The International Monetary Fund has recently released a report titled “India Financial System Stability Assessment”

Key Highlights of the Report

• Objective: The Report assesses the stability of the financial system as a whole and helps countries identify key sources of systemic risk in the financial sector to implement policies to enhance its resilience to shocks and contagion.
• Findings:
• • India’s Overall Financial System: It has become more resilient and diverse since the pandemic and is driven by rapid economic growth of Non Banking Financial Institutions  and market financing making it more diverse and interconnected.
  • Resilience to Macrofinancial Shocks: Stress tests conducted has shown that the main lending sectors are broadly resilient to macrofinancial shocks
    • Banks and NBFCs: They possess sufficient aggregate capital to support moderate lending even in severe macrofinancial scenarios. But PSBs may need to strengthen their capital base to support lending in such situations. 
    • Weak Tails: Few nonsystemic NBFCs and urban cooperative banks are the weak tails of the financial architecture reporting below minimum or negative capital
  • Stagflation Event: It was found that in the event of a stagflation, caused by, “geopolitical risks and monetary policy miscalibration of major central banks” public sector banks may have difficulties maintaining a capital adequacy ratio (CAR)of barely 9%
    • RBI mandates a 12% and 9% CAR for PSB and Scheduled commercial banks respectively
  • Vulnerability of PSBs:  PSBs are relatively more vulnerable to credit risk and need to strengthen their capital base by retaining their earnings instead of paying dividends to the government to ensure they can support economic recovery in a potential future downturn.
  • Concentrated Exposures To Power Sector: It was found that 63% of the power sector loans came from NBFCs (from state-owned infrastructure financing companies like IREDA) in FY 2024 increasing from 55% in 2019-20. 
    • Cause for Systemic Risk: Such high exposure could cause a system wide risk with the distress from NBFCs spilling over to banks, corporate bond markets, and mutual funds that finance NBFCs.
    • `Physical and Transition Risks: Bank exposures to physical and transition risks are moderate, except for those to the monsoon-dependent agricultural sector and carbon-intensive industries including the power sector.
  • The Oversight Framework: Supervisory agencies lack sufficient independence, and their powers over corporate governance in state-owned financial institutions remain constrained compared to international best practices. 

• Recommendations: 
  • NBFCs Supervision: Exemptions for state-owned NBFCs from prudential standards should be eliminated and equated with PSBs  to level the playing field and safeguard financial stability.  
    • To extend the well-established cybersecurity risk supervision framework for banks to key nonbanks.
  • Data Sharing and Analysis: To collect more granular data and improve sharing to sharpen the analysis of systemwide interconnectedness, household credit risks, and climate-related financial risks.
  • Strengthening Banking Supervision: Critical areas for immediate attention include strengthening the credit risk management framework by adopting IFRS 9 and enforcing Pillar 2 capital add-ons.
  • Build releasable countercyclical capital buffers before the next downturn supporting  faster recovery at a relatively low cost
  • To Developing Infrastructures to Adopt Financial Innovations: To enhance financially underserved sectors access to credit by strengthening legal, tax, and informational infrastructures for asset-based and digital lending with state-of-the-art credit enhancement tools.
  • To further enhance insolvency and bankruptcy processes to reduce the time for recovery is also critical for managing credit risks better.