India's economic recovery from the coronavirus crisis could be delayed if banks stop lending to borrowers with low credit scores, or charge them a much higher interest on loans.
The financial sector faces an erosion of loan growth and higher credit costs as it prepares for a rise in bad debt from retail and corporate borrowers — and with India's lockdown extended again, the economic impact could exacerbate.
"I think banks would also want to be a lot more careful in terms of incremental lending," Sanjeev Prasad, managing director, and co-head at Kotak Institutional Equities, told CNBC. He explained that a lot of borrowers who would have previously received loans from banks and non-bank financial institutions would not qualify if lenders become more stringent over whom they lend to. "It will have its own repercussions on recovery in the economy going forward."
India this week entered another 2-week extension of its national lockdown which began in late March.
The country extended its lockdown twice as infection cases continued to rise, and is currently expected to lift restrictions on May 18. Still, there has been some easing of rules, especially in low-risk areas, though most economic activities remain on hold.
Millions of daily wage-earners have lost their jobs since the lockdown started, while others, particularly in the services sectors, have been furloughed.
"Bad loans are going to increase and the longer the lockdown, the more prolonged the economic recovery, the more it will be the increase in bad loans," Prasad said in a late-April interview before India extended the lockdown for a second time.
Bankers and government officials already expected bad loans to potentially double as the outbreak brought economic activity to an abrupt halt, Reuters reported. For its part, the central bank had already anticipated an increase in bad debts between September 2019 and September 2020, before the Covid-19 crisis occurred.
Prasad said there are three segments of borrowers that are of concern: First, the micro, small and medium-sized companies which, unlike the larger corporations, do not have the financial ability "to withstand any sort of slowdown in business for an extended period of time."
Another segment would be the retail borrowers who take personal, unsecured loans and are likely to face job losses. Finally, the microfinance institutions are also at risk. They mostly give small, unsecured loans to daily wage earners, many of whom do not currently have income due to the lockdown.
India's banking sector has been in crisis for several years.
When the Reserve Bank of India told banks to clean up their balance sheets around three years ago, non-performing assets surged among state lenders. That was followed by a shadow banking crisis, which saw bad loans outside the formal banking sector balloon. More recently, a struggling private bank with exposure to shadow lenders received a massive bailout from the government, and is aiming to recover up to $1.35 billion of bad loans, Reuters reported.
The economic fallout from the virus outbreak is expected to hit all lenders.
RBI data showed private banks have been lending at a faster rate than their state rivals over the last several years, making them just as vulnerable to rising levels of defaults worsened by the long lockdown period. Small lenders are even more vulnerable and exposed due to their aggressive credit growth in recent quarters, according to RBI data.
"While not all the job losses will be permanent, a few months of lost income and the resulting rise in the retail delinquency rate could prove to be a potential double whammy for the banks on top of the expected surge in corporate defaults," Kunal Kundu, India economist at Societe Generale, wrote in a late-April note.
He explained that the share of unsecured loans in the banks' overall retail portfolio has "jumped to more than a third, increasing their vulnerability."
"With many banks giving out low-ticket loans without collateral and based on algorithmic lending without any direct connection with the borrowers, delinquencies could reach worrying levels," Kundu added.
Some lenders use software to analyze other sources of information about borrowers who do not have established credit histories, in order to determine if they qualify for a loan.
Still, non-bank financial companies are likely more exposed to rising defaults as they typically lend to small and medium businesses that are being hit by the lockdown, Nitin Aggarwal, senior vice president for research at Motilal Oswal Financial Services, told CNBC.
Kotak's Prasad added that most shadow lenders may not even be able to raise enough funds from banks to grow their loan books. That could essentially freeze up India's credit cycle and people who need loans would not get them. "Which effectively means that a) recovery will be delayed, and b) the credit costs will also be high," Prasad said.
The central bank has stepped up efforts to inject more cash into the market, lower the cost of capital, and provide bigger incentives for banks to lend. That includes cheaper financing options for banks to borrow from the RBI and lend to non-bank financial institutions and microfinance lenders, but it received a lukewarm response.
"With commercial banks still in (the) midst of cleaning their own books, and the additional burden of provisioning against potential increase in stressed assets, has not surprisingly magnified their already weak credit and duration appetite," Radhika Rao, India economist for DBS Group, said in a note.
Policymakers need to introduce schemes where "some portion of the incremental credit cost is taken by the government," and there are guarantees for lenders against potential defaults, said Prasad from Kotak. Fiscal support to the more vulnerable sectors of the economy, including the micro and small businesses, should also be considered, he added.