The recent monetary policy statement from the Reserve Bank of India reflected the change in the thought process of the banking regulator regarding the transient nature of inflation. The Ukraine crisis has aggravated the already existing supply chain problems, resulting in a spiralling increase in commodity prices globally. Inflation is usually a function of three factors – rising demand vis-à-vis supply, reduced supply with the demand being the same and inflation expectations. Any change in one of these variables invariably results in a change in inflation.
What the world is experiencing today is inflation due to supply chain bottlenecks and falling demand due to an uncertain external environment, which in economic terms refers to stagflation. Stagflation is what atleast the world economy is experiencing at large, while the same may not be entirely true for India. However, a high-yield external environment is expected to be a reality. For a world, that has been used to low yields, this is going to be a big change to deal with. The financial services ecosystem globally is structured today to live in a low-yield world and this change towards high yields will possibly create new financial stability risks. Balancing this financial stability risk in a high-interest environment is a big task in front of the regulator.
Some of the key financial stability risk scenarios that the regulator and the financial services ecosystem could take into consideration are:
- Exposure to Foreign Currency Loans – Foreign currency loans were in high demand due to the low yields present globally. A change towards a higher yield structure will result in foreign currency loans no longer being cheaper and a depreciating rupee will only increase the liability further. Portfolio monitoring frameworks within banks would need to focus on this and identify stresses before they are blown out of proportion.
- Liquidity risk within NBFCs – Given that the key source of funding for the NBFCs is bank loans, a rising cost of funding with slow credit growth in the economy. This can potentially disrupt the liquidity position of the NBFCs. Banks will specifically need to monitor the exposure to NBFCs closely, to ensure that the liquidity crisis does not translate into a solvency crisis.
- Assessing the contagion effects – An NBFC crisis can clearly express itself in an unfavourable manner in the capital markets, with the debt papers (a source of market-based borrowings for the NBFCs) losing value and for the investors to lose their savings parked through the various asset management vehicles. The banking regulator will need to continue to work jointly with the capital markets regulator to closely monitor and mitigate such contagion effects.
- Evaluating credit lines to the fintech ecosystem – The fintech ecosystem has been flush with investments on account of cheap capital and as capital becomes expensive, there is going to be a rise in fintech companies, who would go out of business on account of poor fiscal discipline. Credit lines to fiscally undisciplined fintech would need to be evaluated closely by the lenders to identify stresses proactively.
- Deteriorating governance culture – It is usually during times of uncertainty that the governance culture deteriorates significantly, for want of showing superior performance. This could potentially increase instances around window dressing, frauds, diversion of funds, evergreening and so on. Strengthening the governance culture within the governance functions of the organizations is going to be a key focus for the market participants and the regulator alike. While there is enough being done on the same, the momentum needs to be maintained consistently for it to significantly yield results.
While there can be many more scenarios that can impair financial stability risks, it’s been my attempt to highlight some key risks that we have seen play out over the past one and a half decades. History may not repeat itself in the exact same way, but history rhymes. A strong focus on governance culture is the way the regulators globally have been responding to an uncertain environment and a similar focus from the regulator in India would help mitigate this risk greatly.