Michael Debabrata Patra: India's financial sector - from exuberance to
resilience
Speech by Dr Michael Debabrata Patra, Deputy Governor of the Reserve Bank of India,
at the 16th SEACEN-BIS High Level Seminar, hosted by the National Bank of
Cambodia at Seim Reap, Cambodia, 21 September 2023.
* * *
Good afternoon and Namaskar.
Thank you Alfred for those insightful opening remarks. I must mention that Alfred led
the IMF's Article IV India mission for the 2021 consultations. The sheer weight of that
experience and deep understanding of Indian conditions is reflected in his views. I
would also like to commend Alfred and his co-editors for a comprehensive evaluation of
India's financial system and very valuable recommendations on the way forward in a
recent book evocatively titled "India's Financial System: Building the Foundation for
Strong and Sustainable Growth".
I am glad to see Mr Thomas Helbling from the Asia and Pacific Department of the IMF
in this session, and I look forward to hearing from him.
I thank our host and SEACEN EXCO Chair, the National Bank of Cambodia, the
SEACEN Centre and Dr. Mangal Goswami, Executive Director, and the BIS for inviting
me to speak in this distinguished forum. In particular, I am grateful to Deputy Governor
Sum Sannisith for so graciously writing to me to participate in this 16th SEACEN-BIS
High Level Seminar.
The Backdrop
It is widely believed that during the next two decades - if not for longer - the centre of
gravity of the global economy will shift eastwards to Asia. The IMF's Regional Economic
Outlook for Asia and the Pacific indicates that this region will contribute about two-thirds
of global growth in 2023 itself. India will account for a sixth of world output growth in
2023 and 2024. In terms of market exchange rates, India is the fifth largest economy of
the world and the third largest economy on the basis of purchasing power parity. Our
assessment is that by 2027, India will be a US$ 5 trillion economy and the third largest
in the world even by market exchange rates. A key driver in this transformation is likely
to be the window of a demographic dividend that opened up in 2018 and will probably
last till the 2040s, going by fertility and mortality rates. Already, we are the most
populous country in the world at 1.4 billion and the youngest at an average age of 28
years. The other major catalyst of India's progress will be the pace and quality of
sector development, which is the theme of my address today. It is anchored by
afinancial few slides .
For a high saving rate economy, like the rest of Asia, a modern, efficient, and soundly
functioning financial sector is essential for mobilising the resource requirements of
India's developmental aspirations. A broad strand in the literature has established that
financial sector development has positive multiplier effects on the real economy,
including by conferring productivity and allocational efficiency gains. While the jury is
still out on whether economic progress is finance-led or demand-following in its
sequence, a wealth of empirical evidence points to Asia's growth trajectory being that of
the real economy leading financial development, and India is no exception. There is
also stylized evidence that the composition of the financial sector across Asia is
changing, with hitherto bank-dominated systems giving space to alternative financial
intermediaries such as non-banks and capital markets. These developments, in turn,
generate impulses of growth for the rest of the economy. In India, additional dimensions
have opened up exciting possibilities for leveraging our growth potential - the digital
revolution; transformation of the payment and settlement ecosystem; and innovations in
financial inclusion. More recently, India's exponential expansion of the usage of space
technology is reshaping every aspect of our lives, including the financial sector. Against
this backdrop, I thought that I would present some aspects of India's financial sector as
its poised today, the quiet metamorphosis that has been taking place over the years,
and the main challenges and opportunities on the way forward.
Composition of India's Financial sector
In its broadest form, the financial system comprises of banks that account for about 60
per cent of the total flow of credit to the non-financial sector, non-banking finance
companies (NBFCs) that provide 8 per cent, financial markets and others that account
for 20 per cent and foreign sources that constitute 12 per cent. The Reserve Bank of
India (RBI) is responsible for the regulation, supervision and development of banks,
NBFCs (including long-term refinancing institutions, primary dealers and housing
finance companies) and the money, gilt, foreign exchange and credit segments of the
financial market spectrum. In the rest of my remarks, I shall focus on these parts of the
financial sector. There is an inter-regulatory Financial Stability and Development
Council (FSDC) which has oversight over the entire financial system and coordination is
secured by a sub-committee of the FSDC headed by the Governor of the RBI.
