Risks to the banking stability have heightened since the last publication of the FSR six months due to asset quality deterioration, it said.
The Reserve Bank of India (RBI) has warned that stability conditions in the banking sector have worsened in the last six months due to rising bad loans.
Gross non-performing assets (GNPAs) of banks could rise up to 8.6% of gross bank credit by March 2017 from 7.6% in March 2015 in a baseline stress scenario, the RBI said in its bi-annual Financial Stability Report (FSR). The risk of higher NPAs is led by large borrowers.
Under severe stress situation the GNPAs could rise to 9.6% of gross advances, it said.
Risks to the banking stability have heightened since the last publication of the FSR six months due to asset quality deterioration, it said.
The FSR, the last by RBI governor Raghuram Rajan, said, "Stability conditions in the banking sector which started deteriorating in mid-2010, have now worsened significantly. The factors contributing to an increase in risks during the half-year ended March 2016 are deteriorating asset quality and low profitability."
Overall stressed asset ratio, which includes the NPAs and restructured accounts, rose to 11.5% in March 2016 from 6% in September 2015.
Concentration risk with few large corporate borrowers holding on to a lion's share of bank debt could also be detrimental to the banking system, the report said.
The FSR report said, "The GNPA ratio of large borrowers increased sharply from 7% to 10.6% during September 2015 to March 2016 and the increase was evident across all bank groups. In this respect, PSBs recorded the highest GNPA ratio at 12.9%. There was a sharp increase in the share of GNPAs of top 100 large borrowers in GNPAs of all large borrowers from 3.4% in September 2015 to 22.3% in March 2016."
The ever-greening of books by Indian banks had forced the regulator led by Rajan to conduct a review to clean up the bank balance sheets. From September 2015, the RBI had set in motion the Asset Quality Review where it scrutinised banks' books and forced them to recognise over Rs 2.5 lakh crore of bad loans in the last two quarters of fiscal 2016, pushing up the gross bad loans to 7.6% in March 2016.
Certain select sectors could enhance the stress in the banking sector. Iron and steel industry (which had the highest GNPA ratio at 30.4% as of March 2016) could see its GNPA ratio moving up to 33.6% by March 2017 followed by engineering (from 10.9% to 15.9%) and infrastructure (from 7.1% to 13.4%)
The RBI is also concerned about the concentration risk of Indian banks to select corporate groups.
Top two individual borrowers could result in capital losses of 5% while 6% losses could occur in case the three top individual borrowers default. The impact on profit before tax (PBT) could be 112% in case of default of the top three individual borrowers. The losses could be 45% of PBT under the scenarios of default of topmost individual borrower and 81 % in case the top two individual borrowers default.
Failure of the top two stressed borrowers could result in capital losses of 6.9%, while 9.4% losses could occur in case the top three stressed borrowers fail. The impact on PBT could be 162% for the failure of the top three stressed borrowers. The losses could be 70% of PBT under the scenarios of default of topmost stressed borrower and 120% in case the top two stressed borrowers fail.
India's financial system remains stable, even though the banking sector is facing significant challenges. "As global uncertainties and transiting geopolitical risks impact India, continuation of sound domestic policies and structural reforms remain the key for macroeconomic stability," the FSR said.
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