Towards a Stable Financial System
Nani Palkhivala Memorial Lecture Delivered by Shri Shaktikanta
Das, Governor, Reserve Bank of India
on Saturday, January 16, 2021
At the outset, let me pay my homage to Shri Nani A. Palkhiwala and
his grand legacy as a nation builder of modern India. I would also like to
convey my sincere appreciation to the Palkhivala Foundation for
continuing the tradition of organising Shri Palkhivala Memorial Lectures. I
consider it as a great honour to be delivering the 39th Shri Palkhivala
Memorial Lecture today, more so - among others - because he was very
closely associated with the RBI during his tenure as a member of the
Central Board from 1963 to 1970. Gleaning through the history of the RBI,
I gather that he participated actively in discussions of the Central Board
on important issues spanning bank nationalisation, external aid and
development finance institutions. He invariably brought insightful
perspective to the deliberations on various issues. Shri Palkhivala was a
strong votary of enhancing competition in the banking sector and nurturing
native entrepreneurial capabilities to spur economic progress. These
issues continue to be relevant even in the present times.
2. The immensity of Shri Palkhivala's life-long contributions to the
Indian society is well known. He was a gifted jurist who held the
constitution, economic and individual freedoms in highest regard. His
conduct and integrity during the epochal Kesavananda Bharti case and in
many other cases underlined the strength of his character, profound
intellect and a heart full of empathy for the citizens of this country.
3. Shri Palkivala was an orator par excellence, both inside and outside
the courtroom. Starting in 1958, his famous post-budget speeches are still
remembered for their eloquence, intelligence and sharp wit. With growing
audience every year, the venue of Palkhivala's speeches on budget kept
getting shifted to bigger places. In 1983 when it was held in the Brabourne
Stadium in Mumbai, Vijay merchant - the President of the Cricket Club of
India - while welcoming the gathering had remarked1 "Mr. Palkivala has
brought the crowds back to the Brabourne stadium" since test matches
had been shifted to the newly constructed Wankhede stadium.
4. The topic of my lecture today is "Towards a Stable Financial
System". The year bygone could be marked as one of the toughest
periods for human society. The unprecedented health and economic
catastrophe caused by the COVID-19 pandemic has exposed and
widened economic and societal fault lines across countries. It is, therefore,
essential to evolve a prudent and judicious approach towards managing
the financial system not only during the pandemic but also in its aftermath.
I. Changing Contours of Financial Stability
5. Globally, the concept of financial stability has been evolving over
time. With increasing complexity of the financial system, the focus of
financial stability has moved beyond commercial banks and providing
them liquidity during bank runs, to other segments like non-bank financial
institutions, financial markets, payment systems, etc. The focus area has
thus widened to several other pressure points to prevent financial
instability. Not surprisingly, therefore, preservation of financial stability has
steadily evolved to become a major objective among central banks,
implicitly or explicitly, alongside traditional and evolving goals of monetary
policy.
6. Since the global financial crisis (GFC) of 2008, financial stability has
featured even more prominently in the discourse of central banks. It has
been well documented that central banks in many countries were narrowly
focused on price stability and perhaps overlooked the build-up of financial
instability during the great moderation period. The pre-crisis consensus
was for unfettered financial sector growth and minimal regulation that was
supposed to deliver even more growth. The 2008 crisis made it
abundantly clear that financial strength of individual institutions does not
add up to systemic stability. That was evident because before the crisis
happened, almost every financial institution reported substantial capital
adequacy. This made the policy makers realise that while micro-prudential
regulations would help determine the strength of a financial entity, they
have to be complemented with adequate macro-prudential regulations
and anti-systemic risk measures. Preserving systemic stability thus
emerged as the cornerstone of central bank policies.
7. In the Indian context, maintaining financial stability remains one of
the uppermost objectives of the Reserve Bank, drawing from its wide
mandate as the regulator of the banks, NBFCs and payment systems;
regulator of the money, forex, government securities and credit markets;
and also as the lender-of-the-last resort. This unique combination of
responsibilities - monetary policy combined with macroprudential
regulation and micro-prudential supervision - has allowed the Reserve
Bank to exploit the synergies across various dimensions.