Banking Sector
First, let me turn to the banking system. Typically, India's banking system is summarily
described as preponderantly publicly owned and heavily public policy intervened. In
practice, it is more vibrant, with 12 public sector banks facing keen competition from 21
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private banks, 45 foreign banks, and 63 niche banks catering to specific needs and
clientele. It is important to note that all constituents of the banking system are subjected
to the same regulatory regime, with specific modulations for the niche and local banks
in terms of sources and uses of funds.
It is noteworthy that India has not faced a financial crisis of the scale and severity of the
Asian crisis of 1997-98 or the Latin American crisis of 1980s and 2002 or the global
financial crisis (GFC) of 2007-08 although its suffered knock-on effects from each of
them. Financial perturbations have happened in India though, but they were more local
in character and essentially a manifestation of pro-cyclical exuberance.
As the Indian economy emerged out of recessionary conditions in 2001-02 and an
economic upswing took hold, it spurred a credit boom to fund infrastructure expansion.
Masked by lax credit standards and opaque asset quality recognition, it was punctured
by the onset of the GFC. India was among the earliest countries to bounce out of the
GFC, and aspirations of double-digit growth fuelled another burst of bank credit-led
infrastructure and heavy industry investment. On the premise that infrastructure
involves long gestations, bank loans were allowed to be restructured while treating
them as standard advances in banks' books with insufficient provisioning.
In 2015-2016, deep surgery in the form of asset quality review (AQR) was undertaken
and the true quality of banks' assets began to emerge. With the proper recognition of
restructured loans, provisioning requirements, especially of public sector banks, surged.
A revised prompt corrective action (PCA) framework involving thresholds on capital,
asset quality, profitability and leverage was imposed from 2017 in the form of
restrictions on lending, dividend-distribution, and branch expansion, apart from
requirement of higher provisions. At the peak, 12 banks were placed under the
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framework. A massive recapitalisation of US $42 billion was undertaken by the
government. during 2017-2022. The pain was severe, but beneficial effects started to
show up from 2018, resulting in improved asset quality - the gross non-performing
assets ratio fell from a peak of 11.5 per cent in March 2018 to 3.9 per cent by March
2023. By 2022, all troubled banks had exited the PCA.
In recent years, several regulatory and supervisory initiatives have strengthened the
banking sector. An Insolvency and Bankruptcy code (IBC) and the establishment of a
National Asset Reconstruction company (NARCL) have created the institutional
environment for addressing stress in banks' balance sheets on an enduring basis.
Offsite surveillance systems have been made sharper and more comprehensive by
harnessing SupTech - a web-based end-to-end workflow application called DAKSH
and an automatic data reporting platform called the Centralised Information and
Management System (CIMS). Big data techniques are being leveraged to supplement
supervisory initiatives while Cyber Range - a virtual controlled environment and tool -
helps in cyber security drills. Mergers have brought in efficiency gains while a regulatory
sandbox propels innovation. Extension of depositor protection cover, upfront payment
of deposit insurance and the integration of various ombudsman schemes under one
umbrella has made the dispute redressal mechanism simpler and more responsive, all
boosting public confidence in the banking system.
This unencumbering of banks' balance sheets stood them in good stead through the
ravages of the pandemic, and more recently, a virtuous credit upswing has taken root.
Singed by the earlier experiences, we remain on high alert, however, and continuously
monitor sectoral and institution-specific credit expansion and underwriting standards for
any sign of excessive risk-taking.
From 2013, India had started the process of aligning with Basel III norms. Capital
requirements were set one per cent higher than the Basel III minimum, including for
common equity tier 1 (CET1). In 2015, the capital conservation buffer (CCB) was
introduced; the last tranche of 0.625 per cent was temporarily delayed during the
pandemic but it was reinstated in October 2021. Guidelines for the counter-cyclical
capital buffer have been issued to banks in 2015, but it has not been triggered yet as
the credit gap remains negative. The requirement of 100 per cent liquidity coverage
ratio (LCR) was implemented in 2019 and banks have consistently maintained it at
above the minimum requirement, which is also the Basel III norm. Since 2021, the net
stable funding ratio has also been implemented. The provision coverage ratio (PCR)
has been steadily improving and as a result, the net non-performing assets ratio has
declined to 1 per cent by March 2023.
