A Turnaround for Banks: Credit Growth, NPAs and MSME Sector Revival
Syllabus:
GS 3: ● Banking and Economy ● Economic policies and interventions
Why in the News?
Recent trends indicate a decline in gross non-performing assets (NPAs), especially in unsecured retail and MSME sectors, enabling a shift in credit dynamics across Indian banks. While overall credit growth is moderating, improved balance sheets and banking reforms have led to a significant revival in MSME credit growth, driving optimism in India’s banking sector. The latest Financial Stability Report highlights these positive developments, showcasing the resilience of the banking system during a period of heightened uncertainty.
Decline in Credit Growth Momentum
Credit growth has moderated compared to previous years due to various structural and policy-level changes in the banking sector.
● Policy Impact: The Reserve Bank of India’s directive to increase risk weights on consumer and NBFC credit in 2023 has curbed unsecured lending.
● Loan Contraction: Unsecured loan growth fell from 28.3% in March 2023 to 7.8% in May 2025, highlighting a sharp decline in consumer borrowing.
● NBFC Slowdown: Credit to Non-Banking Financial Companies (NBFCs), a key segment in services credit, turned negative in May 2025, affecting overall credit momentum.
● Transmission Friction: The low share of floating rate loans in private sector banks impacts interest rate transmission, reducing credit offtake.
● Private Sector Dip: Credit growth of private banks dropped to 9.5%, the lowest since FY21, indicating weaker retail lending capacity.
● Credit Card Growth: Despite the overall slowdown, credit card growth has shown resilience, with a moderate increase in new card issuances and spending volumes, reflecting changing consumer preferences in the digital payment landscape.
Shift Towards Public Sector Banks
There is a visible transition in credit origination from private to public sector banks (PSBs), reshaping the banking landscape.
● Growth Stability: PSBs showed a 12.2% growth in FY25, marginally lower than FY24 but far better than private sector banks.
● Credit Share Rise: PSBs’ share in incremental credit rose from 20% in FY18 to 56.9% in FY25, indicating increased trust in the public banking system.
● Policy Dividend: The 4Rs strategy—Recognition, Resolution, Recapitalisation, and Reforms—has strengthened PSB balance sheets.
● NPA Reduction: Gross NPA ratio of banks has dropped to a multi-decade low of 2.3%, showcasing asset quality improvement. This improvement is partly due to better management of days past due, a key metric in assessing loan performance.
● Industry Support: Improved credit culture and better provisioning (76.3%) have enabled PSBs to support industrial credit robustly.
MSME Sector’s Credit Revival
Micro, Small and Medium Enterprises (MSMEs) have emerged as a key beneficiary in the changing credit landscape, aided by multiple tailwinds.
● NPA Drop: MSME NPAs fell from 10.8% in 2021 to 3.6% in 2025, restoring lender confidence in the sector.
● Credit Surge: MSME credit growth is now at 18% in May 2025, up from 5-7% in 2011-2013, reflecting renewed dynamism in the sector.
● Formalisation Push: Udyam Registration Number (URN) seeding and expanded MSME definitions are driving greater financial inclusion and credit eligibility.
● Government Support: Enhanced guarantee schemes and initiatives like Trade Receivables Discounting System (TReDS) and Samadhaan portal are improving working capital efficiency for MSMEs.
● Cash Flow Efficiency: With better payment infrastructure, MSMEs are able to manage receivables and reduce delinquency rates, boosting creditworthiness.
Strengthening Industrial Credit Demand
The industrial sector, particularly led by MSMEs, is seeing enhanced credit flows and improving metrics.
● Growth Lead: Industry credit growth outpaced all other sectors in FY25, contributing 17% to incremental credit, up from 11% in FY24.
● Balance Sheet Gains: Cleaner corporate balance sheets are prompting fresh capital investments, encouraging bank credit flows.
● Cash Surplus: India Inc’s cash holdings have increased by 18-19% over FY24–FY25, enabling internal funding for capital expenditure.
● Corporate Demand: MSMEs, being part of corporate supply chains, benefit from increased corporate investment activity.
● Policy Alignment: Regulatory and fiscal policies are being increasingly tailored to support manufacturing and MSME expansion.
Diversifying Credit Ecosystem in India
The credit landscape is gradually shifting from traditional bank channels to a more diverse, flexible ecosystem.
● Private Credit Rise: There is growing interest in private credit markets, especially from global financial institutions, offering structured lending solutions.
● Off-Bank Borrowing: Corporates are tapping into capital markets instruments, external commercial borrowings (ECBs) and bonds, reducing reliance on banks.
● Fintech Entry: Digital lending platforms and NBFCs are emerging as new players in the credit distribution chain.
● Regulatory Challenges: These shifts necessitate a rethink of RBI’s regulatory focus, ensuring systemic stability as markets diversify.
● Stress Testing Need: As seen in the US, regulators may soon need to implement stress tests and question credit rating exuberance. This includes scrutinizing rating rationales to ensure they accurately reflect market conditions.
Financialisation of Household Savings
Changing trends in household savings have significant implications for the banking credit system.
● Equity Preference: The share of equities in household savings rose from 2.5% (FY20) to 5.1% (FY24), showing a move away from deposits.
● Deposit Dependency: Since banks rely heavily on household deposits for credit creation, this trend is concerning for traditional banking models.
● China Comparison: China’s household equity share is 9%, indicating India has room for further financial diversification.
● Policy Implication: Banks need to offer more competitive returns on deposits to retain household funds.
● Credit Sustainability: Long-term bank credit growth will depend on how well the system adapts to these structural shifts in savings patterns.
Future Strategies for Banking Sector
To sustain the current positive trajectory, a set of strategic policy and regulatory moves is required.
● Monitoring Sources: Credit origination from bank deposits must be closely monitored as household saving patterns evolve.
● Reform Continuity: The success of the 4Rs strategy must be institutionalised, especially for PSBs, to maintain low NPAs.
● MSME Focus: Specialised credit instruments and cluster-specific lending models could help MSMEs with tech upgradation and scale.
● Technology Backbone: A stronger digital backbone for real-time credit assessment and risk evaluation must be developed.
● Regulatory Vigilance: As credit markets diversify, regulatory frameworks must remain nimble and anticipatory, not just reactive.
Conclusion:
India’s banking sector is witnessing a turnaround, driven by improved asset quality, revival of MSME credit growth, and policy reforms. While overall credit growth has moderated, the foundations for sustainable lending are strengthening. The reduction in the gross NPA ratio and improvement in the provision coverage ratio indicate a healthier banking system. The insolvency resolution process has played a crucial role in addressing information asymmetry and reducing the financial stress period.
Going forward, maintaining this momentum would require strategic oversight, robust regulation, and continued policy support for inclusive credit delivery. Banks need to focus on underserved segments while maintaining prudent underwriting policies. The RBI’s risk-based supervision approach and the government’s credit guarantee fund for MSMEs are steps in the right direction. However, challenges remain, including managing unsecured consumer credit growth and adapting to the rise of off-bank channels.
As India aims for higher nominal GDP growth, the banking sector’s ability to support credit expansion while managing risks will be crucial. The success of initiatives like pre-packaged insolvency and the performance of asset reconstruction companies will further shape the sector’s trajectory. Ultimately, the banking sector’s resilience and adaptability in the face of heightened uncertainty will determine its role in driving India’s economic growth.
SOURCE:IE
MAINS PRACTICE QUESTION
Q. Examine the evolving credit landscape of Indian banks in the backdrop of falling NPAs and increasing credit availability for MSMEs. What implications does this have for the overall economic resilience of the country?