How to future proof the Indian financial system?

1 May 2023 , 07:23 PM

It is said that a successful management of a company or an economy should never be judged by how well a crisis is managed. Rather, it should be judged based on how effectively a crisis is averted. In other words, crisis management at a macro level should focus on being more prophylactic and less therapeutic. That was exactly the focus of the inaugural address delivered by the RBI governor, Shaktikanta Das, at the Global Conference on Financial Resilience. The focus was on future proofing the Indian financial system.

Background to the future proofing debate

In the last couple of years, the Indian economy had to negotiate a number of major headwinds. There was the unprecedented COVID pandemic, a global economic slowdown, followed by the Ukraine war. Of course, there were also other headwinds for the Indian economy like the supply chain constraints, runaway inflation, and global hawkishness; all of which tested the macroeconomic policy capabilities to the hilt. However, this series of crisis has once again brought the focus on the topic of financial resilience and financial stability. The big question is; can economic managers and central banks proactively avoid such a crisis? This includes a review of the adequacy of existing regulations and supervisory systems as well as a re-look at the risk management systems at a micro and macro level.

What we understand by financial resilience in the Indian context?

The financial sector is an amalgam of a number of financial entities including private banks, public sector banks, development financial institutions, HFC, NBFCs and even the micro financing units. Today, there are a number of checks and balances. For instances, the RBI has ensured that most of the significant players in financial intermediation are directly or indirectly under RBI supervisions. This can avoid the kind of systemic risks that NBFCs and cooperative banks created in the past. Also, thanks to technology, the risk management and supervision is largely real time, which does away with the rather dangerous time lags in action. However, stress is part of any financial system and as systems get more globalized, convergence also brings with it contagion pressures on the Indian financial system.

What RBI expects in terms of a resilient financial system?

As Das rightly put it, risk management, supervision and oversight in Indian banking is at par with the global best practices. However, resilience is not just a challenge for emerging markets like India, but even for developed markets; as we saw in the case of SVB Bank and Credit Suisse in the developed markets. Here is what the RBI expects.

1. When we talk of resilient banking, we start with the basics. For instance, to be financially resilient, banks must have adequate capital buffers and also be in a position to generate earnings in times of severe macroeconomic shocks. Loss making banks can never be able to be resilient. A classic example is the way the RBI nudged banks during the COVID crisis to build capital buffers since liquidity was in abundance.

    

2. Capital alone cannot be sufficient so there is also need for prudential norms. In this regard, the RBI has put in place elaborate asset classification and provisioning requirements. Stressed banks are separately bucketed with a more conservative policy towards manpower costs and dividend distribution. As Das rightly pointed out, it is these prudential norms that have allowed Indian banks to stand up in the recent crisis.

    

3. One of the interesting things introduced by the RBI for banks in the post global financial crisis scenario is the stress tests. The RBI regularly conducts macro stress tests for credit risk to identify whether the banks would be able to comply with the minimum capital requirements even under severe stress scenarios. Most of the Indian banks have gradually started doing well in the stress tests as it highlights the real problem areas.

    

4. Today, the concept of risk has changed due to the advent of technology and the big shift towards internet banking, mobile banking etc. For instance, today banks are expected to deliver critical services even in the face of disruptions. That calls for a high level of technological sophistication and redundancy management. Cyber risks and possible cyber-attacks are on top of the list and the technology teams of banks are now obsessed with preventing data theft and ensuring safe and secure transactions. In this context, it must be mentioned that the RBI has recently laid out a comprehensive policy framework for banks and NBFCs availing third-party services. 

    

5. Finally, we come to organizational resilience of banks and NBFCs such that they anticipate risks early and absorb them efficiently. This is the most dynamic requirement since these demands keep changing on a continuous basis and the organization structure and relative roles need to adapt to these new risks. For instance, cyber risk has transformed from being a peripheral risk for banks to being the core risk of banks. That needs a new structure and thinking to handle proactively.

Apart from the expectations from the financial players, the RBI is also preparing its own roadmap for future proofing the financial system.

How the RBI is working on future proofing the financial system?

To make the Indian financial system robust, the RBI has charted its own path too. Here is what the RBI has put in place, and some are still work in progress.

• Governance holds the key and the RBI has reiterated time and again that good governance is the key to aligning the interests of the bank with that of the consumers and the Indian financial system. This calls for transparency and accountability. RBI insists on Regulated Entities (REs) having systems and processes to promote sound corporate governance. Risk management is a critical aspect of governance too and the RBI has outlined rules for the board and committees to ensure the same.

   

• RBI spends a lot of time and bandwidth on root cause of vulnerabilities. RBI intervenes irrespective of whether the root cause of the problem is regulatory, macro or micro at an organizational level. RBI also has its red flags against an over-aggressive growth approach at the cost of risk management. For this, the RBI closely works with the external auditors to highlight any major risk factors; either patent or latent.

   

• Supervisory analytics through the use of data analytics, artificial intelligence and machine learning is one more area that the RBI has invested a lot of effort. The idea is to capture potential and emerging risks, identify the outlier entities and the vulnerable large exposures of banks. RBI also has a mix of offsite and onsite supervisors to monitor and assess such risk factors on a real time basis. This is an important part of the early warning system adopted by the RBI.

   

• It is said that most banking crisis are a crisis of liquidity, which is a logical corollary of a crisis of trust. That is something the RBI monitors on a close basis and even intervenes and supersedes the board where appropriate. It had done so in the case of banks and NBFCs like Yes Bank, IL&FS, Dewan Housing, SREI Finance etc, where the systemic risk implications are high.

In a complex global financial system, regulation takes on multiple hues. The RBI has the rough task of ensuring that the Indian banks are resilient enough to handle internal and external risks, even while handling the spill-over effect of global risks. The moral of the story is to be safe rather than sorry.