The RBI’s latest Financial Stability Report (FSR), like its four predecessors, attempts to share the results of the central bank’s macro prudential surveillance with the markets. The objective is not only to bridge the knowledge gap in a crucial area but to encourage debate and create awareness of the vulnerabilities of the financial system. The expectation is that the collective wisdom of the regulators and market participants will even be good enough to suggest prompt corrective action. Given that it is the financial sector’s weaknesses that spawned much bigger economic crises in many countries recently, the need to keep a tab on vulnerabilities can hardly be overstated. The subprime crisis in the American mortgage market soon morphed into an unprecedented financial and economic crisis on a global scale. The ongoing eurozone debt crisis is centred on the financial system. Well-known European banks are under intense pressure as the authorities try to cobble together rescue packages for them.

The FSR’s major finding is that the country’s financial system remains robust despite increases in risks stemming from global factors and macroeconomic conditions. Especially reassuring is the fact that important participants of a high-level RBI survey remained confident about the stability of the domestic financial sector. Domestic growth is threatened by the twin deficits of current account and fiscal imbalances. Inflation risks remain. Foreign exchange and equity markets have corrected themselves and are experiencing a high degree of volatility. Banks, however, remain resilient to credit, market and liquidity risks and would be able to withstand macroeconomic shocks given their comfortable capital adequacy levels. There has, however, been a deterioration in the quality of assets — inevitable, perhaps, in a slowing economy. Liquidity issues have come to the fore recently. Banks are mobilising fewer deposits. Their advances are also lower but their level of outside borrowing has increased. The growing “interconnectedness” in the financial sector is a major concern. Among others, it has increased the scope of asset-liability mismatches in the banks, which have been borrowing for short periods from mutual funds to fund their long-dated assets. Finally, “distress dependencies” between banks have risen. The systemic importance of “the most connected” banks has increased, warranting closer monitoring. Any failure here will have large negative implications for other banks, mutual funds and insurance companies, which have lent extensively to banks.

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