Financial Stability Report

Context: Recently, the Reserve Bank of India (RBI) released the 23rd issue of the Financial Stability Report (FSR).

Relevance: Mains: GSIII-

• Indian Economy & issues relating to planning, mobilization of resources, growth, development & employment.

• The Financial Stability Report (FSR) is published bi-annually and includes contributions from all the financial sector regulators.
• Accordingly, it reflects the collective assessment of the Sub-Committee of the Financial Stability and Development Council (FSDC-SC) on risks to financial stability.
• It is published by the Financial Stability Unit of the Reserve Bank of India.

Rising government debt

• Government debt has scaled unprecedented levels, driven by
  • Decline in government revenues
  • Increased spending to safeguard economic and social welfare in the face of the pandemic
• The provisional accounts of the Controller General of Accounts (CGA) reveal that the gross fiscal deficit of the central government amounted to 9.3% of GDP.
• With the expansion in the fiscal deficit, there was a quantum jump in market borrowings during 2020-21 and elevated levels persist into 2021-22.
• With a quantum jump in market borrowings, a significant share of public debt has been absorbed by banks; going forward, however, their absorptive capacity may be circumscribed by the likely expansion of bank credit in the wake of the recovery.
• Given the revenue-sharing arrangements between central and state governments, any revenue shortfall at the center is likely to have a direct and proportionate effect on the fiscal position of state governments.

Non-performing assets (NPAs)

• The most immediate challenge for banks worldwide is a possible rise in corporate insolvencies and non-performing assets (NPAs).
• While banks’ exposures to better-rated large borrowers are declining, there are incipient signs of stress in the micro, small and medium enterprises (MSMEs) and retail segments.
• The health of their balance sheets is tied closely to the strength of the recovery and the continuation of policy support.
• Historical experience shows that credit losses remain elevated for several years after recessions end.
• Going forward, close monitoring of asset quality of MSME and retail portfolios of banks is warranted.
• This calls for banks to shore up capital positions while favorable market conditions prevail. 

Banking Stability Indicator (BSI)

• The banking stability indicator (BSI) of Scheduled Commercial Banks (SCBs) exhibited improvement in all five dimensions in March 2021 as compared to the previous year.
• In particular, soundness, profitability, and liquidity components revealed a noteworthy reduction in risk due to banks’ improved capital positions, better returns on assets, and higher customer deposits to total assets ratio, respectively.

Bank Credit

• The environment for bank credit remains lackluster amid the pandemic, with credit supply muted by persisting risk aversion and subdued loan demand.
• Over recent years, the share of the industrial sector in total bank credit has declined whereas that of personal loans has grown.
• Also, the housing segment within personal loans has longer tenor loans for which stress tends to get reflected with a lag.
• The demand for consumer credit across banks and non-banking financial companies (NBFCs) has dampened, with some deterioration in the risk profile of retail borrowers becoming evident.

Inflation

• Commodity prices have recorded a broad-based upswing in the recent period, portending inflationary implications as well as welfare losses for low-income countries.
• Crude prices continue to rise, supported by strong economic fundamentals in the US and China, and supply-side concerns.
• Industrial metals and base metals made strong gains backed by fundamentals and investor demand for commodity assets.
• The FAO Food Price Index (FFPI)  rose by nearly 40% in April 2021 (y-o-y) to its highest level since May 2014, led by strong increases in the prices of sugar, oils, meat, dairy, and cereals.
• The rise in food prices could pose grave risks of an increase in food insecurity and undernourishment in some low-income economies.
• Meanwhile, climate change risks are ascending the hierarchy of threats to financial stability across advanced and emerging economies alike.
• For net commodity importers like India, the uptrend in the international prices of crude oil and other key commodities has emerged as a source of risk, fuelling inflation expectations and also translating into terms of trade losses.

