Stable, but for how long?

The latest Financial Stability Report (FSR) of the Reserve Bank of India, the sixth in the series, is a half yearly assessment by an expert committee of the outlook for the stability and resilience of the financial sector. The report also suggests policy actions that are needed to contain the risks to stability. Compared to the previous report, the threats to financial sector stability have increased. While the environment of global and domestic macroeconomic instability remains unchanged, there is a realisation that the highly unconventional tools relied upon by governments and central banks across the world at the beginning of the crisis are losing some of their edge and effectiveness. The space for fiscal and monetary action is getting squeezed. Besides, some of the unintended consequences of the policy tools employed, such as the ultra soft monetary policies of the U.S., have started manifesting themselves in countries like India. For instance, the accretion to global liquidity has pushed up commodity prices, and with it the threat of imported inflation in India. Global uncertainties, notably the delay in resolving the euro-debt crisis and domestic policy uncertainties, have caused a deceleration of economic growth in recent quarters. There has been a noticeable fall in the level of domestic savings, inflation has remained persistently high and these along with regulatory and environmental issues have caused a fall in investment demand and moderation in consumption spending.

Despite all of this, financial markets in India have remained largely stable. But the corporate sector’s ability to service its debt has been falling since 2009-10. Some infrastructure companies have substantially increased their leverage. These and a few other factors are responsible for the increased stress on the asset quality of the banking system. A large number of loans have been restructured recently. The banking sector on the whole has remained resilient to credit, market and liquidity risks and is capable of withstanding macroeconomic shocks given their comfortable capital adequacy. However, new provisioning norms require banks to tie up a larger amount of capital to take care of distressed assets. In the context of the imminent shift to Basel III norms, some banks may face challenges in mopping up additional capital. Financial inclusion, financial literacy and consumer protection are interconnected threads in the pursuit of financial stability. Given the strong linkage between stability and inclusion, it is only right that the FSR should highlight, for the first time, the several regulatory initiatives taken and the progress achieved so far.

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