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Unveil Holistic, Integrated Financial Sector Reforms Agenda

DECEMBER 31, 2017

By TIOL Edit Team

INDIA's financial stability has come under focus from a couple of entities. A joint IMF-World Bank Report on India's ‘Financial System Stability Assessment' (FSSA) has pitched for a slew of major initiatives to strengthen India's financial institutions and processes.

Reserve Bank of India (RBI) in its report with its half-yearly ‘Financial Stability Report' (FSR) has also raised a few issues that merit attention of the Government. One such issue is the impact of demonetization of flow of savings and investments.

Both the reports were released on 21 st December 2017.

These reports, coupled with similar reports released in the recent past, should help Government enliven its financial reforms agenda. It should ideally prepare a road-map for holistic, integrated financial reforms to be pursued over next five years.

Financial Reforms in the country have largely been driven by crisis or crisis-like situations such as the ongoing ones propelled by non-performing assets (NPAs). The credit for certain reforms also goes to lobbying by financial services players over the years.

The proactive reforms have, however, been virtually missing all along. The Government should now at least unveil comprehensive financial sector reforms, factoring in recommendations from diverse government and external reports such as ‘Peer Review of India' published by Financial Stability Board (FSB), a global regulator, during August 2016.

FSSA report has recommended formulation of “a strategic plan for their consolidation, divestment, and privatization” in the short run. It has also advised the Government to review loan classification and provisioning rules keeping in view International Financial Reporting Standards (IFRS). This review should be focus on “special loan categories”.

IMW-WB team's other valuable, short-term recommendations include: a) Improve stress testing scenarios and methodologies; b) Subject domestic politically exposed persons to adequate due diligence and qualify domestic tax evasion as a predicate offense to money laundering and c) Improve stress testing scenarios and methodologies.

It also wants India to take a call over the medium term on a few other major recommendations. A key suggestion is to amend relevant laws to provide RBI with full supervisory powers over public sector banks (PSBs). It also wants the Government to clarify RBI's legal independence.

According to an IMF release, “India's key banks appear resilient, but the system is subject to considerable vulnerabilities. Stress tests show that the while largest banks are sufficiently capitalized and profitable to withstand a deterioration in economic conditions, a group of public sector banks (PSBs) are highly vulnerable to further declines in asset quality and higher provisioning needs. Capital needs range from 0.75 percent of GDP in the baseline to 1.5 percent of GDP in the severe adverse scenario”.

RBI, in its FSR released on 21 st December 2017, has voiced a similar concern over the health of banking sector.

As put by FSR, “The overall risks to the banking sector remained elevated due to asset quality concerns. Between March and September 2017, the gross non-performing advances (GNPA) ratio of scheduled commercial banks (SCBs) increased from 9.6 per cent to 10.2 per cent and the stressed advances ratio marginally increased from 12.1 per cent to 12.2 per cent. Public sector banks (PSBs) registered GNPA ratio at 13.5 per cent and stressed advances ratio at 16.2 per cent in September 2017”.

FSR adds: “The macro stress test for credit risk indicates that under the baseline macro scenario, the GNPA ratio may increase to 10.8 per cent by March 2018 and further to 11.1 per cent by September 2018”.

As for demonetization, FSR observes: “The significant increase in liquidity in financial markets in the wake of demonetisation has led to unprecedented fund flows to both equity and debt mutual funds. The effects of pervasive domestic liquidity in financial markets following demonetisation and abundant liquidity induced as a result of foreign exchange operations have pushed down borrowing costs for higher rated Indian corporate”.

Is the reduced cost of borrowings being used to refinance old debt or finance projects and expand businesses? RBI should answer this keeping in view its own conclusion that “overall investment climate remains challenging as seen from the decline in new investment proposals”.

FSSA has been prepared by IMF-WB combine under its Financial Sector Assessment Program (FSAP). Under this, the two multilateral institutions subject 29 major nations to financial surveillance.

The Finance Ministry should also factor in recommendations contained in earlier FSAP reports on India. The reports include one issued in January 2013 and another in August 2013. IMF's annual country reports on India have also made important suggestions over the years. These should also be kept in view while preparing a new roadmap for financial sector reforms.

The proposed roadmap should provide for substantial improvement financial transparency, which is sure-fire means to prevent dubious lending and subsequent cycle of restructuring of bad loans.

It would be worthwhile to watch India's ranking in financial secrecy index (FSI) 2017 that is slated to be released by US-based accountability group, Tax Justice Network.

In FSI 2015, India was ranked 45 th . This is one index, where rank fall should be welcomed to minimize growth NPAs, banking frauds and corruption. Modi Government has not set any target to improve its ranking in this case, unlike in the arena of ease of doing business index.

The Government must not overlook the fact that financial secrecy and crony capitalism (with embedded corruption) go hand in hand.