Akshat Saxena-19B103

T. A. Pai Management Institute

Assessment of Liquidity Risk under Financial

Stability Report (FSR), December 2018 edition

Submitted to Prof. Meera Aranha By: Akshat Saxena 19B103

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Akshat Saxena-19B103

The financial Institution of any economy ought to be immune as well as resilient to the various shocks it
could experience from both endogenous as well as exogenous factors. The need of robust resilience is
more important in the current time which is plagued by uncertainties at both national and international
level.

Overall the banking sector in India has shown some improvement in terms asset quality as the gross non-
performing assets (GNPA) ratio of scheduled commercial banks declining from 11.5% in Mar’18 to 10.8%
in sept’18. It is also expected that GNPA level will fall from 10.8% in Mar’18 to 10.3% in Mar’191.

Apart from asset quality, credit growth in scheduled commercial banks also improved, which was driven
by private sector banks. One interesting observation made was about shrinking of inter-bank market and
rise of bank linkages with asset management companies (AMC-MFs) for raising funds and with Non-
banking financial corporation (NBFC) for lending.

Post global financial crisis, banks capital regimes have increased systematic resilience. Reserve Bank of
India (RBI) has started policy measures to deepen government securities and repo markets. While
Security Exchange Board of India (SEBI) has undertaken several measures to strengthen the integrity and
surveillance of derivate market in India1.

But currently both global and domestic condition suggest a precarious nature of environment which
surrounds the financial system of India and it may check the soundness and resilience of Indian financial
sector soon.

Global condition

On the global front, expected growth in 2018 and 2019 is expected to be along the same lines of 2017
which is 3.7%, though key threats towards this growth are trade conflict and inflation risk in advanced
economies. Overall, the advanced economies are expected to grow at 2.4% in 2018 and 2.1% in 2019.
While the emerging and developing economies are expected to grow at 4.7% in 2018 and 2019, though
in 2019 there will be risk of stronger dollar and geopolitical risk1.

One of the major threats towards the global financial system is the rising tensions among US and China,
the two of the largest economies of the world in terms of world trade. US had developed a belief that its
existing trade has been detrimental to its domestic industry and is seeking to impose more tariffs on its
import, as of sept’18 US has imposed tariffs on $ 250 Bn on Chinese imports2.

China is expected to retaliate against such a move by US and the spill-overs of these would be borne by
the entire world economy, as the global trade equilibrium hampers. But an interesting observation has
been made is that trade volumes are yet to bear any significant impact of the ongoing tension between
US and China.

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Source: CPB, Netherlands, RBI

Domestic Condition

India has been described as the world’s fastest growing nation and world bank expects India to occupy
this position for the next 3 years. GDP growth rate fell from 7.3% to 5.9% between Q3’16 and Q1’18, but
picked up post Q1’18.

GDP Growth Rate

9.00%
7.90% 7.70%
8.00%
7.30% 7.10% 7.30% 7.30% 7.20%
7.00%
6.10% 6.30%
6.00% 5.70%

5.00%

4.00%

3.00%

2.00%

1.00%

0.00%
Q3'16 Q4'16 Q1'17 Q2'17 Q3'17 Q4'17 Q1'18 Q2'18 Q3'18 Q4'18

Source: Financial Express

One cause of worry within the domestic economy has been the shortfall in tax revenue as well as lower
than targeted disinvestment proceeds. Fiscal deficit was targeted at 3.3% in FY19 but it was been
estimated that it will be at 3.5%. The consequence of this would be India missing its fiscal deficit target,
which could potentially have adverse effects on inflation and private investments within India3.

Another development in the economy which requires attention is signs of a slowdown within auto sector
as car sales slip a four year low in FY 19. This is seen as a consequence of slowdown in domestic

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consumption growth, and also telling us that in near future more sectors could be experiencing
slowdown.

Overall, there has been a mood that Indian economy is heading towards an economic slowdown. But it
is still to be gathered whether the slowdown in cyclical or structural in nature.

Sectoral Risk

Apart from domestic and international risk, financial sector also faces risk from the developments on
certain key sectors in the economy. In fact, one of the key drivers of NPA level within banks were the
disruptions in certain sector which made some of the big manufacturing units face solvency. These
disruptions could arise because of technological, structural or political changes in the country.

Distribution of Credit sector wise

Agriculture and Allied Industries Industry Service Personal Loan Priority

Source: RBI

Some level of risk due to disruptions in certain sectors has been mitigated with the introduction of
Insolvency and Bankruptcy Code (IBC), which has created a framework for liquidation of NPA and help
banks partially recover their debt. But IBC is applicable for stressed assets beyond a threshold, below
which IBC cannot be invoked to recover debt.

