Bimal Jalan committee report: RBI, Government, must be mindful of financial instability sources

The report of the Bimal Jalan committee stated that both the Central Government and the Reserve Bank of India (RBI) need to be mindful that new potential sources of financial instability from systematically important financial institutions cannot be ruled out.

The committee was set up to review the RBI's extant economic capital framework.

They also said the interconnectedness in the Indian markets between banks and non-bank financial entities is enlarging rapidly, thus increasing the risk of contagion in a financial crisis.

According to the June 2019 issue of Financial Stability Report, ‘The total outstanding bilateral exposures among the entities in the financial system increased from Rs 31.4 trillion in March 2018 to Rs 36.3 trillion in March 2019.'

The public-sector banks (PSBs) have a net receivable position vis-à-vis the non-banking financial sector (NBFC). In the event of a stress in the non-banking financial sector, the committee observed that the banking sector, and particularly the public sector banks, is likely to come under stress.

For instance, the current stress experienced by the NBFC sector, led to calls for appropriate Lender of Last Resort (LoLR) action by the RBI, it added.

It may be pertitent to note that defaults by non-bank entities such as IL&FS and DHFL have had a ripple impact on the financial system.

Risk provisioning

With regards to the RBI making ELA losses, even when a major part of the banking sector is in the public sector, the Committee believed that prudence would necessitate risk provisioning.

This was because they believed that losses could occur despite the ELA support to the private banks.

According to the Committee's report, having a banking sector dominated by PSBs does not make an economy immune to bank runs. The 2002 crisis in a Latin American economy largely involved public sector banks (PSB). Further, the Global Financial Crisis (GFC) has depicted that the ownership of the banking sector becomes more public sector oriented during the periods of crisis.

Despite large public sector ownership being effective in preventing bank runs in the past, the Committee underscored that the NPA (non-performing asset) crisis has thrown light on the challenges that arise if a sizable majority of the banking sector looks at the Government for recapitalisation.

"Herein lies the challenge of assessing the risk provisioning requirements of the RBI. The RBI would theoretically not be exposed to ELA losses if the Government recapitalizes these banks. However, the European debt crisis has demonstrated that private sector debt crises can transform into a Sovereign debt crisis if the Government over-stretches itself in recapitalising the distressed banks," the Committee said.

Also read: Jalan panel suggests aligning RBI's financial year with Government's fiscal year

In this regard, the committee felt that the position could be even more severe in India. It reasoned that since the Indian Sovereign’s rating is at the lowest investment grade - any downgrade, due to fiscal slippages caused by recapitalization, could exacerbate the capital flight caused by the financial crisis.

The committee further stated that the rupee not being a reserve currency will greatly limit India’s capability to manage financial crises.

The Committee, therefore, recognised that the RBI’s financial stability risk provisions need to be viewed for what they truly are -- the country’s savings for a rainy day (a financial stability crisis), built up over decades and maintained with the RBI in view of its role as the LoLR.

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