8. The conceptual underpinnings of financial stability, as it evolved
post-GFC, entailed preserving and nurturing a well-functioning financial
architecture which includes not just the banks but also other financial
institutions along with efficient and secure payment and settlement
systems. Recent experience across countries during the pandemic
suggests that even though banks, non-banks, financial markets and
payment systems remain at the core of financial stability issues, there is
still a need to look much closer at the system in its entirety. In this sense,
the overall objective of financial stability policies should be closely
intertwined with the health of the real economy. More precisely, given that
the financial system works as a pivot between various sectors of the
economy and given the strong linkages across sectors, financial stability
needs to be seen in a broader perspective and must include not just the
stability of the financial system and monetary stability (price stability), but
also fiscal sustainability and external sector viability. All these operate in
a feedback loop; and disturbances in any of the segments do get
propagated to other segments with the potential of disrupting systemic
stability.
9. When we look at financial stability from such a perspective,
preserving and nurturing the same becomes a public good, which should
facilitate creation and nurturing of congenial underlying conditions for
sustained growth and development. In difficult circumstances, such as the
current one, it is important that all stakeholders recognise and partake in
their shared responsibility for the collective benefit of the society at large.
History is replete with examples of such endeavours in response to
difficult situations and that, in essence, has been the story of human
progress and modern economies.
II. Preserving Financial Stability during COVID-19
10. The idea of financial stability in this broader sense moulded the
Reserve Bank's approach during the pandemic, which was a unique crisis,
more challenging than the global financial crisis of 2008, impacting both
the real and financial sector in great severity. With conventional,
unconventional and new tools, the Reserve Bank responded through a
series of measures to alleviate stress in various segments of the economy
and the financial sector, including the stress encountered by market
players and financial entities. Broadly speaking, our approach to the Covid
situation included the following measures:
(a) Measures to mitigate the immediate impact of the pandemic : loan
moratoriums together with asset classification standstill; easing of working
capital financing and deferment of interest; restructuring of MSME loans,
etc.
(b) Liquidity augmenting measures: LTRO/ TLTRO/refinance schemes for
various sectors including stressed sectors; reduction in CRR, and other
measures totalling about ₹12.81 lakh crore (6.3 per cent of nominal GDP
of 2019-20).
(c) Countercyclical regulatory measures to ease stress on borrowers and
the banking system -relaxation in regulatory compliance; conservation of
capital by banks; relaxation in group exposure norms, etc.
(d) Measures to ensure uninterrupted flow of credit - significant interest
rate cuts (115bps); assuring markets of easy financing conditions;
exemption from CRR maintenance for incremental retail and MSME loans;
extension of priority sector classification for bank loans to NBFCs for on-
lending; rationalisation of risk weights for regulatory retail portfolio and
individual housing loans, etc.
(e) Framework for resolution of Covid-related stress for individuals and
businesses.
(f) Closer surveillance of supervised entities focusing on business process
resilience and continuity, proactive management of risks, stress tests and
proactive raising of capital, etc.
11. Our principal objective during this pandemic period was to support
economic activity; and looking back, it is evident that our policies have
helped in easing the severity of the economic impact of the pandemic. I
would like to unambiguously reiterate that the Reserve Bank remains
steadfast to take any further measures, as may be necessary, while at the
same time remaining fully committed to maintaining financial stability.
III. Adaptations and Learnings: Way Forward
12. The recent period has given us an opportunity to learn and adapt
and decide on the way forward. In today's lecture, I would like to focus on
three key areas: (i) stability of the banking and non-banking financial
sector; (ii) external sector stability; and (iii) fiscal stability. Let me first focus
on the banking and non-banking financial sectors.
Governance Reforms
13. Integrity and quality of governance are key to good health and
robustness of banks and NBFCs. Recent events in our rapidly evolving
financial landscape have led to increasing scrutiny of the role of
promoters, major shareholders and senior management vis-à-vis the role
of the Board. The RBI is constantly focussed on strengthening the related
regulations and deepening its supervision of financial entities.
14. A good governance structure will have to be supported by effective
risk management, compliance functions and assurance mechanisms.
These constitute the first line of defence in matters relating to financial
sector stability. Some of the integral elements of the risk management
framework of banks would include effective early warning systems and a
forward-looking stress testing framework. Banks and NBFCs need to
identify risks early, monitor them closely and manage them effectively.