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Credit distribution within industry-scale wise (in Rs billion)

25000

20000

15000

10000

5000

0
Micro & Small Medium Large

Source: RBI

Sectors where the average ticket size of credit is below Rs. 50 crore are agriculture, small and medium
scale enterprise (SME) and retail sector. As these sector are directly attributed to the masses of India,
there has been a calls to ease the lending norms in these sectors, so that maximum people can avail
credit.

Easing of lending norms and maximise the people who avail credit might lead to social good, but this
social good does not come at the cost of increased risk in the financial sector. In fact between 1910-28
was a period of credit boom in United states which finally culminated into Great Depression of 1929.

Agriculture sector

Agriculture sector contributed 15.87% to Gross value added (GVA), while manufacturing and service
sector contribution was 29.73% and 54.4% in 2018-19. Yet agriculture sector is the biggest employer in
Indian economy covering 50% of the total workforce in India4.

As of May’18, credit extended towards agriculture sector amounts to rising by 5% since May’17.
Agriculture currently is part of priority sector of lending by RBI and therefore receives special attention
the banks.

Agriculture being the occupation of masses has received attention from the government as well in terms
of policies and program aimed at improving standard of living of farmers. Farmers are offered fertiliser
and pesticide subsidy, as well as price and income support policy such as minimum support price (MSP),
minimum export price (MEP), buffer stock options and public distribution system.

In 1998, government also introduced Kisan credit card to offer short term credit requirement for
cultivation of crop and meeting post-harvest expenses. It covered both tenet farmers as well as land
owners.

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Credit extended to agriculture and allied activites

10300
10200
10100
10000
9900
9800
9700
9600
9500
9400
9300
May.26, 2017* Mar. 30, 2018 May.25, 2018

Source: RBI

But still major problems remains in agriculture sector in terms of agriculture as a business and revenue
generating activity. Average agriculture household income remained at Rs. 8931 on a monthly basis and
still the farmers are heavily dependent on rainfall for water supply to their crops4.

Employing half of India workforce without much value addition has resulted in low wages in agriculture
sector. Also a year of bumper harvest makes supply greater than the overall demand, and further results
in decline in equilibrium prices.

Government had introduced minimum support price (MSP) to tackle this problem and also continuously
revise it. But due to improper execution, farmers are unable to collect minimum support price (MSP) on
their produce and sell all their produce at the market value.

Due to these frictions within agriculture sector, delinquencies has seen a spike. At State Bank of India
(SBI) the gross non-performing asset (NPA) for agriculture sector shot up to 11.43% in sept’18, whereas
in sept’17 it was 9.93%. Fresh accreditation towards bad loan stood at Rs. 2700 crore5.

Other commercial banks have their exposure towards NPA in agriculture sector greater than 10% while
Andhra Bank has it as high as 20%. It int interesting to note that the most active lenders in agriculture
sector has been banks where the government has a majority stake, and therefore government pushes
such banks to lend in agriculture sector

Commercial banks also then lend in agriculture sector with relaxed norms in lending compared to other
sectors to make more farmers eligible for credit, and this could be one of the reason behind spike in NPA
level as credit may be availed by someone without the ability to pay.

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Source: Livemint

Apart from this, due to political and social considerations government in certain states have announced
a policy of farm loan waver to ameliorate the farmers from the burden of debt. But this policy has some
serious repercussions over the financial system of India.

Loan waver policy which shifts the burden of debt from farmers to the state government does not
promote a healthy credit culture where the creditor prioritise serving his/her debt obligation. Farm waver
policy promote moral hazard where the farmers who will cease to service their debt, knowing that
eventually they’ll be relieved of it by the government.

Whenever the government waives off the debt of farmers, they are essentially shifting the burden of debt
from farmers to themselves. But even their ability to service the debt is also restricted as because of their
revenue deficit, which states have been experiencing after implementation of Goods and Service Tax
(GST) in 2017.

Therefore, waiving of farm loan taking its burden upon the state has several risk attached to it and should
not be exercised until state is financially healthy and can service debts of farmers well.

SME sector

Small and Medium scale industries amount to about 30 Mn in India and contributes 45% towards total
output and 40% towards total exports. It employs 60 Mn of the workforce in India and is the second
biggest employer after agriculture sector6.

