Despite progress India's financial sector vulnerable: IMF

Since liberalisation in the early 1990s, the system's growth and increasing commercial orientation have been accompanied by steady improvements in the legal, regulatory, and supervisory framework, the International Monetary Fund noted in a Financial System Stability Assessment Update for India.

"The Indian economy and its financial system weathered the global financial crisis well-due to strong balance sheets and profitability entering the crisis, a robust regulatory framework, and timely actions to counter pressures on liquidity, the supply of credit, and aggregate demand," said the paper released Tuesday.

Noting that the system is becoming more complex, with interlinkages across institutions and borders, the update on assessment undertaken in June and October 2011 suggests the main near-term risks to the financial system are a worsening of bank asset quality and renewed pressures on systemic liquidity.

"However, stress tests did not reveal near-term stability concerns, suggesting the banking system would be resilient to a range of adverse shocks," it said.

"The prominent role of the state in the financial sector contributes to a build-up of fiscal contingent liabilities and creates a risk of capital misallocation that may constrain economic growth," the report said.

Gradually reducing mandatory holdings of government securities by financial institutions, and allowing greater access to private (domestic and foreign) sources of capital, would provide more room for the financial sector to intermediate funds toward productive economic activities, thereby improving prospects for sustained growth, it suggested.

The regulatory and supervisory regime for banks, insurance, and securities markets in India is well developed and largely in compliance with international standards, the report noted.

However, areas for improvement include greater de jure independence of regulatory agencies; consolidated supervision of financial conglomerates; reductions in the large exposures and related-party lending limits in banks; stronger valuation and solvency requirements in insurance; and the monitoring of corporations' compliance with reporting, auditing, and accounting requirements for issuers.

Further steps are also needed to promote deeper fixed income markets, including a prudent reduction in banks' minimum statutory holdings of government bonds in line with evolving international liquidity requirements, it said.

These would support liquidity in secondary markets and the development of a yield curve; and upgrading the corporate insolvency framework.

Use of capital markets to refinance infrastructure loans would help alleviate pressures on banks, the report said.

(Arun Kumar can be contacted at arun.kumar@ians.in)