Clean chit for now

The Financial Stability Report (FSR), released by the Reserve Bank of India last week, is altogether positive. Banks remain broadly healthy; they are well capitalised in line with existing regulatory capital ratios; and they have sustainable financial leverage. In short, the Indian financial system is stable. Maintenance of financial stability has been a key objective of monetary policy. Recent decisions of the government and the RBI have sought to institutionalise what has always been an implicit focus — making financial stability “an integral driver of the policy framework.” The RBI established a Financial Stability Unit in August 2009 and, two months later, revealed that it intended “to enhance transparency and augment confidence in the financial system,” by issuing financial stability reports. These reports would review the nature and magnitude of risks that affect the macroeconomic environment and the markets, and over time they would also aid policymakers proactively to deal with incipient risks in the system. Equally important was the announcement in the Union Budget about the setting up of a monitoring body, the Financial Stability and Development Council. Although its role and composition have yet to be clarified, it is clear that the new body will rely on the RBI and, more specifically, the financial stability reports.

Although the global markets have stabilised after the crisis, there are uncertainties about growth prospects and financial stability. India remains exposed to the impact of global economic shocks. Among the key factors that will affect financial stability are inflationary pressures, delays in fiscal consolidation, and the unsettlingly large capital inflows from abroad. None of these potential threats is likely to go out of control. In the FSR's assessment, banks will be able to withstand whatever stress that arises from credit and market risks. Banks are resilient and, even if one assumes that all restructured standard loans become non-performing assets, the stress would not be disruptive. Households and companies have not borrowed recklessly and, at this juncture, the levels of capital inflows are not such as to exceed the absorptive capacity of the economy. However, there are negative features that need to be watched carefully. The propensity of many corporates to take unhedged foreign exposures is a potential source of risk for the banking sector. Beginning April 1, banks will be paying interest on savings bank deposits on a daily basis, thereby incurring a substantially higher cost than now.