Emerging Challenges to Financial Stability
Inaugural Address by Shri Shaktikanta Das, Governor,
Reserve Bank of India
Delivered at FIBAC 2019 – the Annual Global Banking Conference
organised by Indian Banks’ Association (IBA) and Federation
of Indian Chambers of Commerce and Industry (FICCI)
in Mumbai on Monday, August 19, 2019
It is indeed a matter of great pleasure for me to be here today amidst
the business and financial sector leaders. My compliments go to the
partners, namely, the Indian Banks’ Association, FICCI and the Boston
Consulting Group for spearheading this event. What really gives me the
additional motivation to address you is the earnestness with which you
have themed this year’s conference, showing your appreciation of the
need to prepare ourselves for a new paradigm in banking. The
happenings of the past, especially the not so remote ones, have
generated an attitude towards the financial sector that ranges from an
existential angst to a more positive outlook that hinges on the
opportunities beckoning at us. I would like to believe that solutions to a
better future lie in unlearning from the practices which led to that angst
and in relearning to befit ourselves in the changing financial landscape.
Prudent governance and emerging trends in the digital space have the
potential to reshape the way we perceive finance. Against these broad
underpinnings, let me present my thoughts highlighting emerging
challenges to financial stability. This would be the theme of my address to
this august gathering.
2. A consensus on the definition of the term financial stability remains
elusive even today. Broadly speaking, the core principles governing
financial stability can be thought of in terms of a financial system’s ability
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to facilitate efficient allocation of economic resources; its effectiveness in
assessing, pricing, and managing financial risks; and in maintaining its
capability to perform these key functions even when affected by external
shocks. In other words, as one IMF research paper of 2004 puts it, a
financial system is in a range of stability whenever it is capable of
facilitating the performance of an economy, and of dissipating financial
imbalances that arise endogenously or as a result of significant adverse
and unanticipated events 1.
The Global Context
3. The global approach to financial stability changed significantly after
the financial crisis of 2008 which made it abundantly clear that financial
strength of every financial institution does not add up to systemic stability.
The policy makers realised that micro-prudential regulations have to be
complemented with systemic risk measures; otherwise systemic stability
could be at risk.
4. Ten years after the crisis, the major financial sector reforms, called
for by the G20 and co-ordinated by the Bank for International Settlements
(BIS) and Financial Stability Board (FSB), are now mostly in place. Large
banks are better capitalised, less leveraged and more liquid. The banking
system is, therefore, more resilient to economic shocks. Implementation
of Too-Big-To-Fail (TBTF) reforms is advancing, including via the
establishment of effective resolution regimes for banks. Over-the-counter
(OTC) derivatives markets have been made simpler and more
transparent. The use of central clearing has increased, and
collateralisation is more widespread. Those aspects of non-bank financial
1 Garry, J. S. (2004). Defining financial stability. IMF Working Paper, 2004: WP/04/187.
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intermediation that contributed to the financial crisis have declined.
However, the implementation of reforms is not yet complete and remains
uneven, especially in the non-banking space. It goes without saying that
while dealing with all these issues, country specific situations have to be
factored in.
5. Recent developments in the global economy should be seen in this
perspective. A weaker than expected growth with signs of slowdown in
major economies, as projected by multilateral institutions like the
International Monetary Fund (IMF), is one of the key risks to global
financial stability at this juncture. Looming trade-tensions, geo-political
risks, and related uncertainties continue to exert pressure on the
investment outlook. The latest Global Financial Stability Report (GFSR)
by the IMF warns that because of these developments, vulnerabilities in
the sovereign, corporate, and non-bank financial sectors are elevated by
historical standards in several systemically important countries and
regions. Under these circumstances, central banks and other regulators
are required to follow the cardinal principle – the regulator never sleeps.
Cutting the hyperbole out, what it means is that the regulators and other
authorities need to be constantly vigilant and proactively take whatever
steps that are necessary.
6. The current state of the global banking sector also presents a story
of uncertainty. While bank capitalisation has increased significantly in the
post-crisis period primarily due to Basel III reforms, bank profitability has
been lacklustre. Both macroeconomic and bank-specific factors have
contributed to this phenomenon. Importantly, banks are also facing
increasing competition from non-traditional players, such as FinTech and
BigTechs, which are taking advantage of digital innovation. These
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developments have implications for financial stability in Emerging Market
Economies (EMEs) like India. It is indeed imperative that banks capitalise
on these technological advances and the associated business models.
