RBI releases its second financial stability report

RBI released its second FSR. This one is a must read for its excellent analysis and graphs.

Here is a broad summary:

The second FSR holistically assesses, from a systemic risk perspective, disparate elements of the financial sector eco-structure – the macroeconomic setting, policies, markets, institutions. The movements of various vulnerabilities between March and December 2010 and assessment of the resilience of the financial system have been presented in this Report. It also reflects the considerable efforts made within the Reserve Bank to upgrade the methods and techniques for assessing the health of the financial system in identifying and analysing potential risks to systemic stability.

According to the Report, growth has rebounded strongly in the Indian economy while financial conditions remained stable since the publication of the first Financial Stability Report (FSR) in March 2010. The financial sector in India remained stress-free notwithstanding intermittent volatility, especially in equity and foreign exchange markets. This is also displayed by the Financial Stress Indicator for India, which was introduced in the first FSR. Financial institutions remained healthy, credit offtake has picked up, as has profitability, especially in the first half of 2010-11. The Banking Stability Index points to a healthy improvement in the stability of the banking sector over the past few years. This is corroborated by the results of a range of stress tests undertaken by the Reserve Bank.

The Report points at some discernible soft spots. The current account deficit is widening while capital flows continue to be dominated by volatile components. External sector ratios have deteriorated, fiscal conditions are still under pressure and inflationary pressures persist. Liquidity conditions tightened beyond the Reserve Bank’s comfort level and some policy measures have recently been taken to alleviate the stress. Some issues in the financial market microstructure will need to be addressed. Asset quality of banks and their asset-liability management position continue to warrant monitoring. Regulatory gaps in the non-banking financial sector will need to be plugged. A robust macro prudential framework for identification of systemic risks will need to be set up. Convergence with the emergent international reforms agenda presents challenges and will require careful calibration.

Referring to some tail risks to financial stability, the Report states that they are largely exogenous given the increasing correlation between global growth and that in Emerging Market Economies(EMEs), including India. The finance channel has assumed greater importance increasing the pace and degree of contagion from disturbances abroad, it states. Similarly, business cycle synchronisation of the Indian economy with most of the advanced economies and other EMEs has increased. With both financial and real sector still under stress in advanced economies, India will have to guard against vulnerabilities arising from risks to global growth and financial stability.

I am going through it. I see RBI raising risks on housing prices, CCIL as a central counterparty, twin deficits etc.

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