Weak spots in the system

The Second Financial Stability Report released by the Reserve Bank of India (RBI) is reassuring on many grounds. As the Governor says in his foreword: “India's financial sector has by and large remained resilient save for some strains in the money market on account of tight liquidity. Banks continue to be well capitalised and the asset quality at the aggregate level does not cause serious concerns. The Reserve Bank will continue to monitor and address sectoral exposures as in the past.”

But the nature of the task ahead is not underestimated. The RBI Governor says: “Pursuit of financial stability is a continuing endeavour — much like the Greek mythological character Sisyphus, who has been likened to central bankers in a recent bestseller ‘Lords of Finance'.

Sisyphus was condemned by the Gods to roll a huge boulder up a steep hill, only to watch it roll down again and having to repeat the task. The challenge for central bankers is still bigger – they have to manage multiple boulders at a time.”

The analogy is somewhat disconcerting. Sisyphus never succeeded in his efforts. Is it appropriate to use the expression? In a sense, “yes”.

NBFCs MAKE MERRY

Right from the Tulip Bubble, the world has seen innumerable financial crises, followed by regulatory measures which did not prevent new ones from developing. Is it an unending and hopeless battle? Financial stability has to be seen in the context of the larger picture of economic stability. Individuals and institutions seem to find new ways of circumventing every regulatory or prudential measure introduced by the authorities.

Take the instance of non-banking financial companies (NBFCs). For several decades efforts have been made to discipline them.

Yet, we are told that setting up an NBFC is a more attractive option as an entry point, as the stipulation of net owned funds of Rs 2 crore is low compared with that for banks (Rs 300 crore). There are no restrictions on their activities in the capital market, leading to enhanced market risk, and there are avenues for regulatory arbitrage which they can exploit.

Were these limitations waiting to be discovered by the Second Financial Stability Report before action could be taken, even though they were fairly obvious for so many years?

OFFSHORE BANKING UNITS

No one can fault the report for its comprehensiveness and analytical rigour. Still there are a few points that need to be highlighted. In the first place, there is no reference to the Offshore Banking Units (OBUs) that were set up a few years ago. Interestingly, even the Annual Report and the Report on Trend and Progress of Banking in India brought by the RBI are silent on this subject.

It seems as if OBUs don't exist. In the context of the recycling of unaccounted wealth from India to other countries and back, the importance of monitoring the transactions in OBUs can hardly be overemphasised. OBUs are offshore only in a conceptual sense. They are very much onshore in India.

Despite the advances in communication technology that has rendered distance meaningless, for a scamster it is more convenient to carry on his activities through OBUs in the country than those abroad, especially where collusion with the bank staff at a personal level is needed. The investigative agencies that go to tax havens and offshore financial centres like the Isle of Man to ferret out unaccounted transactions do not seem to be aware of OBUs in India. It is time that the RBI prepares and publishes a status report on OBUs in the country.

EXTERNAL ACCOUNT

On the external side, the Report notes the disturbing features as revealed by the proportion of short-term debt to total external debt, and the predominance of reversible inflows of capital. The comfort drawn from the absorptive capacity for foreign inflows through the expansion of current account deficit is misplaced. One can say that if there is a spurt in foreign direct investment, which is not the case now. Portfolio investment is predominant among capital flows. It serves no purpose except introducing volatility in the stock markets. When in the secondary market, portfolio investment does not add to capital formation, but results only in change of ownership of stocks.

The Report says: “…the comfortable capital adequacy position of the banks in India vis-à-vis Basel II norms means that the Basel III requirements, once fully calibrated, are not likely to be very much higher than the current position.”

As Samuleson said, the fractional reserve system is a fair weather system. Many financial institutions with strong prudential standards failed in the past due to imprudent banking practices. There is nothing to save the system from collapse if it loses public confidence. Eternal vigilance is the price that the central bank has to pay for maintaining economic stability.

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