NBFCs, offshore banking units and the predominant share of

portfolio investment in capital flows are potential threats to financial

stability.

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.

Foreign portfolio capital inflows are typically volatile

and require watchful management'.

Large capital flows into India can create imbalances in the near term if they
exceed the absorption capacity of the country, according to the second financial
stability report released by the Reserve Bank of India.

“The two-track recovery in global growth and divergent paths of monetary

policy measures between advanced and emerging economies has increased the
risk of large and auto-correlated capital inflows with the potential to create
imbalances in Indian financial markets, especially if they exceed the country's
absorption capacity”, the report said.

Large capital flows potentially create imbalances in the near term especially
when, in the absence of large and deep capital markets, incremental growth in
absorption capacity fails to match the pace of flows, the RBI said.

Transmission of shocks

The report observed that transmission of shocks from the global economy to the
domestic economy gets heightened due to the presence of foreign banks.

“The transmission of shocks from advanced economies is accentuated by the

presence of international banks through affiliates. While the presence of these
banks has benefits in terms of enhanced efficiency, liquidity provision, risk-
sharing, and overall superior growth opportunities, it also enhances the ease of
transmission of global shocks to the domestic economy, for example through
volatilities in cross-border lending”, it said.
The RBI pointed out that the worrying feature of capital flows to India is the
dominance of portfolio flows and debt flows as compared to the more stable
investment flows.

Volatile portfolios

“Foreign portfolio capital inflows (gross) constituted more than half of all
capital inflows last year. Such capital is typically volatile and requires watchful
management”, the report said. Dominance of volatile portfolio flows could
destabilise domestic financial markets as there may be an outflow due to
external shocks.

The RBI says that they are no easy options to managing excessive capital flows
and emerging markets such as India face the usual dilemma of the impossible
trinity.

Though capital controls for capital account management can help in cherry
picking of flows, they can be circumvented. In the Indian context, a
combination of price, end-use restrictions and quantity based measures have
been calibrated to tackle such flows, the report said.

Article 2:
NEW DELHI: A worried government has put on fast
track the proposed bill to regulate micro-lenders, as it
seeks to ensure that over-regulation by states does not
kill the sector that is envisaged to play a big role in
furthering financial inclusion.

The finance ministry could move a bill in the winter

session of Parliament that will make Nabard responsible
for regulation of all non-profit microfinance institutions
structured as trusts, cooperatives, or mutual benefit
societies.

“Finance minister Pranab Mukherjee has put the bill on

priority list for winter session,” a finance ministry
official told ET.

At present, micro-lenders follow the relevant sector law,

depending on the way they are structured. The new law
will treat microfinance as a separate business and will
also consider bringing non-banking finance companies
in the microfinance sector under the ambit of the
legislation. The decision to fast-track the bill follows the
October 15 ordinance, or emergency law, issued by
Andhra Pradesh that imposed severe restrictions and
debt restructuring obligation on lenders following a
spate of suicides that were blamed on coercion by
micro-lenders to recover their dues.