Developments in External Sector and Foreign Exchange Derivative Market

• Despite the adverse impact of the COVID-19 pandemic, India received strong interest from foreign portfolio investors (FPI's) on the back of stable financial market conditions, favorable economic prospects, and easy liquidity conditions in the global financial markets.
• Powered by record receipts in the equity segment, net Foreign Portfolio Investment (FPI) inflow during 2020-21 stood at US$ 36.2 billion as against a net outflow of US$ 3.0 billion in the previous year.
• India’s merchandise exports and imports contracted by 7.3% and 18.0%, respectively, during 2020-21 which reflected deep recessionary conditions and collapse in world trade.
• Banks in India that operate IFSC Banking Units (IBUs) were permitted to participate in the non-deliverable forwards (NDF) market with effect from June 1, 2020.
• The non-deliverable trading volumes and monthly outstanding amount have generally increased, although turnover in client positions indicate no discernible trend.

• Central banks across the world are bracing up to deal with the expected deterioration in asset quality of banks given the impairment to loan servicing capacity among individuals and businesses.
• The initial assessment of major central banks is that while banks’ financial positions have been shored up, there has been no significant rise in non-performing loans (NPAs) and policy support packages helped in maintaining solvency and liquidity.
• The economic recovery, however, remains fragmented and overcast with high uncertainty.

Scheduled Commercial Banks (SCB's)

• Aggregate deposits of SCBs rose 11.9% y-o-y during 2020-21.
• Current account and savings account (CASA) deposits grew at a faster pace than term deposits, possibly reflecting the propensity of savers to hold more liquid assets in the highly uncertain pandemic situation.
• Bank credit growth remains subdued. During 2020-21, bank credit increased by 5.4% (y-o-y), which was the lowest in the last four financial years.
• The overall credit to deposit (C-D) ratio continued on its declining trajectory. 
• New loans extended by SCBs showed recovery in the second half of 2020-21, especially for agricultural and personal purposes.
• Further easing of monetary conditions since the onset of the pandemic was transmitted to the spectrum of interest rates.
• The cost of funds and yield on assets declined across bank groups to reach their lowest levels in the last two decades.
• Banks were able to bolster their capital positions during 2020-21 by raising equity through various modes, such as preferential allotment, qualified institutional placement (QIP), public issue, and capital infusion by the Government of India as well as through retention of profits.
• As a result, the capital to risk-weighted assets ratio (CRAR) of SCBs increased.
• SCBs’ GNPA ratios for two major sectors, viz., agriculture and industry declined during 2020-21 but rose for the personal loan sector.

Scheduled Primary (Urban) Cooperative Banks

• GNPA ratio of scheduled primary (urban) cooperative banks (SUCBs) declined marginally from 10.4% in September 2020 to 10.3% in March 2021, while their provisioning coverage ratio ebbed from 65.1% to 63.6% over this period.
• The system-level CRAR of the SUCBs improved from 9.2% in September 2020 level to 9.5% in March 2021.
• SUCBs’ liquidity ratio climbed from 34.3% to 35.4%.

Non-banking Financial Companies (NBFCs)

• Credit extended by NBFCs rose 8.8% (y-o-y) during 2020-21 after a deceleration in the preceding year that was marred by credit events in the sector and muted demand.
• Despite the pandemic conditions during the year, the GNPA ratio for the sector declined with a more than commensurate fall in the NNPA ratio attesting to higher provisioning, and capital adequacy improved marginally.
• NBFC-MFIs, which are primarily dependent on bank borrowings for funding, have been undergoing asset quality stress during the pandemic. 
• The decline in collection efficiency could impact the liquidity position of NBFC-MFIs negatively and have implications for the quality of their borrowings.

Interconnectedness

• A financial system network with financial institutions as nodes and bilateral exposures as links provides opportunities for investment, risk diversification, sourcing of funds, and liquidity management.
• At the same time, however, the network exposes its constituents to negative externalities – spillovers and spillbacks – by creating channels through which shocks can spread, leading to contagion.
• The interconnectedness of financial institutions could amplify systemic shocks.
• SCBs had the largest bilateral exposures; however, their share declined by March 2021 on account of the shrinking inter-bank market while the share of NBFCs and HFCs rose sharply due to a significant jump in their payables.
• Owing to the rallies in the equity markets, the share of AMC-MFs in bilateral exposures increased during 2020-21.
• On the other hand, the share of All-India Financial Institutions (AIFIs) and insurance companies went down marginally.

