Mumbai: Fitch Ratings today says that the credit profile of the Indian banking sector has improved during the last two to three years, helped by investment in risk management systems and a benign credit cycle.

The rating agency also noted that the financials of Indian banks strengthened even as the Reserve Bank of India gradually tightened the prudential norms. However, Fitch noted that despite recent progress on disclosures by Indian banks, a lot more still remains to be done in this regard.

In a report titled Indian Banks: Prudential Regulations, Fitch observes that notable changes include increased general provisions on certain retail loan categories, increased risk weight on real estate exposures, permitting banks to issue hybrid capital and shifting to a 90-day norm from 180-day for recognition of non-performing loans.

The rapid loan growth as well as the proposed capital charge for operational risk under Basel II and tightening risk weights on various loan categories has increased the banks' need for capital. With the government's holdings in many public sector banks close to the statutory minimum of 51 per cent, the RBI has allowed banks to issue perpetual debt instruments for inclusion in Tier 1 capital and Upper Tier 2 subordinated debt instruments.

Basel II capital norms will be applicable from FY07 (though the RBI has stated that it is possible that the March 2007 implementation date may be stretched slightly given the state of preparedness of various banks). Banks are required to adopt the "standardised approach" for credit risk and the "basic indicator approach" for operational risk. The final guidelines on the new capital adequacy framework under Basel II have yet to be announced.

While recognition of NPLs is based on the objective norm of 90-days overdue, RBI has encouraged banks to build additional provisions based on consistently applied accounting policies. The rapid growth in the relatively new retail loan business had raised concerns on whether the credit risk is being appropriately priced by banks, particularly since part of the portfolio is unseasoned.

The recent (FY05 onwards) changes introduced by the RBI, including increased general provisions on standard assets (to 0.4 per cent, up from 0.25 per cent) and higher general provisions (1 per cent) on personal loans, capital market and commercial real estate exposures as well as residential lending above INR2 million, has addressed this issue. Fitch believes that this would help banks better prepare for any downturn in the credit cycle, especially given increased risk weights on personal and credit cards loans (all 125 per cent) and commercial real estate exposures (150 per cent), as well as higher risk weight for residential mortgage loans (75 per cent) as compared to the Basel II requirement of 35 per cent.

Revised guidelines for an asset liability management framework proposing a migration to duration gap analysis from the existing method of gap analysis are still pending. Also awaited are revised guidelines on investment classification and valuation. As per the proposed guidelines, unrealised gains / losses on the "available for sale portfolio" is to be carried forward in the balance sheet instead of crediting (or debiting) the income statement, thereby reducing volatility of reported profits in a changing interest rate scenario.

Accumulated provision of unrealised gains will not be eligible as an item of capital funds; however, accumulated unrealised losses will be deducted from Tier 1 capital. The new guidelines also propose to tighten norms for classification of investments in the "held to maturity" category.

While Fitch notes that disclosures by Indian banks have improved during the last three years, the agency says a great deal more still needs to be done. Specifically, disclosures concerning loss on reconstructed assets, modified duration of the investment portfolio, sensitivity of various advances and investments to changes in interest rate, breakup of outstanding provisions and credit exposure to the various sectors would be useful.

The report also provides an update on the regulatory framework for capital adequacy, income recognition, provisioning norms for NPLs, exposure norms, and investment classification and valuation norms. The report will be available shortly be available on www.fitchratings.com & www.fitchindia.com.

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