Small and Medium Enterprises (SME) operate under financial constraints and often seek credit to meet
their obligations and invest further into business. But their small scale does not make them favourites
among big banks to grant credit facilities, specially private sector banks.

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Credit distribution within industry-scale wise

25000

20000

15000

10000

5000

0
Micro & Small Medium Large

Source: RBI

Due to political and social considerations, scheduled government banks eased the access to credit among
SMEs and policies which enabled faster disbursal of credit to them. Institution such as Micro Bank
Development and Refinance Agency Bank (MUDRA) were established to offer low interest credit to
micro-finance and NBFCs which further directed credit towards SME sector.

SME sector was a credit starved sector and many private players among non-banking financial
companies (NBFC) also emerged which focussed only on credit towards SMEs. Banks in fact supported
these NBFCs in terms of liquidity which SME could deliver to NBFC. Government in budget 2019 also
introduced a scheme in which government took partial guarantee of highly rated assets upto $ 14.6 Bn
from NBFC7.

In last 4 years, economic disruptions such as demonetisation and implementation of goods and service
tax (GST) have severely affected the business for SMEs. Apart from this, decreasing competitiveness of
Indian exports in the international market has also been harmful for their business.

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Risk faced by SMEs are also borne by NBFCs and commercial banks are also borne NBFCs and
commercial banks which have high exposure towards them. With a slowdown in the economy, the risk is
only going to accentuate.

Reserve Bank of India (RBI) recently opened up a restructuring window for SMEs with stressed asset upto
Rs. 25 crore and this action is only delaying classification of stressed asset in SMEs. With lack of a
framework to recover debt from SMEs, banks and financial institution have limited options to recover
bad debt from SME sector.

Overall Scenario

Scheduled commercial banks in 2015 had witnessed a huge spike in NPA level after RBI conduced an
asset quality review, with an aim to identify and clean up stressed assets in the system. Majority of the
stressed assets arose from large industries which had faced disruptions in one form or the other.

Later insolvency and bankruptcy code was introduced (IBC) to create a framework to enable faster
resolution towards stressed asset and help banks recover part of their debt. IBC allowed bankers to take
over the assets and auction them in open market to recover their debt.

But one thing common among all was that the credit extended was towards industries which used them
for creating assets. Only a part of the credit was used for working capital requirement, rest was mainly
for setting up of manufacturing units and creating capacity.

This allowed banks to recover part of their debt by auctioning the manufacturing units and other assets
of the borowee in case he defaults. But in case the credit extended by banks are unsecured and not used
to create assets, it will limit the ability of banks to recover their debt. Also for credit below Rs. 1,00,000
insolvency and bankruptcy code cannot be used to recover debt back.

With greater uncertainty in international as well advent of slowdown in the economy, level of
delinquencies can be expected to rise from agriculture and SME sector. But more pertinent question here
is how can banks recover their debt if case such a scenario occurs.

There is lack of framework which effectively deals with such kind of defaults, and the need of such a
framework is important as defaults are expected to rise in agriculture and SME sector, given the domestic
scenario and current situation in these sectors. With SME sector there is also the problem of identification
of stressed asset after debt restructuring scheme was announced recently by the Reserve Bank of India
(RBI)

Sources
1. Reserve Bank of India-Financial Stability report 2018
2. https://www.bbc.com/news/business-44529600

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3. https://www.livemint.com/Politics/p4JEOENOjSbenKznG8ceqJ/India-set-to-miss-
201819-fiscal-deficit-target-due-to-reven.html
4. https://www.financialexpress.com/industry/farm-stress-agri-portfolios-see-spike-in-
npas/1401473/
5. https://www.thehindubusinessline.com/economy/agri-business/bring-npa-norms-for-
farm-loans-on-par-with-others-sbi-research/article25800019.ece
6. https://www.dbs.com/blogs/in/SMEs-in-India.html#.XWpkrS-B3fY
7. https://qz.com/india/1512868/rbi-eases-npa-norms-for-indias-gst-hit-msme-sector/

Other References

 https://indianexpress.com/article/business/economy/states-fiscal-position-
deteriorates-in-fy18-on-widening-revenue-deficit-care-ratings-report-5148952/ (state
fiscal deficit)
 https://www.downtoearth.org.in/news/agriculture/in-4-years-farmers-income-has
increased-by-just-rs-2-505-per-month-nabard-report-61410 (agriculture)
 https://www.rbi.org.in/Scripts/MSM_Mintstreetmemos13.aspx (RBI-MSME)
 https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=47443 (Sectoral
deployment of bank credit)
 https://www.financialexpress.com/economy/dirty-dozen-npa-resolution-4-done-8-
under-process-heres-ibc-update-for-12-big-accounts/1258908/ (Insolvency and
bankruptcy Code)
 https://www.financialexpress.com/economy/dirty-dozen-npa-resolution-4-done-8-
under-process-heres-ibc-update-for-12-big-accounts/1258908/ (Insolvency and
Bankruptcy Code)

