Financial Stability Report Highlights

The Reserve Bank of India's (RBI) Financial Stability Report (FSR) addresses potential challenges and forecasts related to the banking sector and economic growth.

Banking Sector Challenges

• Projected increase in bad loans and potential decline in capital buffers under stress scenarios.
• Concerns over microfinance and consumer credit stress.
• Sharp rise in write-offs among private sector banks could mask asset quality deterioration.
• Small finance banks face higher retail lending impairments, with a GNPA ratio of 2.7%.
• 50% of credit card and personal loan borrowers have other existing loans.
• Unhedged external commercial borrowings (ECBs) remain high at $65.49 billion (34.4% of total ECBs).
• Foreign currency borrowing by NBFCs poses currency risks if unhedged.

Economic Growth Projections

• Economy expected to grow by 6.6% in FY25.
• Growth aided by rural consumption, government investments, and strong service exports.
• Mutual funds have indicated their ability to withstand redemption pressures

Risk Factors

• Irrational market exuberance could be fueled by monetary easing and accommodative conditions.
• Cyberattack risks highlighted due to reliance on AI tools like ChatGPT.
• Potential risks from softened industrial activities, global spillovers, and protective trade policies.

Stress Test Scenarios

• Bad loan ratio could rise to 3% by March 2026, from 2.6% in September 2024.
• Capital adequacy ratio may decline to 16.5% in March 2026 under baseline, and further in high-risk scenarios.
• Key financial ratios for banks, insurance, and finance companies are expected to stay above regulatory requirements until 2026.

The report underscores the need for close monitoring of financial vulnerabilities and stresses the importance of maintaining economic resilience in the face of potential shocks.

Emerging Risks from AI in the Financial Sector

The Reserve Bank of India (RBI) has highlighted significant emerging risks associated with the increasing use and adoption of Artificial Intelligence (AI) in the financial sector.

Key Concerns

• Cyber Risks:
  • Generative AI may raise the risk of cyber threats, such as sophisticated phishing attacks using deepfakes.
  • The widespread availability of AI services, like ChatGPT, could potentially be exploited for cyberattacks.
• Financial Stability:
  • AI evolution and adoption pose risks to financial stability due to enhanced interconnectedness and reliance on shared technology and service providers.
• Market Risks:
  • AI adoption in capital markets may lead to increased market speed and volatility, especially under stress, due to highly correlated AI trading strategies.
  • Leverage-funded trades could amplify market stress through fire sales and feedback loops.
• Market Concentration:
  • Risks of market concentration within the financial sector and with third-party service providers of cloud and AI services are high.
  • High technological penetration and concentration can lead to nonlinear risk transitions, posing systemic risks.

Regulatory Response

The RBI urges regulators to update their skills and tools, adapting frameworks to address and mitigate emerging risks from AI technologies.

AI Regulation Committee

• An eight-member panel has been established by the RBI to develop a framework for the responsible and ethical use of AI.
• The committee will analyze current AI adoption in financial services and review global regulatory and supervisory approaches.
• Recommendations will include governance aspects for the responsible, ethical adoption of AI models in the financial sector.

Systematic Deregulation and Reform of Business Laws

The central government has urged states to implement a "systematic deregulation" or "line-by-line reform" of laws, aimed at simplifying the processes for businesses to open, run, grow, or exit. This initiative was discussed at the National Conference of Chief Secretaries held from December 13-15, with the aim to attract investments, create jobs, and stimulate growth.

Key Areas for Deregulation

• Restrictions on increasing women's employment.
• High electricity tariffs.
• Complex land and building zone/construction regulations.

Employment of Women

• The Centre recommends adopting zero prohibition regimes for working women, similar to countries like Vietnam, Philippines, Malaysia, and Singapore.
• Bihar prohibits women from working at night, while states like Karnataka, Maharashtra, and Telangana allow it conditionally.
• Women are barred from certain industries deemed "dangerous," impacting their potential income.

Regulatory Standards and Industry Expansion

• Rigid zoning laws and worker schedules are seen as hindrances compared to more flexible standards in countries like Japan and South Korea.
• Examples of stringent regulations include minimum road width requirements for factories and parking space regulations.
• Industrial buildings in India lose about 50% of land due to stringent building standards.

Hostel and Power Tariff Regulations

• Restrictions on setting up worker hostels vary across states, with some like Bihar not allowing them at all.
• The industrial power tariff in states like Telangana and Maharashtra is significantly higher than the cost of supply, increasing operational costs.

Administrative Challenges

• "Arbitrary" administrative actions and lack of representation and redressal mechanisms are identified as key issues.
• Short duration validity of 'No Objection' certificates for fire safety and absence of third-party certification are concerns.

Phased Approach to Deregulation

Phase 1

• Reduce compliance burden to save time and cost.
• Streamline system and process flow.
• Digitisation of processes.
• Provide incentives to key sectors.

Phase 2

• Liberalise standards and controls to improve feasibility.
• Set legal safeguards for enforcement.
• Reduce tariffs and fees for government utilities.
• Use risk-based regulation involving third parties.