Sustaining banking stability

Governance gaps must be avoided

One of the necessary conditions for attaining higher sustainable economic growth is financial stability. While risks to financial stability can emerge from a number of areas, it is important to maintain banking sector stability at all times. Since the Indian financial system is dominated by banks, the health of the banking system is also a key determinant in channelling financial savings. Further, as the system is dominated by public sector banks (PSBs), potential instability can have implications for government finances. It is also worth noting that the need for both internal and regulatory vigilance has increased tremendously because of technological developments. As witnessed in the US recently, any sign of material trouble can quickly lead to the withdrawal of deposits and push banks into insolvency. In this broad context of relevance and risks, remarks made by Reserve Bank of India (RBI) Governor Shaktikanta Das at a recent event organised for PSBs must be welcomed.

To his credit, Mr Das spoke about expectations from the board of directors of banks at a time when the banking system is in good shape. This is important because often complacency sets in when the going is good. As Mr Das noted, it was a matter of concern that despite clear guidelines on corporate governance, certain banks were found following them in the breach, with the potential to cause volatility in the sector. It is extremely important that banks don’t leave any gap in governance, and it’s the responsibility of the board to ensure that. Mr Das also stressed what the chairman and the members of the board are expected to do. While the need for robust governance cannot be disputed, the RBI is often constrained by limited powers over PSBs, which dominate the banking sector. The issue was raised in the past by former governors Raghuram Rajan and Urjit Patel. In a 2018 speech, for instance, Dr Patel noted: “...legislative reality has in effect led to a deep fissure in the landscape of banking regulatory terrain: a system of dual regulation, by the finance ministry in addition to the RBI.” To ensure that the banking system is regulated effectively and performs to its potential, it is important to end the difference in regulation. All banks must be equal to the regulator.

Notably, Mr Das also talked about ensuring the integrity and transparency of financial statements. He specifically mentioned that in the supervisory process, the RBI has found cases with innovative ways to conceal the real status of stressed loans. The regulator has also come across instances where after being pointed out, one method of evergreening was replaced by another. However, it is not clear what the RBI did to penalise such banks. It is important that banks indulging in such practices and people responsible are reprimanded to create deterrence in the system. Part of the responsibility for the banking sector’s stress in the aftermath of the global financial crisis also lies with the regulator because it could not detect the problem in time and nudge banks to improve reporting standards. A clear picture and extent of the problem only emerged after the asset quality review of 2015. Thus, along with bank boards and management, the regulator will also need to be watchful. The hard-won stability in the banking sector must be preserved.