Global Regulatory Developments & Assessments

• European Systemic Risk Board (ESRB) points out that public authorities have shielded the corporate sector so far from COVID-19 induced stress through a variety of measures, including loan guarantees and moratoria.
• Thereby, they prevented the rise in insolvencies that typically follow in the wake of a contraction in economic activity.
• On credit ratings across four asset classes, viz., sovereigns, financial institutions, non-financial corporates, and structured finance, the International Organization of Securities Commissions (IOSCO) observed no material changes to credit rating methodologies.
• It noted the significance of government support measures (GSMs) in alleviating the downward pressure on credit ratings.
• The European Central Bank (ECB) has recommended that banks should exercise extreme prudence on dividends and share buy-backs.
• The US Federal Reserve (Fed) has announced that temporary and additional restrictions on bank holding company dividends and share repurchases currently in place have ended for most firms after June 30, 2021, based on results from stress tests.
• The Prudential Regulatory Authority of the UK has withdrawn its restrictions on dividend distribution and share buy-backs and left it to banks’ boards to decide when to recommence distributions within an appropriately prudent framework.

Domestic Regulatory Developments

The Sub-Committee of the Financial Stability and Development Council (FSDC-SC), chaired by the Governor, Reserve Bank of India (RBI) met twice since December 2020 to review developments in the financial sector impinging on financial stability and to discuss matters involving inter-regulatory co-ordination. Among the issues taken up in its 26th meeting held on January 13, 2021 the Sub- Committee discussed the scope for improvements in

• The corporate insolvency resolution process under the Insolvency and Bankruptcy Code, 2016 (IBC)
• Utilization of data with the Central KYC Records Registry
• Changes in the regulatory framework relating to Alternative Investment Funds (AIFs) set up in the International Financial Services Centre (IFSC)

Initiatives from Regulators/Authorities

Credit-Related Measures

• A limited window upto September 30, 2021, was opened by RBI under Resolution Framework 2.0 permitting lending institutions to implement resolution plans in respect of their exposures to individuals, MSMEs, and other small businesses with aggregate exposure upto Rs 50 crore, while classifying the same as standard.
• Emergency Credit Line Guarantee Scheme (ECLGS) 3.0 was introduced to cover the credit needs of business enterprises in the hospitality, travel and tourism, leisure, and sporting sectors.
• This was followed by ECLGS 4.0 announced on May 31, 2021, which covered the credit needs of hospitals for setting up oxygen generation plants.
• The coverage of ECLGS 3.0 was expanded to include the civil aviation sector and extending the validity of the schemes to September 30, 2021.

Development of the Credit Risk Market

• RBI has been working on a revised securitization framework, a comprehensive framework for the transfer of loan exposures, and institutionalizing a secondary market for corporate loans.
• As part of the latter, it has facilitated the establishment of a self-regulatory body viz., Secondary Loan Market Association (SLMA), comprising market participants.

Pre-Packaged Insolvency for MSMEs

• As regards MSMEs, the Central Government has promulgated the Insolvency and Bankruptcy Code (Amendment) Ordinance 2021 to allow the corporate debtor to initiate pre-packaged insolvency resolution processes in case of a default of Rs. 10 lakh and above.
• This hybrid mechanism (a blend of formal and informal mechanisms) is intended to facilitate resolution for MSMEs expeditiously and cost-effectively with minimum disruption in business continuity.

Bad Bank

• In the Union Budget for 2021-22, the Government announced a proposal for setting up the National Asset Reconstruction Company Limited (NARCL), popularly termed as a “bad bank”.
• It is to consolidate and take over stressed debt from banks, based on decided characteristics.
• Drawing from established market principles and global experience, the success of a bad bank initiative would eventually depend upon design aspects, viz.,
  • Fair pricing
  • Complete segregation of risk from selling banks
  • Investment of external capital
  • Independent and professional management of the new entity
  • Minimizing moral hazard
  • Adequate capitalization of the banks post-sale of assets to invigorate fresh lending.

