India’s booming retail lending is increasingly posing concerns for the banking industry, arising from a potential systemic risk.

The non-mortgage lending growth of banks and NBFCs has been growing at 25-30% YoY, mainly led by credit cards, durables, autos, personal loans, education loans, and others.

A recent RBI research delves into the empirics of retail credit growth and concludes that the quality of retail loan portfolio is healthy across banks, product categories, and borrower risk classes, even as growth continues to surge.

But it warns that some subcategories, mainly credit cards and vehicle loan portfolios, show signs of weakness, and need close monitoring.

The broader message of this study is that there are incipient concerns about rising credit risks from rampant retail lending by banks and NBFCs.

However, the fact that the RBI’s research recommends further regulatory tightening to contain the spillover effect aligns with our fervent alerts on exuberant retail lending.

Considering RBI’s latest study, the announced and prospective regulatory tightening, and our assessment of the economic cycle, the headwinds for the Indian banks and lending industry will likely intensify.

RBI study indicates tightening ahead

RBI’s recent measures to increase risk weights on non-mortgage retail lending and stamping out the evergreening of bad assets by lenders using the AIF route indicates that the regulator is aware of systemic and lender-specific risks, more than what is reported by the lenders.

The RBI study recommends that a) incipient concerns from aggressive retail lending deserve close and continuous monitoring for any undue build-up of stress, b) The regulator could enhance its structural prudential tools using the debt-service ratio and debt-to-income ratio of retail borrowers in addition to the extant framework of differential risk weights for various retail products, c) In addition to the prevailing loan-value ratio, the regulatory framework could be extended by prescribing debt-to-income (DTI) limits for certain borrower or product categories.

These recommendations presage further credit tightening and policy synchronisation to contain systemic risks.

Here is why the RBI’s study may be understating the concerns:

The suggestion that the boom in retail lending is a structural phenomenon, and hence less bothersome, contradicts the inherent procyclical nature of the lending cycle.

This has also been inferred from RBI’s earlier study Re-emerging Stress in the Asset Quality of Indian Banks: Macro-Financial Linkages, 2014.

Accordingly, the difference between retail lending and overall credit growth remained negative during 2007-2012 in response to the rise in the GNPA ratio.

The study overlooks the point that the quality of collateral has weakened now as the proportion of mortgage lending in retail lending has declined to 48%, significantly lower than the peak of 56% in FY16 and the FY12-FY20 average of 50%.

This also implies that the duration of retail lending has also declined. Collectively they are emblematic of greater volatility in credit quality during times of credit tightening than in the past cycle.

The observation that the rising dominance of retail lending loan portfolios exhibits greater granularity than corporate lending is a truism. It is an outcome of a lack of industrial credit demand and a languid private capex cycle.

At the same time, the sustained deceleration in real household income growth over the last decade underlines the weak fundamentals behind aggressive retail lending, which is a risk for lenders pertaining to both growth sustainability and asset quality.

Again, the observation that NPA ratios on retail lending have been low despite the exuberant retail lending is another truism, as there is always a negative correlation between the NPA and lending cycle, both for industrial and retail lending.

Our estimates show that for even a 100bp decline in the credit growth of banks, GNPA ratio rises by 20bp, and for every 100bp decline in inflation the ratio increases by 60bp.

Consequently, the headwinds for the banking sector (and lenders in general) could intensify, as RBI gets more granular in containing exuberant retail lending, using credit tightening instruments in addition to contract systemic liquidity (currently LAF deficit/total deposits at 1.1%) and pushes banks to reduce credit-deposit ratios.

All of these will likely impact the growth and profitability of banks. Investors will have to grapple with uncertainty regarding the prospects.

Possible respite could come from large global capital flows into India to ease the liquidity pressure. A potential deceleration in credit growth (currently at 15.6%) towards the lower deposit growth (12.6%) could also ease the liquidity pressure.

Also, if the surge in retail inflation (5.7% in Dec’23) reverses towards RBI’s target of 4%, the central bank could consider a policy rate cut (currently at 6.5%).

However, realistically speaking, with FDI contracting and volatile FPI flows, normalisation in the liquidity situation could largely come from the narrowing of retail lending exuberance, triggered by the current regulatory tightening.

With food inflation seemingly structural, RBI may find it difficult to reduce rates even amid global rate easing.

(The author is Co Head of Equities & Head of Research – Strategy & Economics at Systematix Group)

(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)