The risk management function in banks and NBFCs should evolve with
changing times as technology becomes all pervasive and should be in
sync with international best practices. In this context, instilling an
appropriate risk culture in the organisation is important. This needs to be
driven by the Board and senior management with effective accountability
at all levels.
15. In addition to a strong risk culture, banks and non-banks should also
have appropriate compliance culture. Cost of compliance to rules and
regulations should be perceived as an investment as any inadequacy in
this regard will prove to be detrimental. Compliance culture should ensure
adherence to not only laws, rules and regulations, but also integrity, ethics
and codes of conduct.
16. A robust assurance mechanism by way of internal audit function is
another important component of sound corporate governance and risk
management. It provides independent evaluation and assurance to the
Board that the operations of the entity are being performed in accordance
with the set policies and procedures. The internal audit function should
assess and contribute to improvement of the organisation's governance,
risk management and control processes using a systematic, disciplined,
and risk-based approach.
17. In all these areas, the RBI has already taken a number of measures
and will continue to do so from time to time. Recent efforts in this direction
were geared towards enhancing the role and stature of the compliance
and internal audit functions in banks by clarifying supervisory expectations
and aligning the guidelines with best practices. Some more measures on
improving governance in banks and NBFCs are in the pipeline.
Supervisory Initiatives
18. In the last two years, the Reserve Bank has initiated a series of
measures to strengthen its supervisory framework over SCBs, UCBs as
well as NBFCs. The supervisory functions pertaining to these sectors are
now integrated, with the objective of harmonising the supervisory
approach. The possibility of working in silos has been eliminated. We have
developed a system for early identification of vulnerabilities to facilitate
timely and proactive action. We have been deploying advances in data
analytics to offsite returns so as to provide sharper and more
comprehensive inputs to the onsite supervisory teams. The thrust of the
Reserve Bank's supervision is now more on root causes of vulnerabilities
rather than dealing with symptoms. Bank-wise as well as system-wide
supervisory stress testing adds a forward-looking dimension for
identification of vulnerable areas. A risk-based supervision framework
focussing on know your customer (KYC)/anti money laundering (AML) risk
has been created in line with global practices. Fintech initiatives are being
embraced in the form of innovative technologies for regulation (RegTech)
and supervision (SupTech).
19. As regards regulatory intervention in banks to protect the interest of
depositors, our approach in recent times has been to first work closely
with the management to find a workable solution. When this does not
work, we have intervened and put in place a new arrangement within a
quick time schedule. With preservation of financial stability and depositors'
interest being uppermost in our agenda, we could swiftly resolve the
situation at two scheduled commercial banks. Notwithstanding
improvements being made, it is recognised that enhancing and refining
the supervisory framework is a continuous process. The RBI remains
strongly committed to preserve the stability of the financial sector. We will
do whatever is necessary on this front.
Recapitalisation of Banks
20. Going ahead, financial institutions in India have to walk a tightrope
in nurturing the economic recovery within the overarching objective of
preserving long-term stability of the financial system. The current COVID-
19 pandemic related shock will place greater pressure on the balance
sheets of banks in terms of non-performing assets, leading to erosion of
capital. Building buffers and raising capital by banks - both in the public
and private sector - will be crucial not only to ensure credit flow but also
to build resilience in the financial system. We have advised all banks,
large non-deposit taking NBFCs and all deposit-taking NBFCs to assess
the impact of COVID-19 on their balance sheet, asset quality, liquidity,
profitability and capital adequacy, and work out possible mitigation
measures including capital planning, capital raising, and contingency
liquidity planning, among others.
21. Preliminary estimates suggest that potential recapitalisation
requirements for meeting regulatory norms as well as for supporting
growth capital may be to the extent of 150 bps of Common Equity Tier-I
capital ratio for the banking system2. Prudently, a few large public sector
banks (PSBs) and major private sector banks (PVBs) have already raised
capital, and some have plans to raise further resources taking advantage
of benign financial conditions. This process needs to be put on the fast
track.
External Sector Stability
22. Given that the domestic financial sector closely interacts with
external sector through various channels, it becomes a critical segment
from a financial stability perspective. A weak external sector can pose a
threat to domestic financial stability in the face of swift changes in the
global economic environment as was the case during the GFC (2008) or
the taper-tantrum period (2013). External sector conditions are generally
captured through movements in current account balances, capital flows,
exchange rates, foreign exchange reserves and external debt position.
