Financial Stability Report

The Reserve Bank of India (RBI) released its Financial Stability Report (FSR) recently. The third in a series, the recent FSR follows the tradition of the two preceding reports (March and December 2010) and represents the central bank's “continuing endeavour to communicate its assessment of the incipient risks to financial stability”.

The FSR's approach is holistic and focusses on risks to the system arising out of an interplay of the disparate elements of the financial sector infrastructure — the macroeconomic setting, policies markets and institutions. Like its counterparts in the developed world, the RBI says it relies on the latest techniques of risk assessments involving stress tests and so on.

Though technical in nature, the FSR has plenty of messages even for the common man. An important conclusion is that the Indian financial system remains stable in the face of “some fragilities being observed in the global macro-financial environment”. Major economies around the world are slowing down even as the risks from global imbalances and sovereign debt crises remain. India's growth momentum too has slackened mainly due to the uncertainties in the global environment characterised by high energy and commodity prices. However, despite high inflation and fiscal concerns, India's fundamentals remain strong.

Findings

Two of the most significant findings of the FSR are (a) that the banking sector in India — by far the most dominant portion of the Indian financial sector — continues to be stable and (b) the domestic financial markets have remained stress free recently. However, a few caveats are in order.

Indian firms are relying increasingly on external sources of finance, mostly euro-commercial borrowings. That has resulted in currency mismatches. The well-known problem in the derivatives segment in which uninformed companies, many of them from the SME segment, sold unhedged products (loans in Swiss francs or other currencies with low interest rates but without a forward cover) has had disastrous consequences. The aggressive selling of an essentially speculative product has also cost the banks dear. According to many that development would not have happened if the RBI had been more gradual in relaxing foreign exchange controls. It has been one of the cardinal rules of exchange control that there should be an underlying commercial transaction behind any forward cover. Sans the commercial it becomes pure speculative trading.

Although the above has not been highlighted in the FSR, it does mention the other great risk arising out of an unbridled access to foreign currency borrowings by Indian companies.

Many of them who issued foreign currency convertible bonds (FCCB) may face refunding risks at the time of conversion by March 2013. The conversion price of these FCCBs is said to be substantially higher than the prevailing market price and the differential is unlikely to narrow. The RBI recently announced some concessions and extended the date of conversion, but the basic problems with FCCBs remain. Despite giving a clean chit to the banks — at least for now — the FSR does voice some concerns. Banks have aggressively expanded their credit portfolio to accommodate their borrowers. In the process they have come to rely on high cost funds such as those mobilised through certificates of deposits (CDs). Resource mobilisation on those terms is generally for shorter periods and hence contributes to the risk of asset-liability mismatch.

High cost funds

In effect, banks have relied on the higher cost funds to fuel credit booms. How far such practices impair their balance sheets may not be clear now but one has to look at a related factor as well. Incremental credit has tended to concentrate on a few sectors such as retail lending (including home loans), commercial real estate and infrastructure. Although, on the face of it, banks are not over-exposed to these sectors, the fact remains that lending to some of these sectors has become a fashion even among public sector banks. Commercial real estate has been subjected to higher provisioning by the RBI to prevent “overheating”. Individual home loans are highly sensitive to interest rate movements. There is strong possibility that the level of non-performing assets (NPAs) will increase.

The share of public sector banks (PSBs) in these sectors is high. In one obvious sense that might be understandable: after all they remain the dominant players. Yet retail lending — home loans, personal loans including credit cards — has never been part of the ethos of public sector banking. Part of their new enthusiasm might have been prompted by their desire to match the foreign and the new generation private banks. The crucial question is whether the PSBs are equipped to cope with failures such as in credit cards.