Regulators on their part also need to provide enabling frameworks for
these endeavours by banks as well as the non-traditional players.
The Indian Scenario
7. The pursuit of financial stability has always been a policy priority in
India. The twin concerns of monetary and financial stability constitute the
core objectives of the Reserve Bank. Similar to the global case, India also
responded to the crisis by introducing changes in the existing institutional
architecture to further the cause of financial stability. Recognising the
various channels that could lead to systemic instability and the fact that
different segments of financial systems are regulated by different
regulators, the institutional mechanisms of the Financial Stability
Development Council (FSDC), under the Chairmanship of the Finance
Minister, and the FSDC sub-committee, under the chairmanship of
Governor, Reserve Bank, have been fully functional. The biannual
Financial Stability Report (FSR), a report of FSDC sub-committee,
analyses the current state of financial system, the extent of
interconnectedness among its various segments and possible sources of
vulnerabilities that could impact domestic financial stability.
8. The headwinds to financial stability could emanate from various
sectors of the economy, namely, (i) the credit market; (ii) financial
markets; (iii) external sector; and (iv) payment system. It may emanate
from some other sources as well. But today, I will focus on these four
aspects.
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Headwinds from Banking Sector
9. In India, the credit market is dominated by the banking sector which
plays a key role in financial intermediation in the economy. Soundness of
the banking system may have a bearing on the financial stability through
various channels - excessive credit growth; maturity mismatches and
liquidity issues; high proportion of non-performing loans; and
overleveraging, among others. Even if individual institutions are robust,
the overall behaviour of the financial sector can pose a systemic risk.
Hence, monitoring the health of the banking sector is crucial for financial
stability.
10. In recent years, as a result of efforts by both the Reserve Bank and
the Government, the overhang of stressed assets in the banking system
has declined. Going forward, the macro-stress tests for credit risk
conducted by the Reserve Bank indicate that under the baseline scenario,
the GNPA ratio may decline further by March 2020 2. Other indicators like
the provision coverage ratio (PCR), capital adequacy and return on assets
have also improved. I have earlier stressed that the real test of
performance, efficiency, internal stability and governance improvement in
public sector banks (PSBs) would be their ability to access capital markets
rather than looking at the Government as a recapitaliser of first and last
resort.
11. Despite certain teething problems, the Insolvency and Bankruptcy
Code (IBC) is proving to be a game changer. New norms for resolution
of stressed assets framed in June 2019 by the Reserve Bank provide
incentives for early resolution, with discretion to lenders on resolution
2 Financial Stability Report, June 2019, Reserve Bank of India.
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processes. The objective is to ring-fence future build-ups of NPA stress
and protect the banking sector. The recent amendments to the IBC should
also be able to facilitate faster resolution of stressed assets.
12. As we have seen in the recent past, the build-up of risks among
regulated entities due to interconnectedness, exposure concentrations,
non-transparent market practices, governance deficiencies, and their
contagion effects have repercussions for financial stability. In this regard,
the Reserve Bank is keeping a close watch on the interconnectedness of
banks and non-banks. The Working Group on Core Investment
Companies (CICs) has already started its deliberations and based on its
recommendations, the Reserve Bank proposes to carry out necessary
changes in the regulatory architecture for CICs. We are also in the
process of building a specialised regulatory and supervisory cadre for
regulation and supervision of banks and non-banks.
13. Another important issue in this context is the immediate need to
strengthen corporate governance structure in banks, which I have
elaborated earlier as well. This would include efficient functioning of their
boards and board sub-committees, especially audit and risk management
committees; robust system for monitoring of performance of MDs/CEOs;
and, an effective performance evaluation system to improve the financial
and operating parameters of banks. We have already sent our
suggestions to the Government for governance reforms in PSBs. Overall,
it is important that risk management systems, compliance functions, and
internal control mechanisms are strengthened and made more dynamic.
