The Financial Stability Report (FSR) is a half-yearly publication with contributions from all the financial sector regulators. The FSR reflects the collective assessment of the Sub Committee of the Financial Stability and Development Council on prevailing and emerging vulnerabilities to the Indian financial system.
Macrofinancial Risk :
Since the December 2022 issue of the Financial Stability Report (FSR), the global macrofinancial environment, which was unsettled by overlapping strains from tightening of financial conditions in response to aggressive monetary policy actions, the lingering effects of the war in Ukraine and a recessionary macroeconomic outlook, was jolted in March 2023 by banking failures in advanced economies (AEs) that tested the resilience of the global financial system.
The episodes of sudden failures of banks in the U.S. and Europe since March 2023 came after a period of prolonged easy monetary conditions in response to the pandemic.
Reasons which led to failures are :
- Unhedged or inadequately hedged investment portfolios brought unrealised losses on balance sheets due to fire sales.
- As interest rates rose, valuation losses spiked in banks, in particular in their held-to-maturity (HTM) portfolios, which are not marked-to-market. The aggregate valuation losses in the U.S. banking system grew from US$ 8 billion at the end of 2021 to more than 4 Common Equity Tier (CET) – I ratio is percentage of common equity tier I capital to risk-weighted assets.
Priorities of RBI :
Headline inflation in India has gradually moderated from its peak of 7.8 per cent in April 2022 to 4.3 per cent in May 2023 due to the combined impact of monetary tightening, supply side measures and easing of global supply bottlenecks. Core inflation has also eased but remains above 5 per cent. The pursuit of price stability while keeping in mind the objective of growth, therefore, remains the overarching priority of the Reserve Bank.
Achievements in Economy :
- The provisioning coverage ratio (PCR) of banks which was as low as 40.1 per cent in June 2016, has improved to 74.0 per cent in March 2023.
- The health of the Indian banking system is robust, fortified by a multi-year low non-performing loans and adequate level of capital and liquidity buffers.
- Retail loans grew at a compounded annual growth rate (CAGR) of 24.8 per cent from March 2021 to March 2023, almost double the CAGR of 13.8 per cent for gross advances during the same period. It formed around one-third of the total banking system’s gross loans and advances.
- Since the last issue of the FSR, the NBFC sector has witnessed a marked improvement across major soundness parameters, viz., asset quality, capital levels and liquidity.
- Bank borrowings remained the principal source of funds and constituted 41.2 per cent of the total borrowings of NBFCs.
- NBFC-MFIs and SCBs accounted for nearly three-fourth of lending to the microfinance sector.
- The distribution by risk tier47 shows improvement in the customer mix across all categories of lenders. On the other hand, the personal loan transition matrix showed moderation in risk tiering, with downgrades from super-prime and prime-plus category exceeding upgrades in sub-prime and near-prime customers.
- In the last issue of the FSR, the financial system stress indicator (FSSI) was presented as a monitoring tool for aggregate stress levels in the Indian financial system. Equity markets witnessing stress following the banking turmoil. However, Bond market imporved due to spreads and volatility being reduced.
Global Risk Survey :
As per the systemic risk survey conducted in May 2023, risk perception across all major categories of systemic risk except institutional risk has receded. Global spillovers remained in the ‘high’ risk category. Financial market risk declined to the ‘medium’ risk category from ‘high’ risk. Macroeconomic risk remained in the ‘medium’ risk category and was perceived to have moderated.
As per the survey response, global growth slowdown has eme.rged as the foremost financial stability risk, followed by tight global financial conditions, volatility in capital flows and rise in commodity prices.
The resilience of the global financial system is being tested by the recent banking turmoil and interaction between monetary tightening and financial sector stress.
The health of the banking system is a positive in this environment, with improving profitability and asset quality and sufficient levels of capital and liquidity buffers.
Aggregate deposits growth, which had undergone a slight moderation during 2021-22 and H1:2022-23, picked up pace to reach 11.8 per cent as on June 02, 2023.
Credit for agriculture, services and personal loans grew faster than lending to the industrial sector.
The ratio of household debt to gross domestic product measures household indebtedness at the aggregate level and does not factor in household wealth across income groups and provides no information on distribution of debt. Accordingly, a more granular assessment of risk from household debt is warranted. The June 2022 issue of the FSR presented the results of a sensitivity analysis of the impact of a fall in housing prices on the capital of banks, using data from the Reserve Bank’s quarterly residential asset price monitoring survey (RAPMS). Using the same data, indicators of the equated monthly instalment (EMI)-to-income ratio (EIR) and financial margin have been compiled and repayment capacity of households in different income buckets is evaluated to get a more accurate insight into lenders’ exposure to the household sector.
Stress Test for NBFC : System level stress tests for assessing the resilience of the NBFC sector to credit risk shocks were conducted for a sample of 13542 large NBFCs. The tests were carried out under a baseline and two stress scenarios – medium and high risk, with increases in the slippage ratio by 1 SD and 2 SDs, respectively.
Stress Test for Mutual Fund : As mandated by the SEBI, the stress testing of all open-ended debt schemes (except overnight schemes) is carried out by asset management companies (AMCs) every month to evaluate the impact of various risk parameters, viz., interest rate risk, credit risk, liquidity risk and redemption risk faced by such schemes on their net asset values (NAVs).
Stress Test for Clearing Corp. : Stress testing is carried out at clearing corporations (CCs) to determine the minimum required corpus (MRC) of the core settlement guarantee fund (SGF). The segment-wise MRC is determined on a monthly basis using stress testing. For determining the MRC for cash and equity derivatives segment, the CC calculates the credit exposure arising out of a presumed simultaneous default of top two clearing members (CMs).
SCBs’ share as fund provider to the system reduced during 2022-23, whereas their share in borrowing from entities (including other SCBs) increased. The factors leading to SCBs increasingly relying on borrowing from the market include credit growth outpacing deposit expansion and lower surplus liquidity at system level.
SCBs’ share as fund provider to the system reduced during 2022-23, whereas their share in borrowing from entities (including other SCBs) increased.
The degree of interconnectedness in the banking system (SCBs), as measured by the connectivity ratio52, reduced during H2:2022-23 partly due to inclusion of an additional foreign bank in the analysis and reduction in number of net payable connections of PVBs.
The report of the Federal Deposit Insurance Corporation (FDIC) on the options for deposit insurance reform observed that bank failures were largely caused by convergence of rapid asset growth in banks funded by uninsured deposits, exposure to unrealised losses in their securities portfolio and business models concentrated on providing services to digital asset firms. It highlighted the contribution of technological developments in quickening information dissemination and consequently, faster depositor runs.
3 options to reform the deposit insurance system are offered:
(a) limited coverage, which maintains the current structure of finite deposit insurance limit;
(b) unlimited coverage of all deposits; and
(c) targeted coverage, which allows different levels of deposit insurance coverage across different types of accounts and focusses on higher coverage for business payment accounts.
Contagion Analysis :
Contagion analysis uses network technology to estimate the systemic importance of different banks. The failure of a bank, which is systemically important leads to greater solvency and liquidity losses for the banking system, which, in turn, depends on the initial capital and liquidity position of banks along with the number, nature (whether it is a lender or a borrower) and magnitude of the interconnections that the failing bank has with the rest of the banking system.
Stable financial conditions, balance sheet strength and return to profitability on the back of surge in net interest income (NII) has enabled the Indian banking system to support the growing credit needs of the economy.
Macro stress tests indicate that SCBs have sufficient capital buffers to withstand moderate to severe adverse macroeconomic circumstances, though some individual banks may fall short of minimum capital requirements (including the CCB), under a severe stress scenario.