The June 2011 Financial Stability Report (FSR) of the Reserve Bank of India (RBI) reflects great perspicacity. The Report underscores the RBI's analytical skills as it assesses sources of systemic risk. The Report is not something to be glanced over and consigned to the archives. It is truly reflective of RBI's concern on various issues, and outlines certain policy pointers in the way forward.
The Report recognises that a slowdown in the growth momentum is inevitable as inflation looms large, with the possibility of further upward pressure in the ensuing months. This could affect the quality of assets of the financial sector.
The present level of current account deficit is not really a concern, but as demand for funds in the industrial countries gathers momentum, Indian financial institutions could face increased funding costs. The enhanced recourse to external commercial borrowing (ECB) is increasing currency mismatches in Indian corporate balance-sheets. The increase in the non-official sector's net liability position reflects the risks that could arise from depreciation of the rupee.
Foreign Currency Convertible Bonds (FCCBs) maturing during the next 12-24 months are large, which portends that a sizeable proportion may not be converted into equity and any refinancing would necessarily be at high interest rates.
BANKING SECTOR CONCERNS
While the banking sector, by and large, reflects good health, the robust credit growth points to future vulnerabilities. As deposit growth has been less than credit expansion, there would be increasing maturity mismatches affecting profitability. Periods of high credit expansion give rise to credit booms which are precursors to credit busts and financial crisis.
As Liaquat Ahmad, the author of Lords of Finance said during a recent visit to India, India will be faced with a financial crisis in the future, though he could not say precisely when. The Indian authorities have been forewarned and should take heed well before a financial crisis hits India. While Indian banks are well capitalised and are above the Basel II norm of 12 per cent, increased provisioning for pension liabilities and increased non-performing assets (NPAs) could erode the capital of banks.
The Report further says that the increase in the savings bank deposit rate could affect profitability.
However, in a dynamic context, the possible deregulation of savings bank deposit rates could increase low-cost deposits rather than longer-term high-cost deposits, and thereby contribute to enhanced profitability. Amendments to the banking sector legislation are on the anvil and the Financial Sector Legislative Reforms Commission (FSLRC) has a mandate to recommend a revamp of financial sector laws.
The FSLRC would hopefully make its recommendations in a non-partisan manner and not be caught in the inevitable conflicts of interest between institutions. The FSLRC has constituted eight sub-committees, each of which would look into specific areas.
It is unfortunate that despite the Indian deposit insurance system being the second oldest in the world, its development has been stunted. The FSR does well to focus attention on the deposit insurance system. The present theology is that no bank should be allowed to fail and hence the deposit insurance system is reduced to a mere pay-out agency.
DEPOSIT INSURANCE
A major problem relates to the system of a uniform premium. It is necessary to move over to a system of differential premia. A differential premia system would not lead to a collapse of the weaker banks; rather it would be an incentive for banks to take early action to rectify weaknesses. There is a need for a broader mandate for the deposit insurance agency, so that it can be proactively involved in regulation/supervision of bank deposits, as in the case of the US Federal Deposit Insurance Corporation. The present banking regulation/supervision system within the RBI would need to be restructured to ensure that the deposit insurance agency has a major role in safeguarding depositors' interests, rather than being a poor relative in the RBI fold.
The FSLRC should give close attention to altering the present legislative framework under which the RBI's banking regulation/supervisory wing is treated as the top gun and the deposit insurance agency as a mere vassal. Unless the RBI is proactive in this restructuring, the FSLRC may even need to opt for a total separation of the deposit insurance system from the RBI. There is an urgent need for an attitudinal change in the RBI on this issue. The RBI should be in the vanguard of the move to empower the deposit insurance agency with regulatory/supervisory powers relating to bank deposits.
The majestic sweep of the June 2011 FSR is such that it is just not possible to make a fair assessment in a single column. The Report should be mandatory reading for all players and regulators/supervisors in the financial sector, the government and the FSLRC.
(The author is an economist. blfeedback@thehindu.co.in )