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Non-Banking Sector
14. Coming to the NBFC sector, we all know that this sector
complements the banking sector and aspires to act as the bridge to
provide last mile connectivity. Further, niche NBFCs fulfil the unmet and
exclusive credit needs of infrastructure, factoring, leasing and other such
activities. Non-traditional and digital players are now entering this space
to deliver financial services by way of innovative methods involving digital
platform. There is a web of inter-linkages of the NBFC sector with the
banking sector, capital market and other financial sector entities. The
Reserve Bank keeps a close watch on these inter-linkages to ensure
financial stability. With a view to strengthen the sector, maintain stability
and avoid regulatory arbitrage, the Reserve Bank and the Government
have been proactively taking necessary regulatory and supervisory steps.
It is our endeavour to have an optimal level of regulation and supervision
so that the NBFC sector is financially resilient and robust. We will not
hesitate to take whatever steps are required to maintain financial stability
in the short, medium and the long-term.
15. Our objective is to harmonise the liquidity norms between banks and
NBFCs, taking into account their unique business models. We are also
looking at governance and risk management structures in NBFCs.
Recently in May 2019, NBFCs with a size of more than ₹5,000 crores have
been advised to appoint a functionally independent Chief Risk Officer
(CRO) with clearly specified role and responsibilities. This is expected to
bring in professional risk management to the working of large NBFCs.
16. The move to bring Housing Finance Companies (HFCs) under the
regulatory ambit of the Reserve Bank is significant, given their asset-
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liability profiles. Including HFCs, the size of the NBFC sector constitutes
about 25 per cent of combined balance sheet of scheduled commercial
banks. The Reserve Bank will take necessary measures to deal with these
challenges.
Headwinds from Financial Markets
17. Apart from banks and non-banks, headwinds to financial stability
can also originate from financial markets. The increasing frequency and
severity of currency and debt crises globally and their ability to cause
output loss calls for careful regulation and surveillance of financial
markets. Globalization of finance, by amplifying the risk of contagion, and
thereby constraining the policy space for effective regulation, has added
to the difficulty of this task. As a regulator of various market segments
such as money markets, G-sec, forex and interest rate derivatives, the
Reserve Bank has followed calibrated, sequenced and careful approach
to develop and integrate these markets. The broad objective has been to
keep pace with the requirements of fast-growing Indian economy, while
being vigilant of potential risks to financial stability. This is done through
freeing up market forces by moving away from prescriptive to principle-
based regulation, whose core features are simplification of processes,
encouraging product innovation, removing regulatory differentiation
across participant categories and ensuring protection for retail market
participants.
18. Let me give one example. Recently, we have permitted the creation
of an electronic platform on which one can buy or sell foreign currency at
market rates. This platform is accessible over the internet and the
customers can get the best market price without having to approach any
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individual bank/broker. This is how FinTech can be used to inject greater
efficiency to financial markets.
19. As financial markets are opening up, stability concerns are
addressed through capital flow control measures (e.g., the overall cap on
foreign investment in the debt market) or macro-prudential measures
(e.g., cap on total external borrowing as a percentage of GDP).
20. Adoption of global best practices to improve market integrity is
another important aspect of regulation. In the last couple of years, the
Legal Entity Identifier (LEI) system has been implemented in a phased
manner in all financial markets, including derivative markets regulated by
the Reserve Bank, as well as for bank loans. We believe transparency of
financial markets will greatly improve once the LEI system is used widely.
The recent regulations to control market abuse, upgrade the benchmark
setting process are all consistent with global standards.
21. A key feature of regulation of derivative markets has been the
differential treatment of professional and non-expert clients. Moreover,
differential access to derivative markets is being gradually removed.
Anyone - resident or non-resident - can now access these markets for
hedging on similar terms. In fact, alignment of incentives for non-residents
to gradually move to the domestic market is an important regulatory aim.
As you would be aware, the Task Force on Offshore Rupee Markets with
Mrs. Usha Thorat, former Deputy Governor as chairperson, has made
important recommendations that are likely to improve participation of non-
residents in the onshore market. Our aim is to make the onshore market
more accessible and attract higher transaction volumes.
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External Headwinds and Domestic Financial Stability
22. With increased trade and financial linkages with rest of the world,
India has become more susceptible to the vagaries of heightened global
economic uncertainties. While trade channels take some time to show a
tangible impact of global shocks, it is the financial and confidence
channels that quickly transmit the global shocks as was evident in the
case of India during the taper tantrum period in mid-2013. In fact with
negative and low interest rates in major economies, net private capital
flows to EMEs in the form of direct and portfolio investments have nearly
doubled in the post-crisis period. However, with high monetary policy
uncertainties in advanced economies, these flows have proved to be fluid
and therefore posed considerable risk to EMEs. Just a year back, EMEs
like India faced financial market turbulence due to a faster-than-expected
tightening in monetary policies in advanced economies. Many EMEs
including India witnessed portfolio capital outflows, exerting downward
pressure on domestic currencies.
