24th Financial Stability Report (FSR), December 2021 – Explained, pointwise

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Introduction

The Reserve Bank of India (RBI) has released the 24th Financial Stability Report (FSR). The report explains the robustness and vulnerabilities of the Indian financial system — especially the banking system — to the changes in the economy. The report also tells whether and to what extent will the banks and other lending institutions be able to support future growth.

What is the Financial Stability Report (FSR)?

The FSR details the state of financial stability in the country, and it is prepared after taking into account the contributions from all financial sector regulators.

The FSR explains the current status of different financial institutions including the non-banking lending institutions. It also maps the state of credit growth and the rate at which borrowers are defaulting on paying back loans.

Preparation: The FSR is prepared through collective assessment of the Sub-Committee of the Financial Stability and Development Council (FSDC – headed by the Governor of RBI)

Methodology of FSR: 1. The RBI looks at the state of both the global as well as the domestic economy, 2. The RBI also conducts certain “tests” to figure out how different variables may be affected if the economy does not grow as anticipated, 3. The RBI also conducts a Systemic Risk Survey (SRS), wherein it asks experts and market participants to assess the financial system on five different types of risks — global, financial, macroeconomic, institutional and general.

Report frequency: The FSR is published twice each year (biannual).

 

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What are the key findings of the latest Financial Stability Report (FSR)?

Macro financial Risks: Since the July 2021 issue of the FSR, the rejuvenation of the global recovery was impacted by the resurgence of infections in several parts of the world, supply bottlenecks and disruptions and the persistent inflationary pressures. “The slowdown in activity is occurring even in countries with relatively high vaccination rates that seemed to be emerging as global growth drivers.”

This is reflected in both the Baltic Dry Index and Goods Trade Barometer of the World Trade Organization (WTO).

Note: Baltic Dry Index is a measure of shipping charges for dry bulk commodities. and Goods Trade Barometer measures the World merchandise trade volumes.

Bank credit growth is improving, but not fast enough: The banking stability indicator (BSI), which indicates the changes in underlying conditions and risk factors of India’s commercial banks, showed improvement in “soundness, asset quality, liquidity and profitability” except the “efficiency.” The recovery is also a “U-shaped” recovery.

NPAs may rise by September 2022: The latest FSR pegs the NPA of India’s Scheduled Commercial Banks (SCBs) at 6.9% at the end-September 2021. “Stress tests indicate that the Gross NPA ratio of all SCBs may increase to 8.1% by September 2022 under the baseline scenario and further to 9.5% under severe stress.”

Read more: PSBs to introduce common staff accountability guidelines for NPAs

Systemic risks evenly balanced: On the whole, the Systemic Risk Survey (SRS), “across all broad categories of risks to the financial system were perceived as ‘medium’ in magnitude, but risks arising on account of global and financial markets were rated higher than the rest”.

Time for the Indian economy to make a full recovery from the pandemic: Almost 64% respondents to the survey expect the economy to recover fully in the next 1 to 2 years while 22% believe it may take up to 3 years to recover completely.

What are the challenges highlighted by the latest Financial Stability Report (FSR)?
FSP
Source: IE

The challenges in bank credit include 1. The growth rate is still far off the ideal level, 2. Retail credit (that is, less than Rs 5 crore) is growing but not the wholesale credit, 3. Most of the wholesale credit is being picked up by public sector undertakings, 4. Credit to the MSME segment slowed down (y-o-y).

Assessment of Systemic Risk: For India, the main sources of risks are commodity prices, domestic inflation, equity price volatility, asset quality deterioration, credit growth and cyber disruptions.

The FSR mentions that the risks generated by merged state-owned banks were higher than of their unmerged counterparts.

FSR
Source: IE

Disconnect between the real economy and India’s equity markets: “The Indian equity market surged on strong rallies….” states the FSR. “Strong investor interest has driven up price-earnings (P/E) ratios substantially.”

Other valuation metrics such as the price-to-book value (P/B) ratio, the market capitalisation to GDP ratio, and the cyclically adjusted P/E ratio or Shiller P/E are also above their historical averages.

“This reflects some disconnect between the real economy and equity markets,” the RBI report. The divergence between stock market valuations and economic growth rate is a cause of concern from the perspective of financial stability, although it has happened in the past as well.

The digitalisation of financial services: Digitalisation can also bring in its wake various risks such as greater reliance on third-party service providers, mis-selling of financial products, breach of data privacy, unethical business conduct and illegitimate operations.

How India can recover from the challenges pointed out by the FSR?
Recommendations of the FSR

Close monitoring of stress in micro, small and medium enterprises (MSMEs) as also in the micro-finance segment going forward.

Regarding FinTech: RBI is currently in the process of consolidating all fintech-related work under one umbrella to manage risks and ensure effective regulation and supervision of fintech entities, products and services. “The new setup will be tasked with managing the entire gamut of fintech-related activity in coordination with its regulatory and supervisory departments,” the report said.

Faster implementation of crypto regulations: The FSR highlights that private Cryptocurrencies pose immediate risks to customer protection, anti-money laundering efforts and combating the financing of terrorism. So, it urged the government to implement crypto regulations faster and facilitate Central Bank Digital Currency (CBDC).

Other recommendations

Generating Demands in the Economy: The government has to generate demand in the economy. The banks and the significant leaders in the economy have a key role. When the demand begins to rise, only then economic recovery can occur at a steady pace.

Increasing the Efficiency of Public Sector Banks: The public sector banks need to be made more efficient, if necessary the government can consider ownership changes (privatisation) too.

Ensure proper functioning of NARCL: National Asset Reconstruction Company Limited has to ensure faster debt consolidation to reduce the rising NPAs.

Carry out Second Generation Reforms: These are microeconomic reforms, which include strengthening the infrastructure of the market economy. The most important segment of the second generation reform is the rural development including agriculture & allied sectors and small scale industries. So, the government has to concentrate on these areas.

The latest FSR’s suggests that India’s banking and financial system has largely improved since the July 2021 report. But with global growth faltering, monetary tightening in the developed countries (which is likely to hurt foreign fund flows) as well as the rise of omicron, the risks are evenly balanced. The government and the RBI have to work in a coordinative manner to avert these risks.

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