The financial system of the country remains robust, though risks to stability have increased since the publication
of the last Financial Stability Report (FSR) in December 2011. The combined effect of the dismal global
macroeconomic situation and the muted economic performance on the domestic front has caused marginal
increase in risks to stability. The financial sector stakeholders, however, continued to repose confidence in the
stability of the domestic financial system, as revealed by the findings of Reserve Bank’s second Systemic Risk
Survey, though there has been some reduction in the level of confidence. Threats to stability are posed by the
global sovereign debt problem and risk aversion, domestic fiscal position, widening current account deficit and
structural aspects of food inflation. Falling international crude oil prices and a normal monsoon could, however,
be positives for the domestic economy, going forward. The foreign exchange and equity markets witnessed high
levels of volatility while investor confidence and sentiments ran low. Indian banks’ soundness indicators remained
robust, although the pressures on asset quality persisted. Given a decelerating deposit growth, banks’ reliance
on borrowed funds, especially short term funds increased. The country’s financial market infrastructure
functioned without disruption. But, potential vulnerabilities such as settlement lags in the Real Time Gross
Settlement (RTGS) System and large uncollateralised intra-day exposures assumed by the Clearing Corporation
of India Limited (CCIL) on its designated settlement banks need to be addressed. The results of a series of
stress tests to study the impact of adverse macro-financial shocks showed that the banking system remained
resilient even under extreme stress scenarios.
The financial system remains robust though risks to
financial stability have worsened
1. Risks to financial stability have worsened since
December 2011, primarily due to global risks and
domestic macroeconomic conditions. Risks to domestic
growth are accentuated by fiscal and external sector
imbalances. Financial markets, particularly the foreign
exchange market, continue to correct downwards and
experience heightened volatility. The recent decline in
international crude oil prices, if sustained, could provide
relief. A normal monsoon could also alleviate pressures
on the growth front and provide impetus towards
reviving the domestic economy, given its inherent
strength. Banks are well capitalised, though trends in
asset quality and their ability to withstand sustained
liquidity pressures pose some concerns. The overall
stability of the system remained robust as indicated by
the trends in the Financial Stability Map (Chart 1)1.
Survey respondents express concerns about global
risks and twin deficits; remain confident about
stability
2. The respondents of Reserve Bank’s second
Systemic Risk Survey, conducted in April 2012, expressed
their concern about the evolving global risks as well as
a host of domestic factors including the current account
deficit, fiscal deficit, asset quality of banks and potential
funding risks. However, the participants remained
relatively sanguine about the stability of the domestic
financial system, despite some fall in the level of
confidence since the previous Survey, conducted in
October 2011.
Global environment
Global macroeconomic risks have deteriorated
3. Deepening crisis in the Euro area and continued
global slowdown contributed significantly to the
deterioration in global risks. The downside risks to the
global macroeconomic environment are expected to
intensify further in the coming months, owing to the
political uncertainty in the Euro area, the persistence of
global imbalances, fiscal stress and sluggish growth
prospects. Debt and gross financing needs continue to
be high in several Advanced Economies (AEs), even as
sovereign yields are rising for some Euro area countries.
The contagion from Euro area spreads to other
advanced and emerging economies
4. There are signs of spillover of the developments
in the Eurozone to other AEs and emerging and
developing economies (EDEs) through the trade, finance
and confidence channels. Weakening demand for
exports, decreasing trade finance owing to deleveraging
by banks in Europe and possible impact on the capital
flows to emerging economies are threatening a sustained
global recovery. The persistently high unemployment
rates in several AEs and moderating internal demand in
some of the emerging economies are adding to the
problem.
Global financial markets under stress
5. The global financial markets remained under
stress and experienced high volatility during the period
under review. There was a brief period of improvement in sentiments following the two rounds of Long Term
Refinancing Operations by the European Central Bank.
Reduced institutional appetite for the sovereign bonds
of the troubled Eurozone economies has translated into
funding pressures for European banks. With
worsening access to unsecured funds, these banks
remain vulnerable to funding market freezes and
dependent on central bank support.
Extended run of accommodative monetary policies in
AEs could create vulnerabilities
6. The existing regime of very low policy rates in US
and other AEs is generally expected to continue for some
more time. This has further reduced the cost of debt
capital relative to equity. Going forward, this could result
in greater use of leverage and lead to a ‘search-for-yield’
behaviour among investors.
Macroeconomic environment
The domestic economy has decelerated sharply
7. Domestic GDP growth declined sharply to 6.5 per
cent during 2011-12 from 8.4 per cent in the previous
year, weighed by global uncertainties as well as domestic
cyclical and structural factors. The trend reflected the
experience of similar EDEs, especially the BRICS
countries. The deceleration in GDP growth was reflected
across all the three segments of the economy –
agriculture, services and industries. The downside risks
to growth may persist given the headwinds from the
global economy and moderation in private and
government consumption and investment demand.