23. In recent years, India’s external sector has benefited from a
sustainable level of current account deficit, largely financed by robust
foreign direct investment inflows and flexible exchange rate policy.
Improvement in other vulnerability indicators during 2018-19 such as fall
in external debt to GDP ratio (from 20.1 per cent at end-March 2018 to
19.7 per cent at end-March 2019) and debt service ratio (from 7.5 per cent
at end-March 2018 to 6.4 per cent at end-March 2019) also augur well for
mitigating the spill over of external headwinds on the domestic financial
markets. Notwithstanding strong macroeconomic parameters, constantly
changing dynamics of external headwinds warrant policy preparedness in
order to minimise spill overs of global shocks and preserve financial
stability. As a supplementary safeguard, the Reserve Bank has signed a
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bilateral currency swap agreement with the Bank of Japan for US$ 75
billion with the objective of bringing greater stability in foreign exchange
and capital markets in the country.
Payment System and Financial Stability
24. A number of innovations have taken place in retail payments which
have reshaped payment processes and changed the retail payments
landscape. India’s payment systems are considered to be efficient, safe
and secure. While acknowledging this and without trying to be
complacent, the Reserve Bank has made an attempt to benchmark
domestic payment systems and practices with those prevalent in
prominent countries worldwide. The assessment of various indicators
including regulation and oversight suggests that India has a strong and
robust regulatory structure.
25. However, new entrants into the financial services space, including
FinTech and BigTech firms are altering the universe of financial service
providers. A range of new lending platforms, including P2P and
marketplace lenders, have appeared in jurisdictions around the world.
Highlighting some of the related challenges and opportunities, the recent
Annual Economic Report of the Bank for International Settlements (BIS)
states that such firms can collect large amount of data at nearly zero costs,
which can be used to better assess the riskiness of borrowers and could
reduce the need for collateral to assure repayment. These new players
have also made inroads in the provision of payment services, remittance
services and cross-border payments. Moreover, they have the potential to
grow very quickly and become large and systemically important financial
institutions, raising concerns over financial stability and consumer
protection.
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26. Faced with such profound changes, the policy makers’ dilemma is
more than walking the middle path between innovation and regulation.
The public policy approach here needs to be more comprehensive and
holistic, taking into account issues such as financial regulation,
competition policy and data privacy regulation. Coordination among
various authorities – such as financial regulators, competition authorities
and data protection supervisors – becomes critical at this juncture.
27. The Reserve Bank’s Vision-2021 for Payment and Settlement
Systems in India visualises empowering every Indian with access to a
bouquet of e-payment options that is safe, secure, convenient, quick and
affordable. The Committee on Deepening of Digital Payments under the
chairmanship of Shri Nandan Nilekani has suggested to increase the
volume of digital payments by 10 times in the next three years which can
be facilitated by initiatives such as removing transaction charges on digital
payments, simplifying KYC processes, and reducing KYC costs for banks.
The Reserve Bank is taking necessary action based on the committee’s
recommendations.
Concluding Observations
28. At the end, I would like to highlight the significance of consumer
protection which is not only important from the point of view of access but
also from a broader context of stakeholders’ trust. The trust of the
consumers that the services are fairly priced, the trust of the investors that
the stakeholders are acting in their best collective interest, the trust of the
regulators that the audited financial statements do represent a fair and
reasonable assessment of the activities of a firm – all have intangible but
substantial contribution to national savings and financial stability. Post
Lehman developments in the US financial markets are a prime and
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sobering example of what happens when investor trust evaporates. In
fact, consumer protection should be seen as a key pivot around which all
regulatory and supervisory initiatives are required to evolve.
29. Let me conclude by saying that much progress has been made in
maintaining a stable financial system. However, as we have seen, the
financial landscape is continuously changing, and new challenges are
emerging. The Reserve Bank is continuously harnessing the regulatory
and supervisory framework to better adapt to the evolving scenario. The
IBA, its members and other stakeholders should, therefore, be active
partners in ensuring that such a process evolves successfully.
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