The FINANCIAL — On November 17, 2017, the Executive Board of the International Monetary Fund (IMF) discussed the Financial System Stability Assessment (FSSA) of India.
Since the 2011 Financial Sector Assessment Program (FSAP), India has recorded strong growth in both economic activity and financial assets, supported by important structural reforms and terms of trade gains. Increased diversification, commercial orientation, and technology-driven inclusion have supported growth in the financial industry, backed by improved legal, regulatory, and supervisory frameworks. Yet, the financial sector is facing considerable challenges, and economic growth has recently slowed down. High nonperforming assets (NPAs) and slow deleveraging and repair of corporate balance sheets are testing the resilience of the banking system, and holding back investment and growth.
The Indian financial system is undergoing a gradual structural shift, with a greater role for nonbank intermediaries and higher recourse to market funding for large corporates. Financial system assets equal about 136 percent of GDP, close to 60 percent of which reflect banks’ assets. The state retains an important footprint in the system via ownership of large financial institutions, captive government financing, and directed credit to priority sectors.
India’s key banks appear resilient, but the system is subject to considerable vulnerabilities. Stress tests show that the while largest banks are sufficiently capitalized and profitable to withstand a deterioration in economic conditions, a group of public sector banks (PSBs) are highly vulnerable to further declines in asset quality and higher provisioning needs. Capital needs range from 0.75 percent of GDP in the baseline to 1.5 percent of GDP in the severe adverse scenario.
The authorities have been pursuing policies to accelerate the process of NPA resolution. The 2016 Insolvency and Bankruptcy Code introduced a modern framework that aims at reorganization and insolvency resolution in a time-bound manner, and the Reserve Bank of India (RBI) was empowered with directing restructuring cases to the insolvency process. This approach shows promise to deliver progress in NPA resolution, particularly if accompanied by sufficient upfront provisioning and capital buffers in the PSBs; broader restructuring of the PSB sector, including improvements in governance; more flexible out-of-court debt restructuring mechanisms; and increased capacity and resources for the insolvency courts. The authorities recently announced a recapitalization plan for the PSBs amounting to approximately 1.3 percent of GDP, as well as the establishment of a mechanism to seek consolidation across these banks, according to IMF.
The FSAP took stock of the considerable progress made in strengthening financial sector oversight, and identified areas where scope for further improvement remains. Notably, these include strengthening the RBI’s de jure independence as well as its powers over the PSBs; expanding other financial regulators’ resources; introducing a risk-based solvency regime and extending risk-based supervision for insurers; and unifying the oversight of commodities markets. Other gaps include risks from politically exposed persons and the gold sector. In the area of crisis management, the planned introduction of a special resolution regime for financial institutions is an important step toward aligning the financial safety net with international standards, although there is duplication of supervisory responsibility for going-concern institutions between supervisor and resolution authority; also, the proposed new framework does not ensure equal treatment of domestic and foreign liability holders in resolution. There is scope to enhance other elements of the safety net, including deposit insurance, emergency liquidity assistance, and crisis preparedness.
Executive Board Assessment
Executive Directors broadly agreed with the findings and recommendations of the Financial System Stability Assessment (FSSA). They welcomed the important progress made by the authorities in strengthening financial sector oversight, deepening markets, and fostering financial inclusion. Directors commended the authorities for the major reforms undertaken since the 2011 FSAP, notably in introducing Basel III standards and risk‑based supervision of banks and securities firms, improving interagency cooperation under the auspices of the Financial Stability and Development Council, and introducing a modern insolvency framework for companies.
Directors encouraged the authorities to implement the recommendations of the FSSA to accelerate the resolution of nonperforming assets and the repair of corporate balance sheets. The recently announced measures to recapitalize the public‑sector banks (PSBs), including through government contributions, will foster consolidation in the sector and support effective resolution of nonperforming assets. They encouraged a broad‑based restructuring of PSBs, including improvements in governance, to avoid a resurgence of asset quality problems. Going forward, greater participation of the private sector in bank capital, a smaller footprint of the public sector in the financial system, a cautious reduction in statutory liquidity requirements, and assessing the effectiveness of directed lending, would boost the system’s capacity to support credit to the economy, while reducing moral hazard and contingent fiscal liabilities.
Directors underscored the importance of adequate resources, de jure independence, and a full set of supervisory powers—including over PSBs—in underpinning the Reserve Bank of India’s effective supervision and regulation of financial institutions. There is also a need to introduce risk‑based solvency and supervision of insurers, and to continue moving toward a market‑based environment for the sector. Unifying the oversight of all commodities markets would promote more efficient market functioning, in line with the authorities’ intention to modernize the sector.
Directors welcomed the planned introduction of a special resolution regime for financial institutions, which will improve incentives and reduce the potential risks to public resources that could arise from the failure of financial institutions. They urged the authorities to continue with efforts to further align the proposed resolution framework and other components of the safety net with international standards and best practices.
Directors welcomed the important progress in enhancing the framework for anti-money laundering and combating the financing of terrorism, and called on the authorities to overcome the remaining gaps.