The International Monetary Fund (IMF) has said that despite recent successes in developing a stable financial system, India’s financial sector still confronts long-standing impediments to its ability to support growth as well as new challenges to stability.

“The prominent role of the state in the financial sector — through ownership of large financial institutions, captive government financing, directed credit to priority sectors, tight controls over the range of allowable activities, and restrictions on the availability of foreign capital — contributes to a build-up of fiscal contingent liabilities and creates a risk of capital misallocation that may constrain economic growth,” IMF said in its ‘India: financial system stability assessment update’.

This report is part of IMF’s Financial Stability Assessment Programme (FSAP) for members with systemically important financial sectors.The assessment recognises that the Indian financial system remained largely stable on account of a sound regulatory and supervisory regime. However, the assessment identifies some gaps, including some limits on the de jure independence of the regulators (RBI and IRDA).

Reversal risk

As demonstrated by the current turbulence in international markets, there is a risk of reversal of capital flows and a repeat of the liquidity pressures experienced in 2008. Stress tests suggest, however, that banks’ substantial buffers of high quality assets (cash and holdings of government paper) should enable them to deal with such pressures, including through recourse to central bank facilities.

The IMF also is concerned with the multiple roles of RBI which create the potential for conflicting goals. “RBI officers are nominated as directors on the boards of public sector banks while, at the same time, RBI serves as the prudential supervisor of these banks. It would be preferable for the government to focus on policies that ensure the appointment of well qualified, independent board members that are not from the RBI. And while there may be some synergies, RBI’s role as monetary authority, bank regulator, and government debt manager may have led it to require banks to hold larger holdings of government debt than might be needed on prudential grounds.”

Using the banking system rather than government programmes in meeting the needs of priority sectors — agriculture, small and micro credit, education, health — and underserved areas may conflict with RBI’s supervisory role, IMF opined.

Even though RBI has broad resolution authority, “stronger powers to conduct carve-outs and more attention to crisis preparedness would be desirable”. Resolution powers and contingency planning for insurance companies and the payment system also need strengthening.