Inflationary pressures have moderated but risks
remain
8. Core inflation has moderated during the period
under review. Nevertheless, the persistence of overall
inflation, in the face of significant growth slowdown,
points to serious supply bottlenecks and sticky inflation
expectations. While falling global commodity prices
could aid in checking inflationary trends in the coming
months, the potential impact of the lagged pass-through
of rupee depreciation, suppressed inflation in energy
and fertilisers and possible fiscal slippage continue to
pose a threat.
External sector risks aggravated; recent trends in oil
prices provide comfort
9. The external sector vulnerability indicators point
to increased risks. The current account deficit has
deteriorated with decelerating growth in exports even
as imports remained high on the back of sustained
demand for gold and crude oil. The net international
investment position of the country worsened with rising
short term debt relative to total external debt. Falling
international oil prices, if sustained, will help moderate
external sector risks. But, domestic factors viz., a fast
depreciating exchange rate, reduced capital inflows and
the risk of downgrade of the sovereign rating of the
country, continue to pose challenges for the financing
of the deficit.
Trends in the composition of fiscal deficit pose
concerns
10. Fiscal risks remain elevated, given that both fiscal
and primary deficits have increased during 2011-12.
Recent trends in terms of an elevated ratio of revenue
deficit to gross fiscal deficit and the increasing proportion
of revenue expenditure relative to capital outlays are
also disquieting. Gross financing needs of the Government
remain high with consequent impact on private
investment and growth.
Plans for fiscal consolidation afoot; risks of slippages
remain
11. The Union Budget for 2012-13 set out a roadmap
for fiscal consolidation during the 12th Five Year Plan
period. The proposed fiscal consolidation for 2012-13 is
primarily based on the revenue-raising efforts of the
Government. The achievement of proposed reduction
in the ratio of gross fiscal deficit to GDP would also
depend on the commitment of the Government to
contain its expenditure on subsidies within the
stipulated cap of 2 per cent of GDP in 2012-13.
Financial Markets
India’s foreign exchange market corrected and
remained volatile
12. The turmoil in the Euro area, a widening current
account deficit and perceptions of slowdown in policymaking
in India affected the domestic foreign exchange
market during the review period, resulting in a rapid depreciation of the Indian rupee. These trends were,
however, broadly in line with the wider trend evidenced
in case of currencies of EDEs, especially those with high
current account deficits. A combination of administrative
measures and foreign exchange market intervention
were taken to address the stress.
Potential rating change could impact overseas
borrowing
13. The process of deleveraging underway amongst
European banks has had some impact on the cost of
borrowing of Indian firms and banks. A change in the
current external rating of the country could have ‘cliff
effects’, impacting both, the availability and the cost of
foreign currency borrowing for Indian banks and firms.
The domestic equity markets reflecting weak
sentiments
14. The domestic equity markets appreciated in the
first two months of the calendar year. Thereafter, the
markets retraced to their December 2011 levels as
Foreign Institutional Investment (FIIs) flows reversed in
the wake of worsening global outlook, weak domestic
sentiments and the sharp depreciation of the Indian
rupee.
Implications of increasing use of Algorithmic and High
Frequency Trading need to be watched
15. Some recent episodes in Indian markets have
highlighted the need for a carefully calibrated approach
towards technological advancements like direct market
access supporting algorithmic and high frequency
trading. Globally, too, the balance between the benefits
of such advancements vis-à-vis the risks posed by them
is a subject of debate.
Financial Institutions
Banks’ reliance on borrowed funds growing
16. Credit growth in the banking sector decelerated
to around 16.3 per cent in 2011-12, as compared with
about 22.6 per cent as at end March 2011, reflecting the
overall slowdown in the economy. Deposit growth also
decelerated and, at less than 14 per cent as at end March
2012, was the lowest growth rate recorded in the past
10 years. The disproportionate slowdown in deposit
growth vis-à-vis credit growth led to increased reliance
of banks on borrowed funds, which may translate into liquidity risks.
Asset quality concerns persisted; comfortable capital
position act as cushion
17. An increase in slippage ratios, rise in the quantum
of restructured assets and a high rate of growth in Non
Performing Assets (NPAs) relative to credit growth
implied that the concerns on asset quality of banks
remain elevated. The Gross NPA ratio for scheduled
commercial banks (SCBs) increased to 2.9 per cent as at
end March 2012 (2.4 per cent at end March 2011). The
position is not alarming at the current juncture and some
comfort is also provided by the strong capital adequacy
position of banks.
Growing interconnectedness warrants closer
monitoring of the ‘most connected’ banks
18. Distress dependencies between banks have been
on the rise, as evidenced by the trends in the Banking
Stability Measures. The analysis of the network of the
Indian banking system reveals that the maximum
potential loss to the banking system due to the failure
of the ‘most connected’ bank has risen during 2011.
These trends would need to be carefully monitored,
through rigorous microprudential supervision of the
‘more connected’ banks.
