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RBI's stress on financial stability

Importance of macro-economic balance

THE TRENDS and Progress of Banking in India is an annual publication of the Reserve Bank of India containing a wealth of data on the financial sector. The latest report released on November 14 covers the period 2005-06 with major developments after March suitably incorporated.

By its very nature, a report of this type, though providing valuable data, can hardly be expected to reveal any sensational developments.

It is thus more of an excellent reference material and not something for newspapers to base their headlines on. Incidentally, in another annual publication _ the Annual Report _ the RBI has tried to develop a central theme without of course diluting the required contents.

There is bound to be a substantial overlap in coverage and the data cannot be breathtakingly different from one report to another.

Indeed, with credit policy announcements now being made once every three months (instead of the half-yearly announcements before) there is hardly anything new that the central bank can convey each time.

The central theme (if one can identify any) is maintenance of financial stability. It is often understood to mean a smooth functioning of markets and institutions without serious disruptions.

Recurrent theme

That has been a recurrent theme in all RBI reports. Last year's report on banking too laid considerable emphasis on the topic, making pretty much the same points to explain why maintaining financial stability is particularly important in the reform era.

At the same time, it must be admitted that it is because of financial sector reform (as part of the larger economic reform) undertaken since 1990 that financial stability is more likely to be achieved. Macroeconomic balance minimises the various risks. Financial crises in several countries in the late 1990s inflicted heavy costs on their economies. They also exposed the fragilities of their financial systems and paved the way for macro-economic restructuring.

Globalisation no doubt has brought a number of benefits. But on its flip side, it has brought in some new types of risks for economies like ours. Cross-border flows, so much a part of globalisation, have exacerbated the possibility of contagion.

Also, hedge funds and private equity, both dominant conduits for global capital flows, are opaque.

Regulators in the U.S. and elsewhere are now concerned with the consequences of allowing hedge funds a free run without regulatory checks. In India, identity of people remitting money from abroad through the participatory note (PN) mechanism has been a matter of serious concern.

The rapid advance in technology has made it possible to frame complex financial instruments besides enabling speedier remittances. There is a flip side here too; while many types of risks can be covered _ for instance, through the device of customised derivatives _ the very complexities of those instruments can threaten stability. Other risks have arisen in the wake of the emergence of large conglomerates with diverse interests and operating across borders.

Three key areas have engaged the central bank in its task of ensuring financial stability _ maintaining an uninterrupted payments and settlements system; ensuring a level of confidence in the financial sector; and checking excess volatility that can harm economic activity.

There are risks to macroeconomic stability. Petroleum prices might have come down from their recent highs but they are still volatile and nobody can say that they will not climb up again. Interest rates have been hardening everywhere. Inflation expectations are high. The much talked about global imbalances (the U.S.'s current account deficit being met by the surplus of Asian countries) may finally wind down in a disorderly fashion.

The RBI is however optimistic: India's macro economy and the financial sector are resilient enough to withstand any risks. The central theme apart, the Report provides details of policy developments and performance of commercial banks, co-operative banks and non-banking financial companies (NBFCs) during 2005-06.

Of particular interest is the performance of commercial banks. There has been a robust growth in bank credit for the second successive year, most noticeably in the retail and home loans segments. Those are areas where a shakeout can be expected. The RBI had earlier warned banks against reckless lending in these areas and had followed it up by making some of these loans costlier. Already a number of frauds have been detected in the home loan segment, through faulty documentation and spurious land records.

Deposit growth has lagged behind credit growth. Net profits of commercial banks as a group however increased thanks to a jump in non-interest income.

PSBs lose market share

A break up of the performance into individual categories of banks _ public sector banks, foreign banks, and new and old private banks _ is more revealing. PSBs have lagged behind foreign banks and the new private banks in asset growth. With deposit growth mirroring the trend on the assets side, it is likely that the PSBs are on a long-term decline. How well they will be able to recoup their market share will be the most engaging story of this year.

C. R. L. NARASIMHAN

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