In the two decades since India started liberalizing its economy in 1991, it has improved supervision and regulations in the country. This helped India escape from the 2008 financial crisis relatively unscathed. However, despite the progress made so far, the Indian financial sector still confronts barriers to growth as well as challenges to stability. In the short term, financial system vulnerabilities can be easily circumvented. However, over the medium to longer term challenges still remain and the issue needs to be addressed. Besides, certain regulations put in for the safety of the financial system, may actually also be hampering growth.
The International Monetary Fund (IMF) recently released its Financial System Stability Assessment Update and questioned the role of the Indian government in the financial sector. The center owns big financial institutions such as the public sector banks, which control 70% of the Indian banking sector. The state also directs credit to certain priority sectors, controls the range of permitted activities and the availability of foreign capital. According to the IMF, this contributes to a build-up of fiscal contingent liabilities and creates a risk of misallocation of capital that may constrain economic growth. According to the agency, if the mandatory holding of government securities could be reduced it could help in proper allocation of capital. Plus greater access to both domestic and foreign sources of capital can help in improving the balance sheets of these financial institutions. Basel III norms, which are expected to be implemented over the next few years, require banks to bolster their capital base and limited access to capital can prove problematic. Plus, there should be more room for private initiative in order to increase financial inclusion in the country, in terms of tapping poor borrowers.
The IMF also questioned the Reserve Bank of India (RBI's) use of the banking system rather than government programs in meeting needs of priority sectors - agriculture, small and micro credit, education, health. It believes that the RBI, in its supervisory role should pay more attention to being prepared for the next crisis, contingency planning for the insurance and payments system, and stronger resolution powers. Overall, while the Indian central bank is doing a good job of regulating the sector, maybe the government can do a better job in allocation of capital.