Copyright thehindubusinessline
The spate of proposed RBI regulatory reforms has generated extensive commentary. One group sees a bright new beginning; another easing that may invite a future crisis; a third group continuing restrictive excess caution. But these views miss two aspects. First, the continuity with the path of gradual liberalisation for the financial sector started in the 1990s. There were some steps backwards, but also many forward, depending on the circumstances of the time. Second, the financial sector is prone to excess volatility and over-leverage. But the design of Indian regulation includes many simple prudential rules that enable broad coverage and create incentives to restrain these and other flaws. Therefore the current detailed rules and high risk-weights result in over-regulation and can be safely relaxed towards a better mix. We illustrate these arguments with respect to easing for banks and NBFCs and the external debt deregulation. Aligning with Basel norms The 1990s made it clear that a controlled financial structure was unstable. Gradual market-friendly reforms were initiated, aiming for a shift from micro intervention to a strategy of macro management. But the RBI’s view was that there are more risks in emerging markets (EMs) so stronger and multiple regulations are required. Moving to global best practices has to match greater financial sector maturity. For example, since capabilities and data-bases had to be built for accurate own-risk assessment, only the standardised Basel Pillar 1 was adopted, but with more stringent capital adequacy requirements and risk-weights as well as other measures such as provisioning, exposure limits and conservative gain-loss accounting norms. But the rise in NPAs in 2010s led to a return of detailed multiple rules in a kitchen sink approach to regulation that threw everything at it. Bank, NBFC and corporate balance sheets, however, have recovered and are robust today as entities turned risk averse. Ongoing reforms such as strengthening bankruptcy and credit recovery processes, corporate governance, boards, customer protection, disclosure and analyst assessment with listing helped. Post-pandemic strength surprised analysts as well as regulators. Moreover, all financial regulators are participating in the government reform drive to simplify regulations and reduce transaction costs of doing business. Past mission creep can be seen in the 9,000 regulatory circulars RBI plans to repeal and consolidate into 238. These largely involve aligning with Basel by reducing risk-weights towards international Pillar-1 values as well as setting a path towards Pillar II forward-looking own risk assessment with the move to expected credit loss (ECL) from the current incurred-loss-based provisioning framework, subject to prudential floors and updated principles of income recognition. But actual capital to risk-weighted assets ratio (CRAR) is about 3 per cent above the regulatory levels, so the regulatory reduction will affect allocation more than aggregate credit. Advanced economy (AE) banks that were on Pillar II, underestimated own risk and over-leveraged, leading to the global financial crisis (GFC) in end 2000. Regulatory tightening that followed was largely focused on banks and on borrowers, not on entities, and has led to arbitrage towards shadow banks (NBFCs). Therefore, the AE financial sector is riskier than that of AEs. Most problems have shown up there. EM regulatory simplification is therefore warranted but has to retain measures to mitigate common financial sector hazards, such as pro-cyclical credit pushing, busts following booms, non-transparency and arbitrage, preferably through prudential mechanisms that improve incentives. Continuing reforms have many of the required features. India was a pioneer in using countercyclical provisioning, pre-GFC. This works even if there is excess CRAR. Unlike in AEs regulation is broad-based and covers NBFCs also. For example, the new draft consolidated regulation for NBFCs continue with a leverage cap of seven, that is, total outside liabilities divided by owned funds cannot exceed 7. Post-GFC Basel III imposed a leverage cap for the first time but too generous at 33.3. The leverage in Lehman Brothers was 30 and in Bear Sterns 33 when they collapsed. Therefore some relaxation in CRAR is acceptable. Risk-weights for MSME lending are reduced, but are subject to supervisory review. Supervisors now have live data and better analytical tools, enabling rapid response. For example in 2024, sectoral tightening helped deleverage multiple microfinance loan, and credit card loan pushing, without a crisis. New deal for foreign debt? The new external commercial borrowing (ECB) framework, expands eligible borrowers, gives companies flexibility on pricing, relaxes end-use restrictions, permits shorter tenors and simplifies documentation. All this will promote efficiencies in borrowing, but it does not imply an unrestricted opening or a flood of debt inflows. It is part of India’s sequenced move to capital account convertibility, where liberalisation in FDI and equity flows came first but was still gradual. Initial absolute caps on debt caps were slowly relaxed, then made a function of domestic market size. The current limit is 6 per cent. But even with no limit on the fully accessible route for investment in GSecs foreign debt remains about 2 per cent. The stock of foreign debt security liabilities has fluctuated around $100 billion since 2018. Inclusion in global indices led to inflows, but although the total was $130 billion in March 2025, as a share of foreign liabilities it was lower at 8.9 per cent compared to a peak of 11 per cent in 2018. Inflows were about half of market expectations. Just as domestic investment has made equity markets less volatile despite FPI equity outflows, debt flows of less than 10 per cent of domestic market size can be absorbed without macroeconomic stability issues. Indonesia, where share of foreign debt was 40 per cent at the time of the Taper Tantrum had to face large interest rate volatility. More debt is required, especially for green infrastructure, but there is room to absorb it safely in a deeper domestic market with greater maturity of institutions. So the risk weight on borrowings from eligible multilaterals is being reduced to zero from 20 per cent currently. Equity is expensive, debt or debt-equity structures can be relatively cheaper if there is macroeconomic stability. Indian risk premia have fallen with ratings upgrades. Freedoms in borrowing are coming under improved corporate governance and balance sheet strength. Past liberalisations have not led to unmanageable inflows. Firms will make careful commercial decision on ECBs, factoring in hedging costs, since the rupee is flexible. Domestic banks can also now finance mergers and acquisitions. More flexibilities hedged with better incentives, will only make Indian finance, and those it serves, more efficient. It will not lead to over-borrowing since regulations are being simplified, largely by reducing earlier over-strictness, not by easing too much. Simpler, easier to understand structures help shift compliance beyond just ticking boxes. Movement continues along a well-defined path. But identifying the ideal regulatory mix and better coordination of sectoral with aggregate tightening is still work in progress. The writer was a member of the previous MPC Published on November 4, 2025
