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The recent improvement in recovery of the non-performing assets and decline in provisioning of loans in the banking sector are expected to improve further in the coming year, rating agency ICRA said.

Accordingly, the improvement in such parameters has helped realise better profitability for the banks, the rating agency said.

However, subdued credit growth and surplus liquidity continue to be a drag on the profit margins for the sector.

"The banking sector navigated well during 2022, despite the challenges posed by the second wave of Covid-19... Even in the absence of relief measures such as moratorium on loan repayments or standstill on NPA classification, which were allowed during the first wave, banks were able to reduce their NPAs," said Anil Gupta, Vice-President and Sector Head at ICRA.

For small finance banks, the Covid-19 pandemic significantly impacted the performance during FY21 and H1FY22 in terms of growth, asset quality and profitability.

"The asset quality was impacted adversely as the product segment for SFBs is largely unsecured with a focus on the self-employed segment, which is more vulnerable to income shocks," said Sachin Sachdeva, Vice-President and Sector Head at ICRA.

Notably, microfinance constitutes the largest product segment for such institutions.

The rating agency expects the SFB sector to witness improvement in asset under management growth in FY22 as compared with FY21, but the asset quality metrics are expected to remain weak, which would thereby keep credit costs elevated and hence profitability subdued.

For non-banking financial companies, including the housing finance companies, the rating agency is of the view that their asset under management growth in FY22 would be four-to-six per cent lower taking into consideration the impact of the second wave of the pandemic and all other regulatory changes.

But, this estimate didn't take into the account the possible impact of the new variant - Omicron.

"The reported asset quality numbers would be impacted in the near term in view of the tightened regulations, which could lead to earnings-related headwinds for some (NBFC) players," said A.M. Karthik, Vice-President and Sector Head at the rating agency.