The Reserve Bank of India’s latest Financial Stability Report (FSR), the fifth in the series of such reports, was released on June 28. In line with the best global practices of central banks and the IMF (International Monetary Fund), the RBI, through these half-yearly reports, attempts to share the results of its surveillance with the market players, with the twin objectives of encouraging a debate and creating an awareness of the vulnerabilities of the financial system.

An exercise like that involves the use of the latest techniques at “modelling”, putting through stress tests and so on.

Those might appear to be arcane but far from being restricted to banking professionals, regulators and other experts, the FSR’s messages have a broad appeal. One way of looking at the FSR is that in the broadest sense financial system’s stability cannot be discussed separately from the larger macro-economic discourse.

Consequently, some of the lesser known but critical problems of the financial economy are discussed in the FSR.

A clean chit but....

Like its predecessors, the latest FSR gives a clean chit to the financial system, terming it to be “robust”. However, risks to stability have increased primarily due to global factors and domestic macro-economic conditions. Interestingly, respondents to a survey remained confident about the stability of the system.

Risks to domestic growth have been accentuated by fiscal and current account imbalances. Although inflationary pressures have moderated, the risks remain. Volatility in the stock and exchange markets is another cause of concern. The rupee has depreciated and the stock indices have been down.

How does the FSR see the banking system? At one level, the FSR says that banks remain resilient to credit, market and liquidity risks. Indian banks have adequate capital to withstand macro-economic shocks. They will migrate to Basel-III from a position of relative strength although there could be challenges in the form of higher capital.

But clouding this generally bright picture is the decline in asset quality across the banking system. Also, liquidity pressures have intensified. Banks have been mobilising fewer deposits. Their credit growth has slowed but their reliance on borrowed funds has increased. That, in turn, raises certain serious concerns.

It is not for the first time that the RBI has been critical of inter-connectedness of banks and the systemic risks it poses to other segments of the financial sector.

The possibility of asset-liability mismatches is large as banks have been borrowing from mutual funds for short-periods.

Apart from liquidity concerns, there are roll-over risks: banks may not find, on the maturity date, another lender at the same price. Moreover, the banking sector’s problems, such as declining asset quality, can impact adversely on the non-banking institutions — insurance companies and mutual funds — which have lent them money.

A closer monitoring of banks is also required because “distress dependencies” between banks has risen. RBI’s analysis of the branch network of Indian banks reveals that the systemic importance “of the most connected” banks has increased.

The risk that the failure of a large bank could ripple through all parts of the financial system has increased because of growing inter-dependence of banks, insurance companies and mutual funds. The random failure of a bank, which has large borrowings from the insurance and mutual funds segments of the financial system, may have significant implications for the entire system,” says the report.

The maximum potential loss to the banking system due to the failure of the “most connected “bank has increased in 2011. Micro-prudential regulation over these “most connected banks” must be made more rigorous.

Liquidity remains a serious concern to the banking system, second only to the deterioration in the asset quality. If the deterioration in the asset quality, as evidenced by rising non-performing assets (NPAs), is not checked, it could develop into a major problem affecting the stability of the banking system. The signs are ominous because decelerating economic growth can only add to the NPAs.

The FSR points out that the policy framework for reforms, started after the global financial crisis, is now in place in several countries. National policy frameworks for reforms, however, vary across countries raising concerns over cross-border consistency in an increasingly interconnected, globalised financial system.

There can be no doubt at all that the underlying tone of the FSR is one of caution. As RBI Governor D. Subbarao put it, “the report has been released against a backdrop of worrisome global and domestic macro-economic developments despite some negative indicators, particularly on asset quality, the Indian financial sector has remained sound and resilient. Banks continue to be well capitalised with leverage at healthy ratios.”

More In: Economy | Business