Fresh concerns for systemic stability must be monitored

The RBI is moving to implement changes in guidelines on Liquidity Coverage Ratio with higher runoff rates and haircuts

A reading of the Financial Stability Report (FSR) of June 2024 gives the impression that bank balance sheets are strong enough to withstand shocks. Lowest impairments in a decade, robust earnings and strong buffers have raised comfort levels. Governor Shaktikanta Das, in his foreword, assured the Reserve Bank of India (RBI) is watching emerging risks. The fact remains that the banking sector governance framework is still not in place, with the recommendations of the IMF’s FSAP of 2017 swept under the carpet. The government’s reluctance to divest majority ownership in public sector banks remains the big stumbling block.

Details on potential fragilities were sprinkled inside the FSR. Credit risk stress tests indicate that under a severe shock of two standard deviations, six banks may fail to maintain the regulatory minimum capital. The banks do not have a large share in assets, but the network effects from their failure were not spelled out. All we know is that concentration risk from large borrowers is low. On the liquidity risk, the reverse stress test shows that a 30 per cent uninsured deposit runoff can completely knock off liquid resources for most banks. Should regulators draw comfort from this? During the run on the Silicon Valley Bank crisis in the United States, 81 per cent of the total deposits was withdrawn — a staggering figure.

In all fairness, the RBI is proactively using risk mitigation tools. It is moving to implement changes in guidelines on Liquidity Coverage Ratio with higher runoff rates and haircuts. In November 2023, it increased the risk weights on consumer credit, credit cards and bank loans to non-banking financial companies. The risk weight measures were not exactly in tune with sectors where credit growth has spurted and it is unclear if the step was prompted by inferior quality of monthly data on sector-wise credit. In any case, the impact of risk weight on capital adequacy has been immaterial as the system-level capital to risk assets ratio remains at 16.8 per cent, well above the regulatory minimum of 9 per cent.

What has been strangely missing in the deployment of tools is the countercyclical capital buffer (CCyB). The RBI’s calculation of credit gap is based on application of filters to credit data that include credit bubble period and techniques that impart an upward bias to potential credit growth. So, it finds that the credit gap is still not closed in relation to the 16 per cent trend credit growth. With these metrics, RBI will not get an opportunity to use CCyB the way it has been used so effectively by some central banks on both ends of the credit cycles.

The emerging risk from the credit-deposit (CD) mismatch for banks was downplayed in the FSR. Yet three weeks later, Das, speaking at a forum, cautioned banks on this mismatch. The FSR analysis was based on credit and deposit outstanding that mask much of the story. In incremental terms, adjusted for merger (of the HDFC twins), the CD ratio on July 12, 2024 was at a high of 98.7 per cent. If one were to add increments in both bank credit and investments, the ratio is at 123.4 per cent of the deposits. This is not a one-off number. The structural mismatch arose right from April 2022, when this ratio rose from underneath 97 per cent to spike to 153.2 per cent in six months.

This also means that despite the two dissent votes in the Monetary Policy Committee, it might have to resist pivot and cut the policy rate at the current juncture, though since March 2022, adjusted for inflation, the weighted average fresh term deposit rates have increased by 455 basis points (bps) and weighted average lending rates are up by 396 bps.

The mismatch also reflects to some extent disintermediation, but it needs to be understood that if the money goes to investment in equities, it should have come back to the banking system and should have only slowed down the process of multiple credit creation. One explanation could be the surge in government cash balances by Rs 4.18 trillion in H1 FY24, but not the entire period since 2022. So, the data puzzle is deeper and requires better explanation or better data, or both.

The writer is a professor at IIM Kozhikode; and a former RBI ED and MPC member. The views are personal. This column has been edited for space.