The bank failures in the world’s largest economy and in Europe following the pandemic and war-induced tightening cycle posed a lot to brood over for policymakers on the vulnerability of financial systems. The concerns were particularly true for emerging market economies, who may have to struggle with fiscal packages to calm markets.
However, India’s banking system has considerably less chances to face such incidents, the finance ministry said today in a report.
“While incidents like those mentioned above are bound to happen in a rapid tightening cycle amid an uncertain economic environment, an analysis of the Indian banking system reveals that Indian banks appear well-placed to handle any stress emanating from the current tightening cycle,” the ministry said in its monthly economic review. “The importance accorded to system-wide financial stability has its origins in the aftermath of the 2007-08 global financial crisis. The macro- and micro-prudential measures in recent years by the RBI and the government have culminated in the enhancement of risk absorption capacity, thereby improving the banking system’s stability.”
Banks face interest rate risk when the country’s policy rates increase rapidly in a short span of time. This spelled trouble for the two regional US banks – Silicon Valley Bank and the First Republic Bank. Since March 2022, the Federal Reserve aggressively raised rates by 4.5 percentage points to tame galloping inflation rate. Subsequently, the yield on debt soared at a commensurate rate.
Days after the US saw its second and third largest banking failures, where the authorities had to step in to rescue the banks and depositors’ money, Swiss banking giant Credit Suisse got into an excruciating financial crisis.
After six consecutive hikes of a cumulative 250 basis points, the Reserve Bank of India’s rate-setting panel this month took a pause. Some experts believe most global central banks are also close to a peak or already done with interest-rate hiking, amid the first signs of dents to growth now visible while fallout from financial-market tensions persist.
“The exposure and attunement to regular interest rate cycles have made Indian banks well-equipped to handle the cycles. This is unlike the case in advanced economies where long-term interest rates have been close to zero for an extended period of time,” India’s finance ministry said.
For advanced economies, financial participants expected the rates to remain at low levels. So, when rates went up sharply within a short time to curb inflationary pressures, vulnerabilities in the financial markets came to the fore, the ministry said.
It also listed various measures taken to safeguard the banks, including the creation of an investment fluctuation reserve to create a buffer to shield banks from adverse yield movements, uniform application of capital and liquidity requirements to all banks, irrespective of their asset size and exposure, provision of guidelines on governance in commercial banks etc. with the focus on dealing with the root cause of vulnerabilities.
The central bank has also stipulated that banks cannot place more than 23% of their deposit liabilities in their Held-to-Maturity portfolios, implying that a 10% loss sustained in banks’ HTM portfolios will have only a deposit impact of 2.3%, it added.
The RBI is also “meticulous” in its bi-annual assessment of not just scheduled commercial banks, but also the shadow lenders or non-banking financial corporations and cooperative banks. This frequent assessment ensures that vulnerabilities are identified even in smaller institutions, which may be impacted relatively more by monetary tightening and yield spikes.
The central bank’s Basic Statistical Returns show that 60.1% of India’s deposits are with state-run banks, as of March 2022. Households own 63% of total deposits and therefore the deposit withdrawals in this category will remain limited as they are considered to be sticky retail customers.
ndian banks don’t hold a majority of their assets in the form of bonds. Instead, for the top 10 banks in terms of asset size, loans constitute more than 50% of their total assets, making banks more immune to the rising interest rate cycle, the ministry noted.
Asset-Liability Mismatch is another threat that emerges as policy rates climb and it is crucial for the regulatory and supervisory framework to manage the vulnerability arising out of it.
While a buildup in this mismatch exposes banks to risks if short-term interest rates rise or if there is a sudden demand for liquidity, the finance ministry said it is not an onerous issue in the Indian banking system.
Bank recapitalisation and cleaning up of balance sheets in recent years have also led to improvements in various banking indicators, including net interest margin, ratio of net bad loans to net advances and capital adequacy ratio, which for top 10 banks remained well above Basel III norms, the ministry said.