As the COVID-19 outbreak has caused unprecedented uncertainties and exposed the country’s financial system to vulnerability, the Reserve Bank of India (RBI) has asked lending institutions to conduct periodic “Covid stress tests” on their balance sheets to always remain alert and take timely action to raise capital and mitigate the risk as the economic outlook remains uncertain in the medium term.
RBI Governor Shaktikanta Das on Saturday said, “While the multi-pronged approach adopted by the RBI has provided a cushion from the immediate impact of the pandemic on banks, the medium-term outlook is uncertain and depends on the COVID-19 curve.”
“Policy action for the medium-term would require a careful assessment of how the crisis unfolds. Building buffers and raising capital will be crucial not only to ensure credit flow but also build resilience in the financial system,” he said.
He said RBI has advised all banks, non-deposit taking NBFCs (with an asset size of ₹5,000 crore) and all deposit-taking NBFCs to “assess the impact of COVID-19 on their balance sheet, asset quality, liquidity, profitability and capital adequacy for the financial year 2020-21.”
“Based on the outcome of such stress testing, banks and non-banking financial companies have been advised to work out possible mitigating measures including capital planning, capital raising, and contingency liquidity planning, among others. The idea is to ensure continued credit supply to different sectors of the economy and maintain financial stability,” he said.
Mr. Das was delivering the keynote address “Indian Economy at a Crossroad: A view from Financial Stability Angle” at the 7th SBI Banking & Economics Conclave organised by the State Bank of India through a video link.
He said going forward certain stress points in the financial system would require constant regulatory and policy attention to mitigate the risks.
“The economic impact of the pandemic – due to lock-down and anticipated post lock-down compression in economic growth – may result in higher non-performing assets and capital erosion of banks. A recapitalisation plan for PSBs and private banks (PVBs) has, therefore, become necessary,” he said.
He said under the current context, redemption pressure on NBFCs and mutual funds need close monitoring. Increasing share of bank lending to NBFCs and the continuing crunch in market-based financing faced by the NBFCs and Housing Finance Companies (HFCs) also need to be watched carefully.
Mr. Das said the minimum capital requirements of banks, which are calibrated based on historical loss events, may no longer be considered sufficient enough to absorb the losses in the present circumstances.
“Meeting the minimum capital requirement is necessary, but not a sufficient condition for financial stability. Hence, it is imperative that the approach to risk management in banks should be in tune with the realisation of more frequent, varied and bigger risk events than in the past,” he said.
He said the supervisory approach of the RBI would be to further strengthen its focus on developing financial institutions’ ability to identify, measure, and mitigate the risks.
“The new supervisory approach will be two-pronged – first, strengthening the internal defences of the supervised entities; and second, greater focus on identifying the early warning signals and initiate corrective action,” he said.
Stating that higher emphasis is being given on identifying causes of weaknesses than on symptoms, he said the symptoms of weak banks were usually poor asset quality, lack of profitability, loss of capital, excessive leverage, excessive risk exposure, poor conduct, and liquidity concerns.
“These different symptoms often emerge together. The causes of weak financial institutions can usually be traced to one or more of the following conditions: inappropriate business model, given the business environment; poor or inappropriate governance and assurance functions; poor decision-making by senior management; and misalignment of internal incentive structures with external stakeholder interests,” he said.
He said the thrust of the approach is, to improve the risk, compliance, and governance culture amongst the financial institutions. He said in commercial banks there needs to be separation of ownership from management.
He said the apex bank has further enhancing its off-site surveillance mechanism. “The objective of the off-site surveillance system would be to ‘smell the distress’, if any, and be able to initiate pre-emptive actions. This requires use of market intelligence inputs and on-going engagements with financial institutions on potential vulnerabilities,” he said.
“The off-site assessment framework, which takes into account macro and micro variables, is more analytical and forward looking and aimed at identifying vulnerable sectors, borrowers as well as supervised entities,” he added.
He said in a possibly vastly different post-COVID-19 global environment, reallocation of factors of productions within the economy and innovative ways of expanding economic activity could lead to some rebalancing and emergence of new growth drivers.
“The policy measures, i.e., monetary, fiscal, regulatory and structural reforms, provide the enabling conditions for a speedier recovery in economy activity while minimising near-term disruptions,” he added.
Stating that the need of the hour is to restore confidence, preserve financial stability, revive growth and recover stronger, he said the central bank would strive to maintain the balance between preserving financial stability, maintaining banking system soundness and sustaining economic activity.
“Post containment of COVID-19, a very careful trajectory has to be followed in orderly unwinding of counter-cyclical regulatory measures and the financial sector should return to normal functioning without relying on the regulatory relaxations as the new norm,” he said.
Emphasizing that the Reserve Bank is making continuous assessment of the changing trajectory of financial stability risks and upgrading its own supervisory framework to ensure that financial stability is preserved, Mr. Das urged banks and financial intermediaries to be ever vigilant and substantially upgrade their capabilities with respect to governance, assurance functions and risk culture.