surveillance as the first line of defence.

The risks are amplified by the banking system’s increasing exposure to loans, which accounted for around 65% of total assets by March 2026, while the credit-deposit ratio approached 82%.

That balance-sheet composition leaves banks more vulnerable to a deterioration in borrower cash flows during periods of economic stress. Credit risk management frameworks, special mention account monitoring, CRILC data and exposure norms will therefore need to be deployed more dynamically rather than mechanically.

Banks may need to intensify surveillance of overdue loans before they turn non-performing, particularly in the 1–89 day bucket, while also closely monitoring working capital facilities and non-funded exposures. Large borrowers and sensitive sectors warrant particular scrutiny because any deterioration in their financial position could disproportionately affect system-wide asset quality. Coordination among consortium lenders will also become more important to preserve business continuity for stressed borrowers rather than triggering disorderly recoveries or legal escalation.

The article argues that conventional rulebooks designed for stable economic periods may not be sufficient under present conditions. Credit decisions may require greater flexibility, quicker response mechanisms and a more pragmatic understanding of borrower stress. The objective would not merely be recovery enforcement, but the preservation of viable economic activity through temporary turbulence.

Retail Stress
The government’s introduction of the Emergency Credit Line Guarantee Scheme 5.0 could provide an important buffer. The scheme offers full guarantee coverage for MSMEs and 90% coverage for certain larger borrowers and airlines, with total support of up to ₹2.55 trillion until March 2027. Proper deployment of the scheme could help banks prevent a broader migration of stressed accounts into SMA and NPA categories.

Retail lending represents another area of vulnerability.

The rapid growth in unsecured personal loans and credit-card exposures could become problematic if inflation rises further and employment conditions weaken. Gig economy workers, digital-platform employees and borrowers dependent on small-ticket consumption loans may face disproportionate stress if wage growth slows or layoffs emerge in sectors such as IT-enabled services.

Banks may, therefore, have to balance recovery efforts with regulatory expectations on fair recovery practices and borrower treatment.

Looking ahead, monetary policy may remain constrained by inflation risks stemming from commodity price volatility and supply disruptions. While the RBI may shift the stance of the monetary policy from present ‘neutral’ to ‘accommodative' to support market sentiment during periods of stress, inflationary pressures could limit room for aggressive easing. Banks will therefore have to navigate a difficult operating environment in which elevated risks coexist with the need to maintain credit flow and economic stability.

The broader message is that the present environment requires a recalibration of credit administration and risk management practices within the regulatory framework. Banks may have to empower frontline risk-management systems, improve responsiveness and adopt a more flexible approach to borrower engagement if they are to preserve asset quality while continuing to support economic activity through a potentially prolonged period of stress.