Mumbai: The Reserve Bank of India’s (RBI) maiden financial stability report (FSR), released on Thursday, said Indian banks are healthy and can withstand unexpected levels of stress in terms of credit and market risks, but identified rising inflation, high government borrowing and a likely surge in capital flows as key challenges to financial stability in India.
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The wholesale price-based inflation rose to 9.89% in February and analysts expect it to inch closer to 11% in March. The Indian central bank had last week raised its key policy rates by a quarter percentage points each, a month ahead of its annual monetary policy, to rein in inflation.
RBI had set up a financial stability unit sometime back in the wake of the global financial meltdown that followed the collapse of the US investment bank Lehman Brothers Holdings Inc. and plans to prepare FSR periodically like many other global central banks.
Incidentally, finance minister Pranab Mukherjee in the Union Budget proposed to set up an apex level Financial Stability and Development Council to monitor the overall supervision of the economy and large financial conglomerates.
“It is hoped that FSRs will emerge as one of the key instruments for directing pre-emptive policy responses to incipient risks in the financial system,” said RBI deputy governor Shyamla Gopinath.
The stress test conducted by RBI on credit risk, interest rate risk and liquidity risk that commercial banks are running has shown that the Indian banking system is resilient and can withstand any unexpected shocks.
For instance, in the worst case scenario even if all loan accounts restructured after the global meltdown turn bad, the banking system will remain resilient as banks have enough capital. RBI allowed banks to restructure loan accounts where borrowers were not in a position to pay after an unprecedented liquidity crunch hit the financial system.
Going by RBI estimate, even if all such accounts turn bad, the non-performing assets of the banking system will rise by 3 percentage points, but this will not affect the system as banks are well capitalized.
Similarly, Indian banks’ vulnerability to interest rates risk is not significant. They have long-term assets, but most of them are floating rate loans. This means the loans are re-priced periodically in accordance with the rise and fall of interest rates. Indeed they need to set aside a portion of their profits to provide for any loss in the value of their bond portfolio, but such requirement is not huge as they do not need to do so for bulk of their bonds where such an accounting practice is not applicable.
Some banks run liquidity risk, but the risk is not that high as they invest at least 25% of their deposits in government bonds, which they can sell to generate liquidity
“Stress tests for credit and market risk reveal banks’ ability to withstand unexpected levels of stress. The liquidity scenario analysis, however, shows some potential risk. We have to keep in mind that banks were subject to stringent stress conditions, nevertheless the results of the stress test suggest banks will have to monitor their contingency liquidity plans on an ongoing basis,’’ said Gopinath.
Other risk factors are unhedged corporate foreign exchange exposures and funds flow between non-banking financial companies (NBFCs) and banks and mutual funds. The RBI report has, in fact, made a strong pitch for close monitoring of the systematically important non-deposit taking NBFCs.
The report also highlighted the need to evolve a strong supervisory regime for systemically important NBFCs, and enhance the framework for regulation and supervision of financial conglomerates. Gopinath said, “The sector was able to manage the fallout of the crisis without creating systemic issues. However, asset-liability mismatches, credit quality and the interconnected flows between NBFCs and other financial sector entities would need to be closely monitored.’’
The focus is also on “excessive growth in non-insured” deposits. Currently up to Rs1 lakh deposit is insured and the depositors run the risk of losing money beyond this in case a bank goes down under. At present, both strong and week banks pay an identical premium for deposit insurance cover. “There has been a significant element of cross-subsidization”, but the RBI report has ruled out introduction of “risk-based premiums” at this juncture.
Among other risk factors for the Indian financial system, the report identified credit equivalent of off-balance sheet items for banks. Even though they are as low as 3% of the overall balance sheet size of the banking system, but such exposures, particularly related to complex derivatives, are concentrated in a few foreign banks and this “could be a cause for concern”.