Risks to financial stability rising

The Financial Stability Report of the Reserve Bank released in June 2012 observes that the financial system remains robust though risks to stability have worsened due to global and domestic macroeconomic conditions.

Globally, the areas of concern include possibility of sovereign default and the need for substantial bank recapitalisation in the Euro Zone with escalated fears of contagion and recession. And, domestically, slowing growth, elevated inflation and rising fiscal and current account deficits are major concerns.

When the real sector is in trouble because of low savings, investment and growth, it is natural that it gets reflected in the financial sector. The report indicates that both investment and savings declined in 2010-11.

The country’s gross domestic savings rate declined from 33.8 per cent in 2009-10 to 32.3 per cent in 2010-11. While growth in gross capital formation rate declined from 36.6 per cent to 35.1 percent. GDP growth declined sharply from 8.4 per cent in 2010-11 to 6.5 per cent in 2011-12.

The high inflation, poor GDP growth, persistent fiscal deficit, thanks to food, fertiliser and fuel subsidies, sharp decline in the value of rupee (more than 20 per cent since August 2011), policy paralysis in crucial areas such as infrastructure development, FDI, and so on, resulted in international rating agencies downgrading the economy.

The general reluctance of banks and companies to reduce their profit margin despite the deteriorating economic situation have added to the risks to the financial system.

For banks, the deposit growth rate has fallen to around 14 per cent — the lowest in the last decade. Deregulation of savings bank (SB) rates has not made any impact in the mobilisation of deposits. Barring a few, banks have not effected any change in the SB account rates.

Of late, banks prefer to go in more for borrowed funds and wholesale short-term deposits. Their dependence on borrowed funds, including from the Reserve Bank, as a matter of routine has been on the increase. This shift in banks’ approach to business, perhaps due to operational convenience, if not curbed in time could lead to liquidity risks and asset-liability mismatches.

The increase in non-performing assets (NPAs) is another risk factor affecting banking stability. The quantum of restructured accounts has also increased sharply outpacing the growth of both credit and gross NPAs. Unless banks introduce an inbuilt mechanism to discipline borrowers, say, by professional rating and penalising errant borrowers, the problem of NPAs cannot be tackled. Good borrowers and other stakeholders will continue to bear the brunt and subsidise the bad borrowers.

Interconnectedness arises as banks find easy source of funds from insurance companies and mutual funds compared to raising of deposits. The insurance business is fast developing and they find banks as a safe investment avenue.

Interconnectedness brings depth to the market but adds risks which the regulators need to understand and mitigate. The SEBI, the IRDA and the RBI have a greater role to play by mutual co-operation and co-ordination, and not confrontation.

The risk to financial stability is a fact and the concern of the RBI is real. The volatility in various markets is only a reflection of the failure of the economy which is not in the hands of the RBI alone.

The fall in deposit rates, increase in non-performing loans, and the contagion risk due to interconnectedness between banks and other institutions have to be seen in the context of the weakening fundamentals of the economy.

A close observation of the financial system gives one the impression that the RBI is gradually losing its grip on the financial system, excluding, to some extent, on the banking system. Insurance companies, mutual funds, and joint stock companies which carry out various types of monetary transactions have implications on the capital, money and forex markets.

The interference of the Government in banking affairs has been on the increase, affecting the discipline among banks. Serving two masters at a time is difficult. The RBI has explicitly expressed its displeasure, and the central bank Governor has asked the Finance Ministry not to micro manage banks.

Financial stability is in the interest of the healthy growth of the economy and all the regulators have an equal responsibility in ensuring that the stability is not at risk at any point of time.

As and when the markets expand both nationally and internationally in terms of business, products and services, complications will arise and risks to stability are inevitable.

While a proactive approach of the regulators and the support of the Government can help to minimise the risk and attain the desired level of stability, growth of the real sector is the only solution to bring financial stability on an sustained basis.

(The author is a Mumbai-based consultant.)