West Asia Conflict to Trigger Layered Stress on India's Financial Sector: EY

The report stated that the road ahead for India's financial sector will be shaped less by the cumulative impact of sustained geopolitical and macroeconomic stress. Early signs of stress, such as elongated supply chains, rising cost pressures, and tightening liquidity across value chains, are already visible.

It stated, "While the second-order pressure could unfold in margin compression, deferred investments, and stretched working-capital cycles, third-order stress will transmit via ecosystem payment strain and selective employment shocks, driving heightened cash-flow volatility across MSME and retail segments, with asset-quality risks emerging with a lag".

According to the EY analysis, these pressures will directly affect companies as rising input costs, higher freight and insurance expenses, and longer delivery timelines begin to impact profitability and cash flows.

Third-order impacts, the EY said, will be more systemic and could emerge through ecosystem-level stress, including payment delays, supplier strain, and selective employment disruptions.

These factors could lead to increased cash-flow volatility across MSME and retail segments, with asset quality risks appearing with a lag.

EY highlighted that Indian banks are currently navigating a multi-factor disruption driven by supply risks linked to West Asia, persistent input cost volatility, and the growing impact of artificial intelligence (AI) on employment.

These factors are transmitting non-linearly across the system, starting from margins and moving to working capital and eventually affecting income and demand.

The analysis also pointed out that AI is adding another layer of risk, particularly in employment. Job risks are concentrated in sectors like IT services, BPM/KPO, and routine white-collar roles, while manufacturing and infrastructure sectors remain relatively insulated.

This creates a "double bind" for retail borrowers, as both income disruptions and inflation pressures affect household finances, especially among urban lower-middle-income groups.

EY noted that second-order effects generally emerge before formal loan defaults, through early warning signs such as irregular salary credits, shrinking buffer balances, GST and invoice volatility, and ageing receivables.

Third-order effects, on the other hand, spread across the broader ecosystem through delayed payments, supplier stress, and localised job losses. This could result in a 1-2 quarter lag in rising loan slippages, particularly in unsecured and small-ticket retail segments.

The report suggested that banks may need to adopt a tiered approach to assess the evolving risks. While first-order impacts are reflected in treasury metrics such as foreign exchange movements and interest rates, second-order impacts are borrower-driven, and third-order impacts emerge through demand and income stress.

- ANI