Tuesday, December 27, 2011

RBI Releases Financial Stability Report

At a time when there is growing uncertainty about the health of many Western banks, the latest version of the Financial Stability Report (FSR) just released by Reserve Bank of India (RBI) is reassuring. Indian banks remain robust though capital adequacy ratios have fallen and Non-Performing Assets (NPAs) have increased.
Capital Adequacy of Banks
Stress tests show banks are reasonably resilient though the capital adequacy of some banks could be adversely affected under severe credit risk stress scenarios. At a more disaggregated level, the picture is less encouraging. In particular, the consequences of, largely, public sector banks' headlong rush into lending for infrastructure projects, often at the behest of the government and the RBI, are now evident.
The report warns the 'growth rate of credit to the power sector has been much higher than the aggregate banking sector's credit growth and could unravel in case of a sharp economic downturn'. The same could also be said about bank lending to other infrastructure sectors such as real estate and airlines.
Low-Interest Rate Regime
A slowdown in domestic growth could raise the risks for the banking system as loans made in the low-interest rate regime of the previous two years turn sticky. More so since, as the report points out, all components of domestic demand, private, government, consumption and investment, have decelerated. On the external front, Indian banks with their limited exposure to overseas markets are relatively safe.
Nonetheless, contagion from the European sovereign bond markets to international banks could trigger further deleveraging and raise the cost of foreign currency loans for Indian banks and corporates. However, to the extent regulatory arrangements worldwide have been strengthened with national regulators recognizing the importance of a coordinated approach, the system is, hopefully, less vulnerable than before.
Real Test
The real test is whether the financial market infrastructure, in particular the payment and settlement systems, will continue to function without major disruption, when the next crisis strikes. As long as the lessons of the 2008 crisis have been learnt, there is reason to second the FSR's vote of confidence.

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