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Opinion | The financial system is under stability watch

With rules tightened and direct supervision extended to sub-sectors that had been off its radar, RBI has sought to allay worries over risks to the whole financial set-up

The Reserve Bank of India (RBI) has admitted that the economic slowdown is making our banking system more vulnerable despite a more vigilant regulatory environment. The central bank’s half-yearly review of financial stability warns that tapering credit growth could reverse trends of declining dud loans and improving capital buffers of banks. Separately, Prime Minister Narendra Modi and finance minister Nirmala Sitharaman have exhorted bankers to shed their risk aversion and let the liquidity pumped in by RBI since the beginning of the year flow to borrowers. Skittish bank officials are being reassured that loans gone bad because of genuine business failure will not invite official scrutiny for corruption. A revival of commercial lending, which fell sharply this year, is central to the government’s efforts to make India spend itself out of the current slump. Banks may also need to de-emphasize lending to consumers because of its greater susceptibility to economic cycles. State-owned banks, which have been through a clean-up of their books, must learn to conduct business under a more watchful regime, and the government will have to provide them with an environment for healthy business growth.

Overall, the RBI report sees “systemic risks" as no cause for alarm. Financial regulators have been busy plugging gaps in oversight over much of 2019. RBI has come up with a modified mechanism for early detection of bad loans and is in the process of redrafting rules of governance for banks. The eligibility criteria for directors of state-owned banks and compensation standards for those of private banks are being tightened. Banks are being monitored for leverage and the yardstick for this is being pushed to international levels. Auditors now face penalties for lapses. The central bank has taken over the regulation of credit companies and mortgage lenders, and will subject them to some of the prudential practices it requires regular banks to follow. Rules are being rewritten on the mechanism to oversee lightly regulated urban cooperative banks as well. In tandem, India’s securities, insurance and pension regulators are cracking down on delinquency and strengthening disclosure requirements. Efforts are on to make credit rating agencies more accountable. All this, even as the financial sector is drawn into the ambit of the bankruptcy law. The bulk of India’s formal market for money now operates under close supervision.

The central bank’s assessment that economic shocks could destabilize hard-won gains in systemic resilience should serve as a call to action for further reforms. The transmission of monetary policy has to be freed up for this lever to be more effective as a demand rouser. The RBI report talks about asset bubbles that could form if credit fails to reach far and wide. And a greater proportion of the country’s gross domestic product has to go through its formal financial system. In some measure, this process has already begun with household savings moving away from unproductive assets such as housing and gold, but a larger part of the population needs to be weaned off traditional means of holding their capital stock. Financial inclusion, with the aid of technology, has a role here. On the government’s part, its income transfers could catalyze that effort and also serve as a second push towards an economy less reliant on cash. Likewise, if the fiscal stimulus expected of the budget pushes government money into various financial channels, the system could overcome its crunch and the sector would look up.

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