The confluence of balance sheet repair and the rebuilding of capital and liquidity buffers
is reflected in a strong improvement in profitability from negative levels during 2018 and
2019 in terms of both return on assets and return on equity. With the turning of the
monetary policy cycle into tightening mode to fight inflation since May 2022, banks' net
interest margins (NIMs) have expanded due to fuller transmission to lending rates than
to saving and current account (CASA) deposit rates, a phenomenon that has been
observed in many advanced economy (AE) banks during the period of synchronized
monetary policy actions. The widening of the NIMs has also been facilitated by the
suffusion of liquidity from pandemic-related measures which obviated the need for
banks to garner deposits by offering attractive rates.
As I mentioned earlier, bank credit is monitored as a lead indicator of overheating. Our
assessment, based on a menu of approaches, indicates that current rates of credit
expansion are not pointing to systemic stress building up - warning lights flash in the
Indian context at growth rates of 16-18 per cent. Illustratively, the credit gap - the
difference between the credit to GDP ratio and its trend - is currently negative.
Furthermore, NIMs in the banking system are averaging around 3.8 per cent, which is
ruling below the estimated threshold of 5 per cent beyond which it may have
implications for financial stability due to loosening of leverage constraints and adverse
selection. Nonetheless, eternal vigilance is the price of financial stability.
The current episode of bank credit expansion is led by retail loans. Conventional
wisdom suggests that these types of loans being diffused across a wide borrower base
mitigate the accumulation of systemic risk - all borrowers may not default together. We
are, however, watchful as herding by banks in the retail loan space might lead to
potential cascades across the system if defaults do occur.
Macro stress tests for credit risk reveal that all banks in India would be able to comply
with the minimum capital requirements even under severe stress scenarios. The
system-level capital ratio under the baseline, medium and severe stress scenarios is
projected at 16.1 per cent, 14.7 per cent and 13.3 per cent, respectively, by March
2024, well above the regulatory minimum of 9 per cent. Liquidity risk analysis
conducted to capture the impact of any possible run-on deposits shows that in an
extreme scenario of sudden and unexpected withdrawals of around 15 per cent of
uninsured deposits along with the utilisation of 75 per cent of unutilised portion of
committed credit lines, would reduce liquid assets at the system level from 21.1 per
cent of total assets to 11.4 per cent, but it would not turn negative. Furthermore, stress
tests on banks' credit concentration - considering top individual borrowers according to
their standard exposures - show that even in the extreme scenario of the top three
individual borrowers failing to repay, no bank would face a drop in the capital ratio
below the regulatory requirement of 9 per cent, although two banks would see a decline
in the capital ratio below the regulatory minimum inclusive of the CCB requirement
(11.5 per cent).
The recent failure of few banks in some AEs jurisdictions showed how unprepared they
were to manage the transition to rapid increases in interest rates by central banks,
which exposed fault lines in their balance sheets. As interest rates rose, unrealised
valuation losses spiked in their held-to-maturity (HTM) portfolios, which are not
markedto-market. The aggregate valuation losses in the U.S. banking system grew from US$ 8
billion at the end of 2021 to more than US$ 620 billion at the end of 2022. Sizable
portfolios of uninsured deposits exacerbated the impact of unrealised valuation losses,
leading on bank runs. Inadequate capital positions worsened their risk profiles (in the
chart, the distance between blue and red dots shows the erosion of common equity tier
1 capital).
In the Indian context, if a shock in the form of a 250 basis points parallel upward shift in
the yield curve is applied, the mark-to-market impact on the HTM portfolio of banks
(excluding unrealised losses) would reduce the system level capital ratio from 17.1 per
cent in March 2023 to 13.7 per cent, which is still above the regulatory requirement.
Digital Transformation
The financial sector in India is on the cusp of a transformative change leveraged on
technology. The trinity of JAM - Jan Dhan (basic no-frills accounts); Aadhaar (universal
unique identification); and Mobile connections - is bringing the hitherto excluded into
the ambit of formal finance and is enabling the targeting of direct benefit transfers from
the government to the beneficiaries. Currently, there are a record 500 million Jan Dhan
beneficiaries, out of which more than half are women. Mobile internet subscription has
increased sharply, opening up avenues for innovative e-business models to augment
access to financial services in the hinterland through efficient disbursal of e-government
services. It is also boosting entrepreneurship by stimulating tech start-ups. India's
Unified Payment Interface (UPI), an open-ended system that powers multiple bank
accounts into a single mobile application of any participating bank, is propelling
interbank peer-to-peer and person-to-merchant transactions seamlessly. This payment
revolution is attracting wide international interest. In August 2023, the UPI crossed the
milestone of recording more than 10 billion transactions a month. In addition, both large
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value and small value payment systems in India operate on a 24 by 7 by 365 basis.
