UPSC Editorials : Easing Banking Regulations in India

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

Introduction

• India’s GDP is projected to grow from $3.7 trillion (2023-24) to $7 trillion (2030-31), backed by strong fiscal policies, robust digital and physical infrastructure, and financial sector expansion.

• However, to sustain this growth, higher capital expenditure (capex) and increased credit flow are essential.

• The current regulatory framework for banks, including Statutory Liquidity Ratio (SLR), Liquidity Coverage Ratio (LCR), Cash Reserve Ratio (CRR), and Priority Sector Lending (PSL), restricts credit availability, making a case for easing banking regulations.

The Need for Increased Investments

• Capital Requirement for a $7 Trillion Economy

• To achieve a $7 trillion economy, India needs $2.5 trillion in investments, requiring an investment-to-GDP ratio of 34%. The government’s fiscal deficit limits public investment, making private and household savings crucial for capital formation. Private sector investment has declined, with the investment-to-operating cash flow ratio falling from 114% (2008-09) to 56% (2023-24).

• To achieve a $7 trillion economy, India needs $2.5 trillion in investments, requiring an investment-to-GDP ratio of 34%.

• The government’s fiscal deficit limits public investment, making private and household savings crucial for capital formation.

• Private sector investment has declined, with the investment-to-operating cash flow ratio falling from 114% (2008-09) to 56% (2023-24).

Challenges in Financial Intermediation

• The Declining Role of Banks in Capital Mobilization

• Banks now receive only 40% of household savings, down from 50% a few years ago, as consumers prefer mutual funds and pension schemes for better returns. High pre-emptions reduce banks’ lendable resources, pushing up interest rates and discouraging corporate and MSME borrowing.

• Banks now receive only 40% of household savings, down from 50% a few years ago, as consumers prefer mutual funds and pension schemes for better returns.

• High pre-emptions reduce banks’ lendable resources, pushing up interest rates and discouraging corporate and MSME borrowing.

• The Burden of Regulatory Pre-emptions

• Banks must hold up to 30% of deposits as non-lendable reserves due to: SLR (26%) – Higher than the regulatory requirement of 18%, due to LCR constraints. CRR (4%) – No interest earned, further limiting bank liquidity. This reduces credit supply and increases borrowing costs, slowing economic expansion.

• SLR (26%) – Higher than the regulatory requirement of 18%, due to LCR constraints.

• CRR (4%) – No interest earned, further limiting bank liquidity.

• This reduces credit supply and increases borrowing costs, slowing economic expansion.

• Impact of New LCR Guidelines for Digital Deposits

• Upcoming LCR norms for digital deposits will require banks to invest an additional 2-2.5% of deposits in liquid assets, reducing lending capacity further.

Rethinking Banking Regulations: Do We Need Both LCR and SLR?

• Global Best Practices vs. India’s Approach

• Globally, only LCR is mandatory, while India imposes both LCR and SLR, leading to excessive capital retention in low-yield assets.

• In most countries, CRR (which earns no interest) is included in High-Quality Liquid Assets (HQLA), but India excludes it, reducing bank profitability.

• Basel III norms recommend that banks assess their liquidity needs independently, yet RBI’s rigid regulations create compliance burdens.

Addressing Liquidity Challenges

• Limited Access to Credit for MSMEs

• Large corporates access capital through equity markets, bond markets, and bank credit, but MSMEs face credit shortages.

• Priority Sector Lending (PSL) targets exceed 60%, leading to mispricing of credit risks.

• The PSL framework must evolve to reflect new economic priorities and current GDP composition.

Credit Growth and Exchange Rate Management

• Credit Growth Lower than Nominal GDP Growth

• India’s credit growth lags nominal GDP growth, raising concerns about capital formation and financial stability. The credit-to-deposit (CD) ratio must be re-evaluated, ensuring banks can raise debt and equity efficiently.

• India’s credit growth lags nominal GDP growth, raising concerns about capital formation and financial stability.

• The credit-to-deposit (CD) ratio must be re-evaluated, ensuring banks can raise debt and equity efficiently.

• Exchange Rate Management and Liquidity Impact

• Defending the rupee against the strong dollar drains liquidity without stabilizing the currency in real terms. Overvaluation of the rupee reduces export competitiveness, impacting trade balance and forex reserves.

• Defending the rupee against the strong dollar drains liquidity without stabilizing the currency in real terms.

• Overvaluation of the rupee reduces export competitiveness, impacting trade balance and forex reserves.

Way Forward

• Revisiting SLR and LCR mandates to free up bank liquidity and lower lending costs.

• Encouraging private-sector investment through policy stability and demand stimulation.

• Updating PSL norms to reflect India’s evolving economic structure.

• Ensuring credit growth aligns with nominal GDP growth to sustain investment-led expansion.

• Deepening capital markets and reducing regulatory barriers for bond market growth.

• Aligning digital banking costs with international fee models to maintain financial viability.

Conclusion

• India stands at a critical juncture in its financial evolution. With progressive banking reforms, better financial intermediation, and improved liquidity management, the banking sector can drive India’s transformation into a $7 trillion economy.

Practice Question:

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)