Four risks to financial sector stability in India

In a globalized economy like India, external sector indicators are important aspects
that monitor economic health of the country. While a huge current account deficit
has been a cause of worry, a number of other economic parameters also highlight
the growing risks to financial sector stability. Slowing FDI, deteriorating asset quality
of banks, and rising risks of bad loans have the Reserve Bank of India worried. An
RBI stress test shows that if the current situation persists, gross bad loans in the
system could rise from 3.6% as on September 2012 to 4% by end March 2013 and
4.4% by end March 2014.
External sector vulnerability
It is not just the current account deficit, or CAD, all major indicators of external
sector vulnerability continue to deteriorate. While short-term debt and volatile
component of capital flows are on the rise, the number of months' of imports that
the forex reserves can finance too is falling. This is because exports have slowed
down, but imports have not. Besides, other stable sources of capital flows such as
FDI have also slowed. As a result, the cushion of forex reserves is weakening. A
sharp deterioration in the level of reserves could adversely impact the sentiment of
overseas investors. RBI is concerned that given the high CAD, any adverse
development in international financial markets could impact the domestic foreign
exchange markets severely if macroeconomic fundamentals are not very strong.
Capital Adequacy Ratio
RBI appears confident that private banks would be better equipped to raise capital
to meet Basel III requirements as compared to its PSB peers. But its biggest concern
in migrating to the new Basel norms related to deteriorating asset quality and
regulatory changes that require lenders to set aside more money for restructured
loans may pose challenges for banks. RBI estimates that under a severe stress
scenario, CRAR of PSBs may decline to 11.4% and 9.9% by March 2013 and March
2014, respectively. A quick estimate shows that banks would require additional
capital of Rs 5 trillion on account of Basel III of which non-equity capital will be to
the order of Rs 3.25 trillion, while equity capital will be to the order of Rs 1.75
trillion.
Bad Loans
RBI's concern over bad loans has risen as the economy is slowing. An RBI stress test
shows that if the current situation persists, gross bad loans in the system could rise
from 3.6% as on September 2012 to 4% by end March 2013 and 4.4% by end March
2014. Agriculture would register the highest bad loans at 5.8% by March 2013,
followed by engineering, iron & steel and construction. Adverse macroeconomic
shocks seem to have the maximum impact on engineering and iron & steel. RBI is
concerned because bad loans growth at 45% for the year ended September 2012
has outpaced the growth in advances.
Over Dependence

As is the global practice, the financial stability report said that India's financial
system is interconnected and financial institutions depend on each other for funding
and direct credit exposures. While the banking sector is a net lender to NBFCs, it is
a net borrower from insurance and asset management companies. The report said
that banks significantly depend on mutual funds for their short-term funding needs.
This in turn can lead to a potential liquidity risk in case of any stress in the mutual
fund industry. Insurance companies too would be affected. An RBI study of select
NBFCs showed that 100% of the capital funds for the NBFC sector were from bank
borrowing.
Reference:
http://economictimes.indiatimes.com/slideshows/economy/four-risks-to-financialsector-stability-in-india/over-dependence/slideshow/17950256.cms