Regulatory measures aim to mitigate risks from the
rapid growth of gold NBFCs
19. The rapid growth of NBFCs engaged in lending
against gold in recent years could pose risks due to the
business model of such companies, concentration of
business amongst a few companies and their growing
interconnectedness with the banking system. These
risks are sought to be addressed through various
regulatory prescriptions.
Interconnectivities in the Indian financial system
could pose risks
20. Insurance companies and mutual funds are the
major lenders in the Indian financial system with banks,
especially public sector banks, being the major
borrowers. The insurance companies and mutual funds
are, therefore, vulnerable to the risk of contagion from
the banking system. Banks, on the other hand, are
considerably reliant on borrowings from these entities.
As borrowings from mutual funds are largely short term, they could engender greater liquidity risks for the
banking system.
A macro mapping of the non-banking financial segment
may be warranted
21. Strengthening the regulatory framework for
banks globally adds to risks of migration of financial
sector activity to the relatively less regulated ‘shadow
banking’ sector. In the Indian context, the non banking
financial sector in the country functions within a
regulatory framework appropriate to the activities
undertaken by these entities. Nevertheless, a review of
the extant regulatory arrangements and a complete
macro mapping of all kinds of credit intermediation
activities, with regulatory focus on more systemically
important activities and entities, may be warranted in
the light of the international reforms.
Financial institutions remain largely resilient to credit,
market and liquidity risks
22. Credit risks continued to remain the primary
source of vulnerability for banks, while risks from
adverse movements in interest rate appeared manageable,
as evidenced by the results of a series of sensitivity stress
tests. The banking system, as a whole, is, however, well
positioned to absorb even severe credit risks stresses.
Statutory Liquidity Ratio (SLR) investments lend
resilience to banks in managing their liquidity risks. A
sample of banks reported a positive net marked to
market (MTM) position on the derivatives portfolio,
indicating that they are in a position to absorb adverse
market movements in case of simulated historical stress
scenarios and random sensitivity shocks.
23. NBFCs are also well positioned to withstand credit
risk shocks given their comfortable capital adequacy
positions. Stress tests conducted for Urban Cooperative
Banks point to some vulnerability to both credit and
liquidity risks.
Regulatory Infrastructure
Unintended consequences of key reform measures will
need to be managed
24. Gaps and challenges in implementation of the
post crisis reforms are emerging, especially with respect
to the resolution framework for systemically important
financial institutions and reforms in the OTC derivative
markets. There could be unintended consequences of these reforms, particularly for EDEs. Differences in the
calibration of reform measures in different jurisdictions
may leave scope for regulatory arbitrage.
Domestic Basel III guidelines aim at a smooth
transition
25. In line with the present regulatory requirements,
the final guidelines for Basel III also require banks in
India to maintain a capital ratio at 9 per cent of risk
weighted assets (RWAs), which is higher than the 8 per
cent prescribed by the Basel Committee. The timelines
suggested by the Basel Committee have been retained
to enable a smooth transition. Going forward, challenges
will be faced as the additional capital needs could impact
the cost of capital and return on equity of banks,
especially in the short run. The fiscal impact of the
increased capital requirements of public sector banks
has also to be reckoned with.
26. A more stringent leverage ratio has been
prescribed for the period of the parallel run considering
that the leverage ratio of banks in India is currently well
above the minimum ratio of 3 per cent prescribed by
the Basel Committee.
Variations in RWAs will need to be monitored as banks
migrate to advanced approaches under Basel II
27. significant differences in the RWA density (RWAs
to Total Assets) have been observed across jurisdictions
and also across banks in the same jurisdiction. These
are generally driven by differences in the risk profile of
banks, their business mix and also the stage of regulatory
evolution in the jurisdiction. There may, however, be practice-based inconsistencies in the calibration of risk
parameters. Migration to advanced approaches under
Basel II may create further scope for the emergence of
interpretational differences. Variations in RWA density
across bank segments have been evidenced in the Indian
context as well, and the underlying trends will need to
be studied.
Financial Market Infrastructure
Real time gross settlement reduces risks … but
settlement lags need monitoring
28. Delays in settlement of transactions in the RTGS
system, notwithstanding proactive intraday liquidity
management by banks, the provision of intraday
liquidity by the central bank and the availability of
prudential reserve balances, could pose risks. The
underlying trends of variations in settlement lags across
different banks will also need to be monitored.
Newly issued standards and the risks posed by
settlement banks warrant a review of CCIL’s risk
management framework
29. The newly issued international ‘Principles for
Financial Market Infrastructure’ proposing stringent risk
management requirements necessitate a relook at the
risk management practices of domestic central
counterparties such as CCIL. Risks are also posed by the
designated settlement banks of CCIL which act as ‘quasi’
payment systems and require CCIL to assume significant
uncollateralised intraday exposures to these entities.
The trends in this regard need to be assessed vis-à-vis
CCIL’s financial resources and its liquidity and credit
risk management framework.
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