'Banks should undertake stress testing of loan books'

Despite improvement in asset quality, financial institutions, including banks, need to proactively undertake stress testing of their loan books to examine loss absorption limits and take steps to improve them, if required, RBI Deputy Governor M Rajeshwar Rao said on Thursday.

The gross non-performing assets (GNPAs) and net NPAs of banks improved to 5.97 per cent and 1.7 per cent as of March 31, 2022, from 9.23 per cent and 3.66 per cent as of September 2019, respectively, he said.

During the pandemic the financial sector witnessed an increase in liquidity, flow of credit and spending on relief programs, the Deputy Governor said.

He said in the global fora, it is getting increasingly debated as to whether the pandemic-induced measures have led to build-up of leverage and debt overhang in the non-financial sector.

“Prudence has to be exhibited by the banks to ascertain whether the current levels of asset quality being exhibited is on account of improvement in fundamentals of business on account of deleveraging and efficiency gains or on account of support extended by authorities through the measures.

“We expect banks and other financial institutions to proactively undertake stress testing of their loan books subjecting them to various levels of stress, including extreme scenarios, to estimate the loss absorption limits wherever available at their disposal and take measures to augment the same wherever necessary,” Rao said.

He was speaking at a Banking and Finance Conference, organized by IMC Chamber of Commerce and Industry.

While the central bank has attempted to combat the impact of the pandemic on the financial system, (but) the task is only half done, he said, adding, “We have to ensure that the financial system escapes unscathed as we exit from the pandemic-driven regulatory forbearances,” he said.

According to Rao, the preliminary assessment of the health of the banking sector is encouraging.

The restructured portfolio of banks as a percentage of the total advances which has significantly expanded post 2020, owing to the restructuring of the accounts undertaken in view of the resolution framework announced by RBI, seems to be gradually stabilizing, he said.

The fresh slippages have broadly been brought under control and lenders have also enhanced their provisions, including provisions for restructured accounts, Rao said.

The Provision Coverage Ratio (PCR) ratio of banks has improved from 77 per cent in September 2019, to 86.8 per cent in March 2022.

“Today, most of the banks have comfortable capital positions which would position them well to support economic recovery. These data points do give us a degree of comfort at this juncture,” he said.

The Deputy Governor said RBI will continue to roll out measures to improve the resilience of the financial sector.

He said banks in the country follow the incurred loss approach for loan loss provisions, and RBI is now planning to issue a discussion paper on the introduction of a framework on expected credit-loss model soon.

“To achieve global convergence in regulations, we have proposed to issue a discussion paper on the introduction of a framework on expected credit loss for banks. The idea is to formulate principle-based guidelines supplemented by the regulatory backstops, wherever necessary,” Rao said.

He said the discussion paper would seek to solicit comments from all stakeholders, including the business community on the proposed approach, and the final contours or the transition will take into account the feedback received.

A loan loss provision is an expense that is set aside for defaulted loans. Banks set aside a portion of the expected loan repayments from all loans in their portfolio to cover the losses either completely or partially. In the event of a loss, instead of taking a loss in its cash flows, the bank can use loan loss reserves to cover the loss.

Rao further said RBI is also in the advanced stages of finalizing the revised norms for classification, valuation and operations of investment portfolio of commercial banks.

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