Customer Protection

With effect from January 27, 2021 a comprehensive framework for dealing with customer grievances was implemented which comprises:

• Enhanced disclosures on customer complaints
• Monetary disincentive in the form of recovery of cost of redress of complaints from banks when maintainable complaints are comparatively high
• Intensive review of the grievance redress mechanism 
• Supervisory action against banks that fail to improve their redress mechanism in a time-bound manner.

Centralized Payment Systems – Permitting Membership to Non-bank Entities

• Currently, the centralized payment systems (CPS), viz., Real-Time Gross Settlement (RTGS), and National Electronic Funds Transfer (NEFT) primarily function on a bank-led model.
• As non-bank entities have emerged as key players in the digital payments space offering innovative products and solutions, granting them direct access in CPS can minimize the cost and time involved in routing payments through banks.
• Therefore, in line with progress envisaged in the Payment and Settlement Systems in India: Vision 2019-2021, the Reserve Bank announced in April 2021 that entities in the payment space fully regulated by it, viz., non-bank prepaid payment instrument (PPI) issuers, card networks (like Visa and MasterCard), Trade Receivables Discounting System (TReDS) platform operators and white-label ATM operators can obtain direct membership in CPSs after fulfilling the eligibility criteria.
• Non-bank access to CPS is expected to minimize settlement risk in the financial system and widen the reach of digital financial services to all segments of users.

Innovation through Regulatory Sandbox

• RBI has adopted a thematic approach to its regulatory sandbox (RS) in the fintech sector, which allows it to pursue specific sector-wise objectives and visualize risks at sub-levels.
• After the first cohort was launched in November 2019 with “Retail Payments” as its theme, the second cohort was launched in December 2020 with the theme “Cross Border Payments”.
• The Reserve Bank also selected “MSME lending” as the theme for the third cohort.

Strengthening of Cyber Security Preparedness in Supervised Entities

• Digital Payments Security Controls were issued in February 2021 for supervised entities.
• The Computer Security Incident Response Team for the Financial Sector (CSIRT-Fin) under The Indian Computer Emergency Response Team (CERT-In) issued various early warning threat intelligence alerts in near real-time to enable mitigation of attacks by the financial sector organizations.
• CERT-In has onboarded 158 financial sector organizations in the Cyber Swachhta Kendra to track vulnerable services.

Amalgamation of Urban Co-operative Banks

• The enactment of the Banking Regulation (Amendment) Act, 2020 empowers the RBI to sanction voluntary amalgamations of the urban co-operative banks (UCBs) in specified conditions.
• RBI issued comprehensive directions on various aspects of such amalgamations to help in facilitating the amalgamation of weaker UCBs with stronger entities.
• These include incentives for an amalgamating UCB, such as relaxed conditions for closure/merger of branches as well as minimum entry point capital if the entity becomes a multi-state UCB on account of the amalgamation.

Other Developments

Deposit Insurance

• The Deposit Insurance and Credit Guarantee Corporation (DICGC) processed claims amounting to Rs. 993 crore during 2020-21, to ensure payment to insured depositors of liquidated banks under the prevailing pandemic situation. 
• GoI had announced in the Union Budget a move towards streamlining the provisions of the Deposit Insurance and Credit Guarantee Corporation Act, 1961 so that if a bank is temporarily unable to fulfill its obligations, the depositors can get easy and time-bound access to their deposits to the extent of the deposit insurance cover.

Pension Funds

• The enrolment and assets under management (AUM) of the National Pension System (NPS) and Atal Pension Yojana (APY) continued to grow.
• The coverage of citizens under the pension net expanded and the number of banks registered under APY increased to 414.

International Financial Services Centres Authority (IFSCA)

• The IFSCA issued various enabling regulations relating to market infrastructure institutions, banking, bullion exchange, finance companies, global in-house centers, fintech regulatory sandbox, alternate investment funds (AIFs), aircraft leasing, and ancillary services.
• This attracted significant interest and permission was granted for setting up business in IFSC to funds and fund managers, portfolio managers, global inhouse centers, aircraft leasing units, and professional and other ancillary services providers.