Guarding the financial system

Govt, RBI must work on improving supervision

Reserve Bank of India (RBI) Governor Shaktikanta Das is reported to have been questioned by the central bank’s board members about frauds in the banking system. The central bank needs to answer a lot of such questions after the latest scam involving Punjab & Maharashtra Co-operative (PMC) Bank. The management of the bank was manipulating records for years, but the wrongdoing came to light only after the bank on its own disclosed the matter to the regulator. Regrettably, PMC is not an isolated incident where the RBI failed to live up to expectations. The deficiency in oversight is also evident from the current state of the Indian financial system. The fact that the RBI had to issue a statement assuring the public that the banking system is safe shows that the credibility of the system has been somewhat dented. The financial system functions on trust and it is incumbent on the RBI and other financial regulators to make sure that the system works smoothly. A lack of trust in the system can affect financial intermediation, impeding the flow of savings to the productive sectors of the economy.

To minimise financial stability risks, the government and the banking regulator would have to work at multiple levels. For one, it is important to see to it that financial institutions adhere to the best governance standards. To ensure this, the regulator itself will have to build adequate institutional capacity. It is possible that there will be some rogue elements who would want to game the system, but the regulator should be in a position to nab them in time — sadly, it has been found wanting on this in several cases. Clearly, the RBI needs to improve its audit processes for both banks and non-banking financial companies. Failure on this count can put the entire financial system at risk.

Further, despite all the regulatory safeguards, some financial institutions would still fail in a functioning market economy. Thus, India needs a framework to handle the insolvency of financial institutions. As reported by this newspaper on Thursday, the government is reviewing the Financial Resolution and Deposit Insurance Bill. The Bill was withdrawn in August last year, owing to concerns about the “bail-in” clause. Recent developments in the financial sector have provided a good opportunity to come up with a comprehensive framework, as India clearly does not yet have a robust enough financial system to protect the common man’s savings. The government is also reported to be reviewing insurance cover for bank deposits. This is an important aspect and it is worth debating whether depositors should be made to take a hit at all in the case of a bank failure. In a banking system dominated by the public sector, the possibility of bank failures in the private sector and a potential hit for depositors can shift deposits to state-run banks. This would bode ill for the financial system and will increase financial stability risks. The present condition in the financial sector has exposed plenty of weaknesses in the system, which needs urgent attention. A strong and stable financial system is a necessary condition for higher sustainable growth.