Rising Defaults Among Retail Borrowers are Stressing India’s Top Banks

Despite a so-called booming economy, many small borrowers are increasingly unable to meet their loan obligations.

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India’s banking sector, long considered one of the world’s most resilient, is currently grappling with a troubling trend: a rise in loan defaults among retail borrowers apart from the struggle to increase deposit rates.

There is, therefore, a heightened probability of a twin-balance sheet problem that may affect India’s already struggling financial and investment landscape. The rise in retail loan defaults has particularly affected leading private banks like HDFC Bank, Kotak Mahindra Bank, and IndusInd Bank.

Despite a so-called booming economy projected to grow by 7.2 percent in the fiscal year ending March 2025, many small borrowers are increasingly unable to meet their loan obligations.

This issue has emerged against the backdrop of a previously favourable credit cycle in India, where bad loans had dropped to a multi-year low of 2.8 percent of total assets by the end of March. However, the recent spike in defaults signifies a critical shift that banks and analysts believe could create quite some financial stress in the coming quarters. 

Retail lending has been a growth driver for Indian banks, particularly in the personal loan and credit card segments. These segments have expanded at more than 25 percent annually, fueled by increased consumer demand and competitive lending practices.  

The rapid growth of unsecured loans has created a double-edged sword: while it has enabled borrowers to access funds easily, it has also led to a buildup of debt among small borrowers, many of whom have multiple loans. This easy access to credit has allowed borrowers to finance consumption, home renovations, and even medical expenses without sufficient collateral.

But, as the recent data reveals, an increasing number of these individuals are now struggling to repay their obligations, causing a rise in non-performing assets (NPAs) for banks. 

YoY growth in personal and micro-credot loans.

(Author's calculations)

In the September 2024 quarter, five out of the eight largest private banks in India reported an increase in bad loans, with defaults particularly pronounced among borrowers with three or more unsecured loans.

The issue has been exacerbated by rising costs of living in urban areas like Mumbai, where many residents find their disposable incomes stretched.

Provisioning for bad loans by major banks.

(Author's calculations)

Banks have already responded to these trends by increasing their loan-loss provisions—funds set aside to cover bad loans. These provisions reflect an anticipation of sustained stress in the personal loan and microfinance segments, where default rates are expected to remain elevated for at least the next three to four quarters.  

Analysts note that slippages, or the proportion of good loans turning bad, could remain high as banks deal with the fallout from years of aggressive retail lending. This trend has created a delicate balancing act for banks, which must navigate the need to maintain the robust lending growth while managing the financial risks associated with an over-leveraged customer base. 

The Reserve Bank of India (RBI) has also recognised the risks associated with unchecked retail lending growth. In recent months, it has stepped in to impose tighter restrictions on personal loans and credit card lending to curb “exuberance” in the sector.  

These measures include new guidelines to cap interest rates and fees on loans, intended to discourage excessive borrowing among retail customers. However, while these regulations are designed to protect borrowers, they also place additional operational and compliance burdens on banks, which could impact their profitability. 

An even more complex dimension of this issue is the impact of climate-related disruptions on microfinance borrowers in rural areas. For instance, crop failures and erratic weather patterns have eroded agricultural incomes, particularly affecting low-income borrowers who rely on seasonal harvests to meet loan repayments. 

In response, the RBI has sought data from microfinance institutions on loan spreads and pricing practices, signalling its intent to better regulate this segment and protect vulnerable borrowers from excessive interest rates.

The economic implications of these rising defaults are profound. As banks allocate more capital to cover bad loans, their profitability may take a hit, reducing the funds available for future lending. This scenario could lead to a tightening of credit in key areas of the economy, limiting access to financial aid for both businesses and consumers.

Given that India’s economic growth relies heavily on domestic consumption, any slowdown in lending could ripple through the broader economy, impacting sectors dependent on consumer spending. Moreover, as banks shift their focus from retail to secured loans to mitigate risks, small and medium enterprises (SMEs) could face reduced access to capital, hindering job creation and slowing down economic expansion.

For now, well-capitalised banks are equipped to handle moderate increases in bad loans without major financial strain. However, if defaults continue to rise, even these institutions could see their stability tested. Smaller non-banking financial companies (NBFCs), which have been instrumental in driving retail credit growth, are especially vulnerable.

In October, the RBI barred four NBFCs from issuing new loans due to “usurious” pricing practices, underscoring the risks associated with lax lending standards. This crackdown highlights a larger regulatory push to rein in excessive lending in the sector, but it may also constrain the credit available to underbanked populations who rely on NBFCs for financial support.

As the banking sector contends with this rising wave of defaults, banks are also grappling with increasing capital requirements imposed by regulators. These requirements, while designed to bolster financial resilience, add a further layer of pressure on the balance sheets of the banks. The growing need for banks to shore up capital to meet regulatory standards and absorb loan losses could impact their ability to return profits to shareholders, affecting investor sentiment in the financial sector.

The recent rise in retail loan defaults also points to potential structural weaknesses in India’s banking system, particularly in its reliance on unsecured lending to sustain growth. As economic pressures mount, many borrowers who lack collateral may be unable to access traditional credit channels, pushing them into the informal financial sector.

This could create a parallel economy of high-risk lending and perpetuate cycles of indebtedness, particularly for low-income households. Addressing these systemic issues requires a careful recalibration of India’s retail lending model, ensuring that the credit growth aligns with the borrowers’ capacity to repay.

(Deepanshu Mohan is a Professor of Economics, Dean, IDEAS, Office of Inter-Disciplinary Studies, and Director of Centre for New Economics Studies (CNES), OP Jindal Global University. He is a Visiting Professor at the London School of Economics, and a 2024 Fall Academic Visitor to the Faculty of Asian and Middle Eastern Studies, University of Oxford. Aryan Gopalakrishnan is a Research Analyst with CNES and graduated from Jindal School of Government and Public Policy. This is an opinion article and the views expressed above are the author’s own. The Quint neither endorses nor is responsible for them.)