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Assessment of liquidity risk under Financial

Stability Report (2018)-Précis
Banking sector in India has shown signs of improvement as gross Non-Performing Assets (NPA)
of commercial banks declined by 0.7% between Mar-Sept’18, while between Mar’18 to Mar’19
the NPA level is expected to fall by 1.2%. Also the credit growth in commercial banks have
improved, which was driven by private banks.

Another major development in banking sector was the shrinking of inter-bank market and rise of
bank linkages with asset management companies. Banks are linked to AMCs for raising funds and
with Non-banking financial corporation (NBFC) for lending.

But despite positive developments, the risk factor within the banking sector have not diminished.
Slowdown in the global economy along with the impending trade wars are contributing towards
the external risk faced by the banks. Also the decline in quarterly Gross Domestic Product (GDP)
of India indicates slowdown arising within domestic market also.

Given the precarious nature of the banking sector, there is a need of resilient and sound
framework. The Government along with Reserve Bank of India (RBI) collectively are responsible
for granting shield to the banking sector, from the external and internal risk they face.

Sectoral Risk
One of the main components of internal risk faced by the banks in India, is the risk arising from
sectoral disruptions in the economy. These disruptions could arise because of technological,
structural or political changes in the country.

Introduction of Insolvency and Bankruptcy Code (IBC) have contributed in mitigating the risk up
to certain extent. It helped in creating a framework which allowed banks to liquidate their Non-
Performing Assets and partially recover their debt.

So far the source of Non-Performing Assets have been from commercial lending part of the banks,
but the next source of Non-Performing Assets is expected to arise from Retail lending.

Agriculture Sector

Agriculture sector offers employment to 50% of the population of the country yet its contribution
to the Gross Value Added (GVA) is just 15.87%. It is also part of the priority sector which receives
40% of the bank’s credit portfolio. Government further supports Agriculture sector by offering
Minimum Support Price (MSP), Minimum Export Price (MEP) and Public Distribution System
(PDS).

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Despite these government interventions, income of households with agriculture as primary

occupation remained at Rs. 8931 on monthly basis. Government tried to incentivize farmers to
take up credit for meeting their capital requirements, but it did not result in increase in their
income.

This resulted in farmers not having the capacity to repay their debt. Therefore the Non-
Performing Asset level of the banks in agriculture sector spiked from 9.83% in Sept’17 to 11.43%
in Sept’18.

The rise in Non-Performing Asset level further spiked after certain state government introduce
loan waiver scheme, where the burden of credit from farmers shifted to state government. State
government are itself suffering from cash crunch and do have ability to service back the farmers
debt.

Loan Waiver also results in Moral Hazard problem where the farmers who do carry the ability to
service their debt will cease to do so, with a hope that government will later take over their debt.

SME Sector

Small and Medium Enterprises (SME) contribute 40% of the total exports and 45% of the total
output. They operate under financial constraints and often seek credit to meet their obligations
and for capital expenditure. But banks prefer to grant credit to big organisations as banks make
more interest income, and SME remained credit starved.

Government in their attempt to ease credit access to SME launched Micro Bank Development
and Refinance Agency Bank (MUDRA) scheme. Apart from MUDRA, other incentives were also
offered to NBFC and Banks to extend credit to SME sector.

But due to disruptions caused by Demonetization and Goods and service tax (GST), SME sector
lost their ability to service their debt. RBI recently announced restructuring window which
delayed their recognition as an NPA.

Overall Scenario

It is much easier for banks to mitigate their losses from a NPA if its credit has been utilised in
capital expenditure, rather than meeting working capital requirement. Whereas in agriculture
and SME sector credit has mainly been utilised for meeting working capital requirements.

NPA level is expected to only rise in agriculture and SME sector and its recovery will also be
difficult, and this might be the source of next crisis within the banking sector of India. It differs
from other crisis which the banking sector has experienced, as there is a visible intervention of
government in this case.

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Introducing steps which develops a framework for dealing with NPA which are not asset backed,
will help in de-risking the banks from agriculture and SME sector. This would also contribute in
making the financial sector resilient and sound.

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