According to ADB's South Asia Economic Report (SAER), India and Pakistan have witnessed rapid credit growth in recent years, which could lead to a deterioration in asset quality and buildup of vulnerabilities.

To mitigate these risks, strong bank supervision and tight internal risk management should be in place.

The retail banking, particularly for housing and credit cards, is a new growth area for banks in India and Pakistan. In India, credit card debt growth should be monitored. Although still at its nascent stage, credit card debt rose by 36 per cent in 2004, the ADB noted.

Such a rapid rise points to the need for close supervision and consumer education. The bad loans (NPLs) for credit cards stand at about 8 per cent.

The credit card outstandings grew by 59.3 per cent to Rs 9,177 crore (Rs 91.77 billion) by end of March 2006 from Rs 5,760 crore (Rs 57.60 billion) a year ago, according to Reserve Bank of India's [Get Quote] annual report for 2005-06.

The home loans grew by 44.8 per cent to Rs 1,86,429 crore (Rs 1864.29 billion) as on March 31, 2006, from Rs 1,28,728 crore (Rs 1287.28 billion) as on March 18, 2005. However, the share of home loans, which qualify as priority sector lending, is over 70 per cent, the RBI said.

Another aspect closely linked to housing sector is credit to real estate sector. The advances by banks to this (real estate) sensitive sector rose by 133.8 per cent at Rs 13,302 crore (Rs 133.02 billion) in 2004-05. It grew further by 100.6 per cent in 2005-06 to Rs 26,682 crore (Rs 266.82 billion).

The real estate prices in metropolitan areas have witnessed a huge rise in prices throughout 2005-06 and continue to remain high in till date in 2006-07.

Banks face increased risk of assets turning into NPLs due to volatility in realty prices and as a matter of prudence, RBI has already increased the risk weightage on home loans above Rs 20 lakh and advances to commercial real estate to from 125 per cent to 150 per cent.

ADB said some segments of the banking sector and individual banks remain vulnerable. In each economy (in South Asia), a number of banks are unprofitable, are undercapitalised, and have high NPLs. 

One particular area of concern for India is the poor state of cooperative institutions, which account for about 6 per cent of banking system assets. NPL ratios in some rural cooperatives stand at over 35 per cent, ADB added.

While cooperative banks do not present a systemic risk, failures of these banks could impinge on the confidence of the banking system. Hence, strengthening prudential regulations for cooperatives is important for sustainable growth of sector.

Turning to growth in various kind of banks, ADB said the performance in state-owned banks has generally been weaker than that of private and foreign banks.

The state-owned banks still dominate banking sector in Bangladesh and India, whose prudential indicators remain less favorable than those of new private and foreign banks despite recent improvements.

The RBI should bring forward the target date to expanding foreign investment in non -distressed (financially weak) domestic banks from existing policy to further open up banking sector for FDI by March 2009.

Also, the existing 10 per cent cap on voting rights should be lifted, a step contemplated under amendments to the Banking Act. Both steps will help to accelerate foreign participation and provide efficiency gains, it said.