Financial sector [FS] stability promotes growth and monetary policy transmission. It is characterised by healthy functioning of various segments of financial markets, institutional infrastructure and their resilience to face financial shocks with minimal disruptive impact. It inspires confidence among FS participants. Sub-optimum growth, growing vulnerability of credit institutions, weakening of institutional set-up, intractable NPAs, non-convergence working between financial and real sectors and poor monetary transmission continue to haunt us despite RBI’s concerted financial stability measures. Corona crisis exposes and amplifies these vulnerabilities to a breakdown level.
RBI &Financial Sector [FS] Stability
Financial and monetary stability are RBI’s core objectives. RBI institutionalised financial stability work in 2010 by establishing a dedicated departmentto monitor and assess the stability and soundness of the FS on various parameters.It systemically examines the nature, magnitude and implications of FS risks and their impact on the growth environment, credit institutions and markets. It assesses resilience of the FS through stress tests.RBI publishes this information in its half-yearly Financial Stability Report. Expectedly, these enable RBI in undertaking calibrated policy responses to FS risks.However, over the last decade diminishing vitality of credit institutions, weakening ofFS infrastructure institutions, recurring confidence-shaking systemic events, growth slowdown and rising uncertainty show gapping in RBI’s financial stability framework. These reflect outcome of misdiagnosis-based flawed policy measures. It is akin to growing morbidity of a patient due to misdiagnosis-based prolonged wrong-medication. Corona crisis overexposes and amplifies FS morbidities. Risk of economic meltdown is real. RBI’s bank-centric FS policy suffers from tunnel-view syndrome. There are critical “missing variables". The unknown risks emanating from these variablesmess-upthe FS. These variablesinclude impact of dysfunctional trade credit [TC] and massive unscrupulous Chinese import on FS. A brief discussion of these variables is necessary to make academia aware of their importance.
Trade Credit& Financial Sector Working
In terms of credit intermediation, credit volume, value, reach and inclusiveness TC is far-far bigger than bank credit. It is the single largest source of working capital in the world and more so in our case as banks’ reach is limited. Bank credit covers only 5% of MSMEs. RBI’s study of 1876 [annual average number] of private corporates’ financials over 1992-03 shows that bank borrowings to total liabilities at 13% was lower than trade credit to total liabilities at 21% [RBI Bulletin, Nov. 2005]. Rise and success of business communities like Marwaris in trade and industry is basically founded on TC. Various studies find role of TC very crucial and critical in business financing. N. Wilson [SSRN-id2491095.pdf] finds that over 80% of the corporate dealings are through TC in the UK. Stocks of TC in the UK was more than 1.2 times the total amount of lending from the financial sector. Surprisingly, RBI’s FS policy is silent about this. Its risk assessment is oblivious of risks arising from dysfunctional TC. Deterioration in credit culture, integrity and discipline in B2B dealings impair role of TC network in terms of credit intermediation, credit multiplier, last-mile links in credit creation/distribution and credit-based B2B payment system. Changes in social values and weakening of informal institutional infrastructure lead to indiscipline in TC network. This spoils transactional and environmental trust in TC ecosystem; so essential for free flow of B2B credit transactions. Can FS policy be effective without considering the largest credit intermediary ?
The other variable is steady surge in Chinese import esp. massive surreptitious imports by way of under-invoicing/misdeclaration/smuggling and counterfeits since mid-2000s. It covers wide-spectrum of both consumptions and production goods. These cause wide, deep and enduring structural damages to the manufacturing base. Capex, technological/skill development, employment and competitiveness are impacted due to this rampant malaise.Omission of these developments cloud the FS risk analysis. These blur RBI’s ability to read fore warnings, analyse bigdata and its own committee reports to convert these into actionable knowledge tomanage evolving risks.
TC and banks networks are too interconnected. They form interdependent links along the supply chain financing network. Adverse feedback loop effects of day-to-day millions of micro-level TC deals and their repayments contaminated by credit inadequacies, liquidity-bind, repayment delays/defaults and low reliability are transmitted to bank channel. Two-way feedback loop between bank and TC channels and that between FS and real sectors create both economic and financial crises contagion. This transmission and retransmission of the shocks through intra and inter-sectoral linkages are now amplified to epic proportion by the pandemic due to severe disruptions in inter-firm business interactions.
Secondly, direct and spill-over adverse effects of massive unscrupulous Chinese imports on capex, manufacturing output and employment, leakages in GDP and savings to fund imports, surge in black money and currency supply to finance under-invoiced/surreptitious imports, etc; systemically impair ecosystem working.
RBI’s risk-capital based banking soundness criterion is untenable. Capital eroding NPAs and frequent need for capitalisation of banks, recurrence of confidence-shaking systemic events in FS, poor monetary policy transmission, excessive systemic liquidity vs. business credit crisis, mismatching credit/liquidity flows and deteriorating position of MSMEs point to systemic gaps in financial stability framework. Bank-centric remedial measures and the risk management structure have not worked effectively. A meaningful model for financial stability should take an integrated view of risks emanating from banks, TC networks and Chinese imports. Market intelligence is required to understand the working of TC and shady imports. This can help in plugging information gaps and devising measures to overcome the structural faults in the working of TC network and fall-out from shady imports. An inclusive approach to FS stability is warranted.
B L Chandak is Ex-DGM, SIDBI