Excess global liquidity poses risks to India's financial stability: RBI report

The Indian economy is increasingly being subjected to the risks of excess liquidity that has been building up in the global system, even as global growth remains subdued, the Reserve Bank of India (RBI) said in its financial stability report released today.

"The risks, which have been building up over the last five years of excess liquidity in the global system are now surfacing. The markets, especially, in emerging economies need to be prepared for spells of high volatility and uncertainty going ahead," RBI said in a report prepared by the Financial Stability Development Council (FSDC).

The report specifically refers to the US Federal Reserve's indication of a tapering of its bond buying programme, commencing later this year, that has led to large scale sell-offs in foreign exchange, bond and equity markets, especially in emerging markets.

For India, a high current account deficit and its non-disruptive financing have emerged as major challenges from the perspective of the country's macroeconomic stability, RBI said.

The recent fall in inflation and significant fiscal consolidation have provided some relief, it noted.

The performance of Indian corporate sector has been sluggish and in the emerging scenario, the increased external borrowing and un-hedged foreign exchange exposures of corporates may further increase their vulnerabilities, the central bank said.

The risks to the banking sector have increased marginally since the publication of the last FSR in December 2012.

Tight liquidity and deteriorating asset quality, especially since December 2012,  have combined to increase the risks to the stability of the banking system over the period, RBI said, adding that the asset quality of SCBs has, however, recorded marginal improvement in the March 2013 quarter.

The risks to the banking system also stems from its high degree of connectivity with asset management companies, insurance companies and non-banking finance companies (NBFCs).

The report points to a significant degree of 'seasonality' in the performance of banks on the parameters of credit, deposit, and asset quality during the last quarter of the financial year.

Banks with higher leverage were observed to have lower risk-weight-asset density. Globally, this trend is observed when banks graduate to an internal ratings based (IRB) approach under Basel II, RBI noted.

"Stress tests results indicate that if the current macroeconomic conditions persist, the credit quality of commercial banks could deteriorate further. However, the comfortable position on the banks' capital adequacy front lends resilience," RBI said.

It also said that in the life insurance byusiness, a major part of the new business premium in is from single-premium policies with rising ticket size and the potential risks of payouts cold be enormous.

Regarding the the many defined benefit pension fund schemes currently under implementation as well as newly announced (mostly in the government sector), RBI said the large payout for longer periods could be a potential source of fiscal stress.

While the financial sector regulators of major economies have signed a memorandum of understanding (MoU) for co-operation in the field of consolidated supervision and monitoring of financial groups identified as financial conglomerates, the emerging inconsistencies in regulatory approach and a tendency towards home-bias in some of the major jurisdictions, while implementing reforms, may affect the functioning of international as well as domestic financial markets, RBI pointed out.

RBI said regulators in India have been proactive in implementing a framework for regulating the practice of algorithmic trading and steps have been taken to address the risks from erroneous trades. Market regulator Securities and Exchange Board of India (SEBI) is examining the risks from algorithmic and high frequency trading with the aim of providing greater equality and fairness to participants who do not use co-location services, it added.

The latest Systemic Risk Survey of the RBI conducted during April-May 2013 revealed that global risks and domestic macro-economic risks were perceived to be the two most important factors affecting the stability of Indian financial system.