Source: Reserve Bank of India
Source: Reserve Bank of India
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Vinit Sheth
1/8/2023

Resilience of the Indian Financial System

India's economic growth story has been nothing short of remarkable since its economic liberalisation in 1991 with the real annual GDP growth averaging at about 6-7% during the years.
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Even as its neighbours and peers have struggled in the recent years, India has continued to attract global attention and investment and emerged as the world's fifth largest economy. Consequently, developments in India have substantial implications both globally and regionally, with potential spillover effects through international trade and global supply chains. The Indian Financial Sector plays a vital role it its development and has anchored the strong economic growth over the past three decades.

However, over the last few years, the Indian economy has experienced multiple shocks – the credit crunch following the tightening of banking regulation (2014-15), defaults of non-banking financial companies (NBFCs) in 2018-19 and the Covid-19 pandemic. In the present turbulent times as the global economy braces itself for the new-reality of high-interest environment, the resilience of its financial system becomes a critical question for the country’s future development

Evolution and Challenges of India's Financial System

India’s financial system has grown in line with its economy. It has also undergone multiple changes, reflected in the growth of NBFCs and market-based financing. Even still, the Public Sector Banks (PSBs) continue to dominate the financial system, accounting for 60% of total bank assets. The credit expanded significantly in the 2000s to support infrastructure investments and growing corporate spending. Following the global financial crisis, even as credit growth among private sector banks and foreign banks decelerated significantly, the credit growth continued amongst the PSBs. Governance lapses in infrastructure projects led to a credit misallocation problem, significantly increasing the risk of stressed assets in PSBs. This phenomenon is commonly referred to as 'loan evergreening' or 'zombie lending'. Under-capitalized banks rolled over loans to large, struggling borrowers to avoid declaring them as non-performing assets (NPAs)

Recognizing the severity of this challenge, the Reserve Bank of India (RBI) made addressing the NPA problem a top priority in 2014-15, culminating in a pivotal development known as the asset quality review (AQR), which was a regulatory exercise aimed at identifying and rectifying discrepancies in loan classification by banks, ultimately revealing significant underreporting of NPAs and leading to a sharp decrease in public bank lending.

Following the AQR and subsequent credit crunch by the PSBS, the less regulated NBFCs grew rapidly, resulting in about 30% credit growth (for NBFCs) especially to Micro, Small and Medium Enterprises (MSMEs). The default of Infrastructure Leasing & Financial Services (IL&FS), a systemically important NBFC, in August 2018 resulted in a shock to the growing sector and further negative spillover to the rest of financial system and economy. The subsequent default of Dewan Housing Finance Corp. Limited (DHFL) deepened worries about the entire financial system's cross-exposures to troubled NBFCs and the real estate sectors.

Reforms to restore Financial Health before Covid-19

In response to the challenges in the banking sector, the Government of India initiated banking sector reforms and provided capital injections into Public Sector Banks (PSBs) to address the issues. The Banking Reforms Roadmap, unveiled in January 2018, was centred around six key themes, which included bolstering PSBs, enhancing credit supply, and promoting financial inclusion. The improvement in NPAs and capital adequacy ratios resulted in five out of the 11 PSBs successfully exit the RBI’s corrective action framework, in 2018/19. Additionally, during this period, 10 PSBs were merged into four, effectively reducing the number of PSBs from 27 in 2017 to 12 in 2023. 

RBI has been proactively implementing measures to enhance the regulation and supervision of NBFCs. In 2014, the regulatory framework underwent revisions to streamline and fortify the prudential norms. As part of this framework, NBFCs that accept public deposits and systematically important non-deposit taking NBFCs are subjected to stringent prudential regulation and supervision. The central bank published guidelines to enhance liquidity risk management for all NBFCs in 2019. The implementation of a new scale-based regulatory framework, which has brought the regulation of NBFCs closer to that of banks, particularly for the 25-30 largest institutions.

Policy Response to Covid-19

In response to the Covid-19 pandemic, the Indian authorities implemented a wide range of measures to fortify the economy. To bolster the system, the RBI injected liquidity and incentivized banks to channel surplus funds into the NBFC sector. Monetary policy actions, interest rate cuts, and measures to improve policy rate transmission were also taken. Moreover, significant macro-financial support and supervisory actions were implemented, including cleaning up the NBFC sector, providing relief to MSMEs through loan restructuring, strengthening regulation and supervision, and restructuring public sector banks. These measures were instrumental in strengthening the financial system and ensuring its continued functioning even in the face of unprecedented challenges.

The fortification of India's financial system pre-pandemic proved crucial when the global banking sector faced disruptions in 2023. Even as several western banks collapsed, the Indian financial system demonstrated resilience, partly due to prevalence of local currency-based debt (70% of corporate debt is Indian Rupee dominated) and rest due to the proactive repair and restructuring initiatives. This is further demonstrated in India’s retail inflation fell to a 2-year low of 4.25% in May 2023, and its last interest rate hike was in February 2023 when the RBI raised interest rate to 6.5%. India's financial system is witnessing a significant shift towards market-based financing, with the bond market becoming more attractive to international investors. The potential inclusion of Indian bonds in global indices could bring in substantial passive inflows, similar to the experience of China. Although foreign bond holdings are currently modest, there is room for rapid growth. Furthermore, the corporate debt market, accounting for about 18 percent of GDP, offers ample opportunities for further development. On the equity front, India's market capitalization has surged, making it the world's fifth-largest equity market, surpassing the UK and Canada. These trends highlight the increasing importance of market-based financing and signal India's attractiveness as an investment destination for both domestic and global investors.

The source of the statistics and the inspiration of the blog is IMF’s book ‘India’s Financial System - Building the Foundation for Strong and Sustainable Growth’ published In July 2023 and ‘The past and future of Indian finance’ by Ruchir Agarwal

By Vinit Sheth, who has completed work experience at the Money Maze Podcast. Vinit is a second year Master’s in Management student at ESCP Business School. He is enthusiastic about sustainability and global geopolitics. He has worked as an intern with the investment team for a sustainable infrastructure fund. With further contributions from Oliver Bodmer and Celine Basma of the Money Maze Podcast Team.

All content on the Money Maze Podcast is for your general information and use only and is not intended to address your particular requirements. Money Maze Podcast content, including this article, is funded by third party advertising only. We do however offer paid-for content on other shows in our network. Full disclaimer here.

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