Indian banking outlook: how real is the improvement in asset quality

 The big surprise in the latest Financial Stability Report of RBI is not the overall improvement in asset quality or the decline in gross NPAs/total loans to 2.3 per cent. It is that the decline is driven by a remarkable improvement in MSME asset quality. Gross NPAs in MSMEs is a 3.6 per cent, astonishing for a segment that was accustomed to seeing NPAs close to double digits. 

One is left wondering what has brought down gross NPAs in SMEs down from 6.8 per cent to 3.6 per cent in the past two years. Better information from MSMEs? A dramatic improvement in underwriting skills at banks? Large write-offs? The report gives no explanation, which is disappointing.

Could it be just the sharp rise in MSMEs loan growth in the past few years or the denominator effect? If so, the improvement in asset quality could be deceptive. We have to wait and see.

More in my latest article in BS, MSME lending a new driver of loan growth?

MSME lending a new driver of credit growth?

 T T Ram  Mohan

India’s banking sector is in rude health. By a variety of measures — capital adequacy, provision coverage ratio, liquidity coverage ratio, return on assets, and gross non-performing assets (GNPAs) as a proportion of loans — the sector demonstrates strengths that would have been unthinkable five years ago.

Capital adequacy in the system as a whole is 17.3 per cent, with public sector banks’ (PSBs’) capital adequacy at 16.2 per cent. Being over five percentage points above the regulatory minimum of  capital is prudent and a source of stability. Return on assets (RoA) for all banks is 1.4 per cent. PSBs have an RoA of 1.1 per cent, which is above the benchmark of 1 per cent in banking. 

When a bank produces an RoA of 1 per cent or more, it can be reasonably sure of access to capital from the market. In other words, PSBs do not have to turn to the government for capital support.  The question is often asked: How do PSBs compete with private banks that produce higher returns? The answer is that they can compete on their own terms as long as they can raise capital from the market. 

The banking sector will walk on two legs. We will have private banks that are focused on maximising returns by catering to the mass affluent. And PSBs that will marry larger social objectives with profitability while catering to the wider market. The model as a whole remains viable as long as the benchmark of profitability is met. 

So far, so reassuring. Banking is safe and sound. That apart, a few points emerge clearly from the latest edition of the Reserve Bank of India’s Financial Stability Report (June 2025). 

Firstly, credit growth slowed noticeably to 11 per cent in 2024-25 from 16 per cent in 2023-24 and 15.4 per cent in 2022-23. In 2024-25, PSBs have shown higher credit growth than private banks, which means their market share has risen after years of decline. 

The slowing down of credit growth was deliberate and engineered by the regulator. The RBI had two concerns. One, credit growth was outstripping deposit growth and that meant it was being financed by high-cost and volatile funds. Two, growth in segments such as personal loans and non-banking financial companies (NBFCs) was too high for comfort. Between April 2022 and March 2024, bank lending to the retail sector grew at 25.2 per cent, and lending to services, which includes bank lending to NBFCs, grew at 22.4 per cent, far exceeding the overall credit growth of 16.4 per cent. The RBI increased risk weights on these two segments. Credit growth in these segments slowed down as a result. 

 

Secondly, the slowdown in credit has not adversely impacted growth in profit or profitability. Profitability of all banks has gone down marginally, but that of PSBs has increased from 0.9 to 1.1 per cent. Profit after tax of all banks rose by 17 per cent with that of PSBs rising by 32 per cent, mainly on account of other operating income. 

Thirdly, in 2024-25, growth in credit to micro, small and medium enterprises (MSMEs) has outpaced growth to all other sectors. Credit to MSMEs grew by 14.1 per cent, compared to growth of 11.2 per cent in services (ex-MSME) credit and 11.7 per cent in retail credit. The share of MSMEs in retail credit has risen from 17 per cent in March 2024 to 17.7 per cent in March 2025.

Fourthly- and this is, perhaps, the most striking feature of the latest FSR- gross NPAs in the system have touched a new low of 2.3 per cent of loans, with a sharp drop in NPAs in MSMEs. Gross NPAs in MSMEs declined from 6.8 per cent in 2022-23 to 4.5 per cent in 2023-24 and further to 3.6 per cent in 2024-25. 

NPAs in the MSME sector have historically been of the order of 9 per cent or more. Until a couple of years ago, senior public sector bankers wondered how on earth they were to crack the MSME lending issue. In 2024-25, PSB credit growth to SMEs has been greater than that of private banks, reversing the earlier trend. Has something changed fundamentally in lending to MSMEs? What has brought about a dramatic decline in NPAs to this segment?

The RBI might have shed light on the issue instead of merely putting out the numbers. True, bankers have found innovative ways, such as the Trade Receivables Discounting System (TReDS), to finance MSMEs. TReDs is an online platform for facilitating financing of trade receivables of MSMEs from corporations, public sector companies and government departments. These exposures are considered low-risk.  

The TReDS book was about ~2.7 trillion, or 10 per cent of the MSME book, in 2023-24. It cannot explain the current NPA level of 3.6 per cent on the entire MSME exposure. The NPA level in the Emergency Credit Line Guarantee Scheme (ECLGS) is 5.6 per cent. Recall that the ECLGS was introduced during the pandemic in May 2020 in order to facilitate additional lending to MSMEs and prevent a secular collapse in the sector on account of a crisis of liquidity. The eligibility conditions were pretty stringent. Only MSMEs that were solvent prior to the onset of pandemic were meant to qualify.  

The loans granted under ECLGS in the period 2021-23 amounted to ~3.68 lakh crore or 12 per cent of loans outstanding to MSMEs in 2024-25. If gross NPAs on the ECLGS loans were 5.6 per cent and NPAs on total MSME loans are 3.6 per cent, that makes the performance on the remaining 88 per cent of MSME loans truly impressive. It certainly needs explaining. Is it explained merely by the spurt in the denominator, namely, the MSME loans in the past few years? If that is so, we should see a rise in NPAs in the years ahead. The RBI’s stress test projections for NPAs may then turn out to be optimistic.

Banks have tended to pursue a risk-averse approach to lending. Loan growth has been driven by working capital loans to industry, retails loans and loans to the services sector, including NBFCs. The year 2024-25 has seen a shift of gears with loans to MSMEs growing faster than loans to other segments. We will need to wait for a year or two to see what the shift implies for asset quality in the system. 

The real test will, however, come when banks step up growth of term loans and project finance whenever private investment picks up. Celebration over the steep fall in NPAs must be low key until banks begin to take greater risk than they have in recent years.