UPSC Editorial analysis: Recalibrating Banking Regulations for Sustained Growth

*General Studies-3; Topic: Indian Economy and issues relating to planning, mobilization of resources, growth, development and employment.*

Introduction

• India’s economy, currently valued at $3.7 trillion (2023-24), is projected to touch $7 trillion by 2030-31, propelled by fiscal discipline, infrastructure expansion, and financial sector growth.

• To maintain this momentum, robust capital expenditure and enhanced credit flow are imperative.

• However, stringent regulatory norms—such as the Statutory Liquidity Ratio (SLR), Liquidity Coverage Ratio (LCR), Cash Reserve Ratio (CRR), and Priority Sector Lending (PSL)—curtail banks’ lending potential, making the case for regulatory easing.

Rising Investment Needs

• Investment Requirement for a $7 Trillion Economy India must mobilize about $2.5 trillion in investments, implying an investment-to-GDP ratio of nearly 34%. With a limited fiscal space, the private sector and household savings must drive capital formation. Yet, private investment has weakened, as seen in the fall of the investment-to-cash-flow ratio from 114% (2008-09) to 56% (2023-24).

• India must mobilize about $2.5 trillion in investments, implying an investment-to-GDP ratio of nearly 34%.

• With a limited fiscal space, the private sector and household savings must drive capital formation.

• Yet, private investment has weakened, as seen in the fall of the investment-to-cash-flow ratio from 114% (2008-09) to 56% (2023-24).

Challenges in Financial Intermediation

• Shrinking Role of Banks

• Banks’ share of household savings has slipped from 50% to 40%, as savers turn to mutual funds and pension products for better returns. Excessive regulatory pre-emptions reduce lendable resources, raising interest costs and discouraging corporate and MSME borrowing.

• Banks’ share of household savings has slipped from 50% to 40%, as savers turn to mutual funds and pension products for better returns.

• Excessive regulatory pre-emptions reduce lendable resources, raising interest costs and discouraging corporate and MSME borrowing.

• Burden of Mandatory Reserves

• Banks keep nearly 30% of deposits locked in non-lending instruments: SLR (26%) – higher than mandated 18% due to LCR obligations. CRR (4%) – earns no interest, further straining liquidity. The outcome: reduced credit supply, higher borrowing costs, and slower economic expansion.

• SLR (26%) – higher than mandated 18% due to LCR obligations.

• CRR (4%) – earns no interest, further straining liquidity.

• The outcome: reduced credit supply, higher borrowing costs, and slower economic expansion.

• Digital Deposit Norms

• The upcoming LCR norms for digital deposits will compel banks to park an extra 2–2.5% of deposits in liquid assets, further shrinking their lending capacity.

Do We Need Both LCR and SLR?

Global Perspective

• Worldwide, only LCR is required, but India enforces both SLR and LCR, locking excess funds in low-yield securities.

• Many countries count CRR as High-Quality Liquid Assets (HQLA), but India excludes it—hurting bank profitability.

• While Basel III allows banks to self-assess liquidity risks, RBI’s rigid norms increase compliance costs and limit operational flexibility.

Liquidity Bottlenecks and MSME Credit

• Unequal Access: Large corporates tap equity and bond markets, but MSMEs rely solely on banks, facing persistent credit scarcity.

• PSL Constraints: With PSL exposure exceeding 60%, credit risk is often mispriced, affecting efficiency.

• The PSL framework must evolve to reflect changing sectoral priorities and India’s diversified GDP composition.

Credit Growth, Exchange Rate, and Liquidity

• Credit Growth Lag

• Bank credit growth trails nominal GDP, undermining capital formation and financial depth. The Credit-Deposit (CD) ratio must be reassessed to ensure efficient debt and equity mobilization.

• Bank credit growth trails nominal GDP, undermining capital formation and financial depth.

• The Credit-Deposit (CD) ratio must be reassessed to ensure efficient debt and equity mobilization.

• Exchange Rate Pressure

• Defending the rupee against a strong dollar drains liquidity without ensuring stability. Overvaluation of the rupee hurts export competitiveness, worsening trade balances and foreign-exchange reserves.

• Defending the rupee against a strong dollar drains liquidity without ensuring stability.

• Overvaluation of the rupee hurts export competitiveness, worsening trade balances and foreign-exchange reserves.

Way Forward

• Revisit SLR and LCR mandates to free bank liquidity and lower lending rates.

• Encourage private investment through predictable policies and demand-side incentives.

• Revise PSL targets to match emerging economic realities and growth sectors.

• Ensure credit expansion aligns with nominal GDP to sustain the investment cycle.

• Deepen capital markets and ease regulations for corporate bond growth.

• Rationalize digital banking charges in line with global fee structures for long-term viability.

Conclusion

• India’s banking system stands at the threshold of transformation.

• Progressive reforms, enhanced financial intermediation, and balanced liquidity management can unlock credit potential and ensure that banking remains the growth engine of India’s journey toward a $7 trillion economy by 2030-31.

India aims to become a $7 trillion economy by 2030-31. Discuss the role of banking sector reforms in achieving this target. Suggest measures to improve credit availability while ensuring financial stability. (250 words)