As the European Central Bank’s (ECB) President Christine Lagarde highlighted, “The effectiveness of monetary policy is intrinsically tied to the evolving structure of the economy,” which has faced unprecedented global disruptions: the worst pandemic since the 1920s, the biggest conflict in Europe since the 1940s, and the worst energy crisis since the 1970s. These shocks have reshaped the global economy, affecting monetary policy and financial system resilience.
There are additional shocks to deal with. High and growing global debt amid slower growth has deepened the sovereign-bank nexus and heightened vulnerabilities, so debt markets are challenging for broker-dealers to navigate. Rising private leverage has created credit quality and rollover risks.
Financial innovations like cryptocurrency and electronic banking are also reshaping financial landscapes, while banks face shrinking balance sheet space for market intermediation.
With advanced countries dropping interest rates, central banks face the potential for powerful new inflationary forces that would exacerbate trade-offs with growth. A surge in global liquidity following recent moves by the US Federal Reserve, ECB and China could further complicate these dynamics.
Basel standards and regulatory reform: The adoption of Basel III has strengthened global risk management frameworks. In India, the Reserve Bank of India (RBI) has mandated compliance, including stress testing and counterparty risk assessments. However, oversight gaps persist in the sector of non-banking financial intermediaries, which often show weak rule compliance.
Recent financial crises in the US and Switzerland underscored vulnerabilities due to oversight failures, an unwillingness to escalate supervisory concerns and the risk of regulators being co-opted by banks.
Moreover, a trend of ‘gold-plating’ Basel standards for large banks, but not for smaller lenders, as seen in recent US bank failures, has created systemic risks.
While India has made strides in regulating banks, gaps likely remain in the oversight of non-banks—which includes a mix of asset management firms, mutual funds and fintech entities.
And regulators face challenges in gathering comprehensive data on this sector’s complex interconnections through securities lending. Cryptocurrency and private credit require a more comprehensive regulatory approach to manage emerging risks.
Stress testing: India’s crisis management framework has evolved significantly with the Financial Stability and Development Council playing a key role. RBI has expanded its stress-testing capabilities, including liquidity stress tests for major banks.
However, the Silicon Valley Bank (SVB) crisis in the US emphasized the need for adaptive stress tests that account for rapidly changing market conditions.
Mark-to-market practices for unrealized losses, as seen in SVB’s collapse, underscore why global liquidity standards must be updated. For systemic resilience, these should cover a broader range of institutions.
Treasury market vulnerabilities: This market is vital for monetary policy transmission. The rise in US debt, for instance, highlights vulnerabilities in liquidity provisioning during market stress.
India’s government securities market is also central to policy transmission, but relatively less liquid and vulnerable to shocks. Reforms could include enhanced transparency, expanding primary dealer roles and improving market infrastructure to support liquidity.
Cybersecurity: With rising digital transactions, this increasingly vital. However implementing global cybersecurity standards is hindered by a lack of harmonization across jurisdictions and high costs for smaller entities. India’s cybersecurity framework, led by CERT-In and supplemented by the National Cyber Security Strategy, is adapting to new threats.
Yet, greater coordination and stronger frameworks are essential. International cooperation is needed on this issue, but conflicting data privacy laws and geopolitical differences are complicating efforts to establish a unified global cybersecurity framework.
Credit allocation and misallocation: Credit flows to less productive firms remain a concern. India’s public sector banks (PSBs) dominate credit provision, but this often leads to capital misallocation. Evidence suggests that firms reliant on PSB credit have weaker productivity growth.
Reforms have addressed PSB bad loans. Going forward, further bank privatization, enhanced governance and stronger RBI supervisory powers—like its ability to replace PSB managements in cases of severe mismanagement—could reduce credit misallocation and enhance its efficiency. Strengthening private bank capitalization and governance are also crucial steps.
India’s financial sector is exposed to global shocks, rapid innovation and systemic vulnerabilities. To strengthen its financial system, India must bolster regulatory frameworks, crisis management and cybersecurity, and also address credit misallocation.
This will build resilience and help India navigate an increasingly complex global financial landscape, ensuring stability and sustained economic growth.
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