Sudden changes in any of these indicators due to global shocks and/or
domestic developments can impact the viability of external sector and its
interaction with the domestic economy.
23. Notwithstanding the worsening of both external and domestic
demand conditions impinging on exports and imports since the onset of
COVID-19, India's external sector has remained resilient. Lower trade
deficit driven by steeper fall in imports coupled with resilient net exports of
services translated into a large current account surplus to the tune of 3.1
per cent of GDP in H1:2020-21. With surplus in the current account, the
scope of absorption of strong inflows of foreign direct investment and
portfolio investments by the economy was limited which led to a large
accretion in foreign exchange reserves.
24. Sustained accretion to foreign exchange reserves has improved
reserve adequacy in terms of conventional metrics such as (i) cover for
imports (18.4 months) and (ii) reserves to short-term debt in terms of
residual maturity (236 per cent). Sound external sector indicators augur
well for limiting the impact of spillovers of possible global shocks and
financial stability concerns as investors and markets are credibly assured
of the buffer against potential contagion. While abundant capital inflows
have been largely driven by accommodative global liquidity conditions and
India's optimistic medium-term growth outlook, domestic financial markets
must remain prepared for sudden stops and reversals, should the global
risk aversion factors take hold. Under uncertain global economic
environment, EMEs typically remain at the receiving end. In order to
mitigate global spillovers, they have no recourse but to build their own
forex reserve buffers, even though at the cost of being included in
currency manipulators list or monitoring list of the US Treasury. I feel that
this aspect needs greater understanding on both sides so that EMEs can
actively use policy tools to overcome the capital flow related challenges.
At the Reserve Bank, we are closely monitoring both global headwinds
and tailwinds while assessing domestic macroeconomic situation and its
resilience.
Fiscal Stability
25. The COVID-19 pandemic has further brought to the fore the need
for governments to spend on merit goods and public goods; in particular
on improving human and social capital and on physical infrastructure
(IMF, 2020). As per IMF's calculations, the total fiscal support in response
to COVID-19 amounted to about 12 per cent of global GDP by mid-
September 2020. Global public debt is said to reach 100 per cent of GDP
in 2020. As a result, most economies are expected to emerge from the
pandemic with higher deficits and debt vulnerabilities. Under these
circumstances, and given the expenditure requirements to support the
process of economic revival, fiscal stability becomes an even more
important constituent of overall financial stability.
26. Although the scale of fiscal spending is expected to breach the
quantitative targets of fiscal prudence across most economies in the short-
run, it was crucial in the context of the pandemic from the perspective of
welfare aspect of public expenditure. Expenditure on physical and social
infrastructure including human capital, science and technology is not only
welfare-enhancing, it also paves the way for higher growth through their
higher multiplier effect and enhancement of both capital and labour
productivity. Under these circumstances and going forward, it becomes
imperative that fiscal roadmaps are defined not only in terms of
quantitative parameters like fiscal balance to GDP ratio or debt to GDP
ratio, but also in terms of measurable parameters relating to quality of
expenditure, both for center and states. While the conventional
parameters of fiscal discipline will ensure medium and long-term
sustainability of public finances, measurable parameters of quality of
expenditure would ensure that welfarism carries significant productive
outcomes and multiplier effects. Maintaining and improving the quality of
expenditure would help address the objectives of fiscal sustainability while
supporting growth.
IV. Concluding observations
27. Looking ahead, our financial system faces both challenging times
and new opportunities as the Indian economy returns to full vitality. New
vistas of financial intermediation leveraging on technology and new
business models will emerge. With the exponential growth of digitisation
and online commerce in India, the Reserve Bank has also directed its
policy efforts to put in place a state of the art national payments
infrastructure, while ensuring a safe, secure, efficient, cost-effective and
robust payments ecosystem. The Reserve Bank is positioning itself to
provide an enabling environment in which regulated entities are catalysed
to exploit these new avenues, while maintaining and preserving financial
stability. The regulated entities, on their part, need to strengthen their
internal defences to identify emerging risks early and manage them
effectively. Financial stability is a public good and its resilience and
robustness needs to be preserved and nurtured by all stakeholders. We
need to support economic revival and growth; we need to preserve
financial stability.
Thank you.