Indian economy faces near-term risks of worsening bank asset quality and pressures on systemic liquidity, an International Monetary Fund report has said.
The Indian financial system is becoming more complex, with inter-linkages across institutions and borders, the report 'India: Financial System Stability Assessment Update', based on figures available till February 2012, said.
"The main near-term risks to the financial system are a worsening of bank asset quality and renewed pressures on systemic liquidity," the report said.
"However, stress tests did not reveal near-term stability concerns, suggesting the banking system would be resilient to a range of adverse shocks," it added.
India has made remarkable progress towards developing a stable financial system but confronts a build-up of financial sector vulnerabilities, it said.
The areas for improvement include greater de jure independence of regulatory agencies, consolidated supervision of financial conglomerates and reductions in the large exposures and related-party lending limits in banks.
The report also listed stronger valuation and solvency requirements in insurance, and the monitoring of corporations' compliance with reporting, auditing, and accounting requirements for issuers as areas for improvement.
It also added that the regulatory and supervisory regime for banks, insurance, and securities markets is well developed and largely in compliance with international standards.
The prominent role of the state in the financial sector contributes to a build-up of fiscal contingent liabilities and creates a risk of capital misallocation that may constrain economic growth, the report said.
Gradually reducing mandatory holdings of government securities by financial institutions, and allowing greater access to private (domestic and foreign) sources of capital, would provide more room for the financial sector to intermediate funds towards productive economic activities, thereby improving prospects for sustained growth.
The report said that 'steps are needed to promote deeper fixed income markets, including a prudent reduction in banks' minimum statutory holdings of government bonds in line with evolving international liquidity requirements'.
"Use of capital markets to refinance infrastructure loans would help alleviate pressures on banks," it said.
According to the IMF report, the multiple roles of Reserve Bank of India create the potential for conflicting goals.
RBI officers are nominated as directors on the Boards of public banks, while at the same time RBI serves as the prudential supervisor of these banks, it said.
It would be preferable for the government to focus on policies that ensure the appointment of well-qualified, independent Board members that are not from the RBI, it said.
"And while there may be some synergies, RBI's role as monetary authority, bank regulator, and government debt manager may have led it to require banks to hold larger holdings of government debt than might be needed on prudential grounds.
Finally, using the banking system rather than government programmes in meeting the needs of priority sectors (agriculture, small and micro credit, education, health) and underserved areas may conflict with RBI's supervisory role," the report said.
In light of its commitment to retain the public sector character of state-owned banks, the government needs to consider how to manage its ownership in ways that are compatible with the public banks prudently financing a rapidly growing economy, the IMF said.
To perform competitively, banks need the flexibility to attract top notch financial talent, innovate, enhance risk management, and build-up capital.
Public ownership should not impose obligations or restrictions that limit banks' ability to remain competitive and sound, it said.