Macro-Financial Risks
Global Economy and Markets
Global financial markets are showing signs of
improved stability amidst a continuing easy monetary
policy stance in many jurisdictions. Economic growth
in advanced economies is finding traction, although
it appears far from self-sustaining. Emerging geopolitical
risks, however, could unravel subdued
vulnerabilities. Just as there was a need for global
coordination in reducing the spread of adverse
impacts from the global financial crisis, there is also
a case for policy coordination in reducing spillovers
from monetary policy action in advanced economies.
On the other hand, emerging market and developing
economies (EMDEs) need to strengthen their own
macroeconomic fundamentals while building buffers
against global uncertainties.
Domestic Economy and Markets
Moderation in consumer price inflation (CPI) and
reduction in twin-deficits provide some breather.
However, adverse growth-inflation setting obtained
over the last two years which continue to affect saving investment
dynamics, poses a major challenge. Going
forward, with the formation of a stable government,
the prospects of recovery appear bright. However,
supply side constraints need to be addressed to
complement the Reserve Bank’s efforts to contain
inflation expectations. Moreover, a strong push to
implementing policy is expected to provide the
necessary impetus to the investment cycle.
Recent policy measures and timely interventions have
proved to be effective in containing external sector
risks but there is a need to work towards reducing
structural current account imbalances. While capital
expenditure, mainly for developing infrastructure, is
vital for growth, fiscal consolidation also remains a
policy imperative. A greater role for private sector
investment in capital-intensive sectors is warranted.
Activity in domestic equity markets continued to be
dominated by foreign institutional investors (FIIs).
While secondary markets are vibrant, the lull in the
primary markets is not conducive for the investment
climate. The need for a more developed corporate
bond market was never stronger than now and
facilitating its growth by removing hindrances should
be one of the top policy priorities.
Financial Institutions: Soundness and Resilience
Scheduled Commercial Banks – Performance and
Risks
Stress on the banking sector has increased since the
publication of the last FSR in December 2013, mainly
on account of liquidity and profitability pressures,
although asset quality and capital adequacy have seen
a marginal improvement. The decline in the growth
rate of credit and risk weighted assets (RWA) of
scheduled commercial banks (SCBs), coupled with a
decrease in Tier 1 leverage ratios indicates efforts at
repairing balance sheets.
Banks showed some improvements in their asset
quality, which were contributed to by lower slippage1,
a seasonal pattern of higher recovery and write-offs
during the last quarter of the financial year and sale
of non-performing assets (NPAs) to asset reconstruction
companies (ARCs). Industries such as infrastructure,
iron and steel, textiles, mining and aviation account
for a significant share of total ‘stressed’ assets (NPAs
and restructured advances) of banks, especially those
in the public sector. This is also reflected in the
relatively lower profitability of public sector banks
(PSBs).
Stress Tests
Scheduled Commercial Banks
Macro stress tests show that the system level CRAR
of SCBs remains well above the regulatory minimum even under severely adverse macroeconomic
conditions while the ‘expected loss’ analysis indicates
that the present level of provisions of SCBs may fall
short in meeting the expected losses under such a
(extreme but plausible) scenario.
Urban Co-operative Banks
Single factor sensitivity analysis for scheduled urban
co-operative banks (SUCBs) shows that although the
system level CRAR remained above the minimum
regulatory required level, a large number of banks will
not be able to meet the required level of CRAR under
the assumption of doubling of GNPAs.
Non-Banking Financial Companies
Stress tests for non-banking finance companies
(NBFCs) show that while there could be a shortfall in
provisioning levels under stress scenarios, the higher
CRAR level provides an additional cushion.
Interconnectedness and Contagion Risks
PSBs as a group remain the biggest overall net lender
in the system, while new private sector banks and
foreign banks continue to be relatively more
dependent on interbank borrowings. The network
analysis shows that banks with high ‘interbank node
risk’ are seen to be the ones with large balance sheets,
a substantial presence in the payment and settlement
system and significant off-balance sheet activities,
although the overall systemic importance of such
banks is within comfortable range, at present. A
contagion analysis shows that the failure of the
biggest net borrower in the system causes the banking
system to lose around 12 per cent of Tier I capital.
However, the losses incurred by the banking system
will be considerably low if an implicit state guarantee
associated with PSBs is factored into the analysis.
Financial Sector Regulation and Infrastructure
Banking Sector Regulation
India is making steady progress in implementing
global financial sector regulatory reforms while also
taking into account domestic priorities. Challenges
that have to deal with the asset quality and profitability
of PSBs have brought the focus on PSBs’ ownership
patterns, governance structures and management
processes. The spurt in the sale of NPAs to ARCs in
the last two quarters and the increase in the
restructuring of corporate sector advances point
towards the need for a closer monitoring of the
efficacy and effectiveness of such mechanisms. Efforts
to de-stress the banking sector need to be
complemented by necessary steps for developing
bond markets. With the Indian government showing
a greater resolve for fiscal consolidation, there is a
strong case for encouraging PSBs to approach capital
markets for meeting their additional capital
requirements under pillars I and II of Basel III. This
may require the PSBs to be subjected to the
requirements of market discipline. Improvements in
their valuations will provide an opportunity to raise
requisite resources with minimum equity dilution.
Shadow Banking Sector in India
The shades of shadow banking in India’s relatively
underdeveloped financial markets are different, and
unlike other major jurisdictions, the concerns in this
regard mainly relate to a large pool of unregulated
small entities with varying activity profiles. Given the
low levels of financial literacy, there is a risk that the
public may perceive them to be under some regulation.
Also, technology-aided innovations in financial
disintermediation in the form of crowd funding/P2P
lending call for monitoring of such activities and
regulatory preparedness. The increasingly significant
financial market/treasury operations of large sized
non-financial corporates may have implications for
effectiveness of macro-prudential policy measures.
Regulation of the Securities and Commodities
Derivatives Market
Mutual funds and other asset management activities
do not carry the risks experienced in other jurisdictions.
However, the relatively lower growth in trading
volumes in the cash segment of equity markets
compared to that in the derivatives market, especially
options, makes it imperative to review the differences
in transaction costs in different segments of equity markets. The functioning of the commodity derivatives
market is expected to be strengthened with revised
norms for corporate governance and the warehouse
receipt system.
Insurance and Pension Sectors
Lending activities of insurance companies need to be
monitored as a component of the overall lending in
the system, under a prudential framework closely
aligned with that for banks, to avert the possibility of
any regulatory arbitrage. In view of the changing
demographic profile of the Indian population and also
its huge unorganized sector, the pension sector has
the potential to play an important role. The fiscal
implications of inadequate liability computation with
respect to several defined benefit pension schemes
in the government sector could be significant in the
coming years.
Assessment of Systemic Risk
India’s financial system remains stable, even though
the banking sector, particularly the PSBs, is facing
some major challenges. The results of the latest
systemic risk survey (Annex 1) conducted by the
Reserve Bank in April 2014 show that the banks’
asset quality still remains under the ‘high’ risk
category, along with domestic fiscal situation and
global and domestic growth and inflation, among
others.
Overall, there is urgency in addressing the adverse
gowth-inflation dynamics and saving-investment
balance. However, the improved political stability and
expectations of a decisive and coordinated policy
response augur well for the economy and the markets.
But there can be no room for complacency given the
domestic challenges and global uncertainties.
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