Almost a decade after the global financial crisis, economists continue to debate what went wrong, and how the world can avoid another blowout. One concern right now is that years of excessively easy monetary policy have resulted in higher leverage. The corporate credit-to-gross domestic product ratio in both advanced and emerging market economies is at near-historic highs.

From the financial stability perspective, what matters is not just the total amount of credit in an economy but also the quality of the firms that are getting funded. It is in this context that the work in an analytical chapter of the latest “Global Financial Stability Report" (GFSR) of the International Monetary Fund (IMF) could be useful. Some of the takeaways from the research can also be useful for India, which is struggling with a massive bad debt problem.

The GFSR fills the gap in assessing the riskiness of credit flow at the cross-country level, and has mapped firm vulnerability indicators for 55 economies since 1991. The IMF notes: “Taking the riskiness of credit allocation into account helps better predict full-blown banking crises, financial sector stress, and downside risks to growth at horizons up to three years." The riskiness of corporate credit is determined by the extent to which risky firms get credit compared to less risky firms.

Over the last 25 years, the riskiness of credit allocation has followed a cyclical pattern. It bounced back from post-financial crisis lows and was marginally below the historical average in 2016. This will now be an important indicator, as a significant upward move could threaten financial stability. The riskiness of credit allocation also varies across economies. For instance, during 2014-16, it came down in the US but remained at a relatively higher level in Japan. It will be important for the IMF to work with global policymakers to avoid possible threats to global financial stability, as the impact of a financial crisis in large economies does not remain limited to their shores.

India also followed the global pattern but the riskiness of credit allocation was at a relatively lower level in 2016. A lower allocation to risky firms in recent years can perhaps partly be explained by the ongoing twin balance sheet problem. The IMF has used common financial ratios such as the interest coverage ratio and debt-to-profit ratio to assess the vulnerability of firms.

So what can policymakers do to keep credit allocation healthy and avoid stress in the banking system? The IMF highlights that credit expansion is less likely to lead to riskier allocation with tighter macroprudential norms, an independent banking supervisor, smaller footprint of government in the corporate sector, and strong corporate governance.

These are important points as the current mess in the Indian banking system could have been avoided if India had a more effective regulatory architecture. This newspaper has argued in the past that the current bad debt problem is as much a result of weak corporate governance as it is of the vagaries of the business cycle. Therefore, as credit growth picks up with economic recovery, policymakers would do well to strengthen the overall regulatory framework to avoid a repeat of what happened in the banking sector in the last few years.

In fact, India has made progress on some of these indicators in the recent past, but more needs to be done. For instance, the Reserve Bank of India’s (RBI’s) new framework for the resolution of stressed assets makes it mandatory to report non-performing accounts above Rs5 crore on a weekly basis. This will make tracking easier. It will be important for the banking system not to become part of an excessive build-up of leverage in the corporate sector. Further, acceptance of the Kotak committee recommendations will help improve the level of corporate governance. Continued efforts to strengthen the framework to protect the interest of minority shareholders will push managements in the corporate sector to take more prudent decisions.

The debate on whether the RBI has sufficient powers to regulate state-run banks also needs to be settled. The IMF highlighted the government’s presence in the corporate sector. However, in India, the financial system is dominated by state-run banks, which is partly responsible for the ongoing bad debt problem. Since privatization is not on the cards, India should work on a governance system where government holding in banks does not affect their operations.

It is encouraging to see that economists at the IMF and elsewhere are working continuously to deepen their understanding of the global financial system with the idea of protecting financial stability. However, the moot question is whether India will learn its lessons and do enough to build a strong banking system which can adequately fund the productive sectors of the economy in coming years.

What should Indian policymakers do to build a strong banking system? Tell us at views@livemint.com

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