Non-Banking Financial Companies - Connecting the Last Mile
Another important segment of India's financial system, the non-banking financial
companies (NBFCs) have emerged as important intermediaries in India's financial
landscape because they connect the last mile and also provide an alternative to banks.
Unlike in other jurisdictions, NBFCs are regulated by the RBI in a scale-based
framework with bank-like regulatory interventions. Their widening presence is reflected
in a rising credit to GDP ratio - from 8.6 per cent to 12.3 per cent between 2012-13 and
2021-22. The sector has gone through periods of liquidity stress such as evaporation of
market confidence in 2018-19 and again during the pandemic, but it has emerged
stronger and sounder. Credit growth is in double digits and is supported by strong
capital buffers and healthy balance sheets.
NBFCs rely heavily on borrowings to fund their activities, with banks constituting around
41 per cent of their borrowings at end-March 2023. Importantly, around ninety per cent
of bank lending is to NBFCs that are A-rated and above. Therefore, contagion risk is
limited. System level stress tests for assessing the resilience of the NBFC sector to
credit risk shocks under a baseline and two stress scenarios - medium and high risk -
show that under the medium risk shock of a one standard deviation (SD) increase in the
slippage ratio, the GNPA ratio increases to 5.5 per cent. The resulting income loss and
additional provisional requirements reduce the CRAR by 60 basis points relative to the
baseline. Under the high risk shock of 2 SDs, the capital adequacy ratio of the sector
declines by 90 bps relative to the baseline to 23.5 per cent.
Financial Markets
Just as NBFCs complement banks as a source of finance, financial markets are another
important source of resource mobilisation. Led by banking and financial sector stocks,
India's equity markets are outperforming the MSCI Emerging Market index. India's
share in the MSCI has increased from 6.5 per cent in 2012 to 14.9 per cent by August
2023, reflecting the brightening economic outlook, and raising expectations of attracting
higher passive investments. India's 12-months forward price to earnings (PE) ratio is
the highest in the world, reflecting the premium on India's growth story. Equity market
volatility (VIX) in India has remained largely stable and lower in comparison to peers.
India is the largest recipient of Foreign Portfolio investments (FPI) inflows among the
comparable EMEs during April-July 2023.
In the bond markets, the yield curve is flattening but has not inverted as in other
countries, reflecting anchored expectations on India's growth prospects as well as a
certain degree of insulation from global spillovers. The Indian rupee is among the most
stable currencies in the world - during 2023 (up to September 11), the 1-month implied
volatility of the INR decreased to 4.08 per cent from 5.22 per cent during the same
period in 2022. INR volatility, measured by the coefficient of variation, has remained the
lowest among major AEs and EMEs. Exchange rate stability is regarded as an
important element of financial stability.
Conclusion
In conclusion, the approach to the financial sector in India is reflecting a new paradigm
in which macroeconomic and financial stability are seen as strongly complementary and
providing the foundation for medium-term growth prospects. Prudence is taking
precedence over exuberance, and this is reflected in the steady build-up of all types of
buffers. In an overarching sense, this approach is reflected in the accumulation of
foreign exchange reserves which, as our experience has shown, has become our
national safety net in the absence of a truly global financial shield. Besides providing
the wherewithal to protect our financial markets and institutions from being
overwhelmed by global spillovers, the reserves have helped to build bulwarks of
external strength, as reflected in modest external debt servicing and debt to GDP ratios.
We believe that this is strengthening our capability to manage new challenges such as
climate change and cyber threats while maintaining public confidence and ensuring the
financing requirements of India's development strategy.
Thank you.
1
This includes 12 small finance banks, 6 payment banks, 2 local area banks and 43
regional rural banks.
2.9 lakh crore in Indian Rupees.
3
National Electronic Fund Transfer and Real Time Gross Settlement.