Banking system at risk of financial contagion, says RBI

Reserve Bank of India (RBI) warned in a report on Monday that close ties between lenders would leave the domestic banking system especially vulnerable to contagion in case of trouble at a single institution.

That means trouble at a single bank among the top five most connected lenders in the country could lead to contagion that wipes out nearly 50 per cent of Tier-I capital in the banking system under a severe stress scenario, the RBI said in its semi-annual Financial Stability report.

"This underscores the importance of monitoring not just interconnectedness, but also the counterparties and magnitude of exposure involved in the connection," the central bank said.

The RBI did not identify the top five banks used for its study. However, the apex bank said its stress tests involved conditions such as potential failure by a bank that is either a net lender, a net borrower, or both.

The central bank also used money markets as one of its variables for stress tests as banks frequently lend to each other in short-term maturities.

The country's non-banking financial firms (NBFC) also pose a risk to the banking system due to their close ties with banks, the RBI warned in the report.

This so-called shadow-banking system is worth $190 billion in the country, ranking it third largest among BRICS (Brazil, Russia, India, China and South Africa) group of countries and 15th in the world, the Reserve Bank said.

Turning to other risks in the domestic financial system, the apex bank highlighted the need for "closer examination" of the practice of promoters who pledge a substantial portion of company shares to get loans.

Overall, however, the RBI noted it expected the level of bad levels to steadily come down, estimating the ratio of gross non-performing loans to total assets would decline to 4 per cent by March 2016 from 4.5 per cent at the end of September 2014 under its baseline scenario.

But under its "severe stress" scenario that ratio would rise to around 6.3 per cent by March 2016, the central bank said.

Turning to economic indicators, the RBI report said the central bank expects consumer price inflation to hover around 6 per cent in the next 12 months if global crude prices remained steady and monsoons normal.

The apex bank has a target of bringing retail inflation down to 6 per cent by March 2015.

The RBI also expects the domestic economy to grow 5.5 per cent in the ongoing financial year ending March 31, 2015 and then slowly pick up momentum in the following year.

(Reuters)