Improving financial stability

Some areas of concern remain

The Reserve Bank of India’s (RBI’s) Financial Stability Report, or FSR, released last week, suggests the state of the financial system in India is broadly strong and stable. Several indicators of broader financial risk in the economy have declined, and the system appears prepared to deliver the resources required for growth. The gross ratio of non-performing assets in the banking system is at a multi-year low, at 2.8 per cent, and the FSR expects it might continue to decrease. However, there are still certain sources of future risk that require careful monitoring by the regulator.

One of these is the return of the shadow banking sector. Non-banking financial companies (NBFCs) perform a useful role in the economy. But, as was revealed when Infrastructure Leasing and Financial Services, or IL&FS, went into crisis six years ago, they are also a source of vulnerability. Lending and activity took a long while to recover from the chaos in the NBFC sector set off by IL&FS. Since then, the regulatory supervision of NBFCs has become more stringent. But, as the FSR points out, in terms of net borrowing they are the largest participants in the banking system. Most of that borrowing has been taken out from scheduled commercial banks, which now provide over half of NBFC financing. Housing finance companies, or HFCs, play a similar intermediation role. This is not in itself a problem, the FSR contends: The failure of a large NBFC would, in its estimation, cause a serious loss to Tier-I capital in the banking system, of greater than 2 percentage points — but it would not cause a bank collapse.

Yet this might be too sanguine a view of the situation. A single point of failure is rarely a problem. The issue is that whatever might set off failure in a particular NBFC might have a similar effect on others — shocks are correlated, as the 2008 financial crisis taught. Of course, a single fall could also create a crisis of confidence among NBFC depositors, which would have the same practical fallout of contagion. The FSR has also pointed out that NBFCs continue to perform a maturity transformation role. Such intermediaries, who pick up short-term funds but lend for longer tenures, are a well-known source of instability in the system.

It is also worth noting that somewhat newer concerns are beginning to make themselves felt in the financial system. The FSR contained a note on the 26th round of the RBI’s systemic risk survey. Several sources of risk, including global monetary tightening, had moderated. But two domestic risks were perceived to have increased. The first is the risk from lower consumption and demand. This reflects broader concerns about wage and employment growth in the Indian economy. But, more interestingly, climate risk has been allotted “high risk” status in the survey. In fact, climate change is — along with cyber risks — viewed as the greatest macro-financial risk at the moment by the respondents to the survey. The FSR contains a review of global trends when it comes to regulating climate risk. Both the Indian financial system and financial-sector regulators, including the RBI, need to start preparing to deal with increasing climate risk. Climate change will also have implications for monetary policy, which could increase risks for the financial system.