India’s Financial System Resilient, But Reforms Needed: IMF report

Nonbank financial institutions (NBFIs)—especially nonbank financial companies (NBFCs) providing credit with wholesale financing—and market financing have grown, making the financial system more diverse and interconnected. The role of the state has diminished, yet it remains significant, including in using the financial system to pursue social and public finance goals.

India’s financial system has demonstrated remarkable resilience and diversity, recovering from past distress episodes and weathering the Covid-19 pandemic effectively, according to the International Monetary Fund’s (IMF) Financial Sector Assessment Program (FSAP) report. The report, underscores the progress made in strengthening the financial sector while identifying areas for improvement to ensure long-term stability and growth.

Resilience and growth

The report highlights that India’s financial system has become more robust since the last FSAP in 2017. Nonbank financial institutions (NBFIs), particularly nonbank financial companies (NBFCs), have expanded their footprint, contributing to a more interconnected and diverse financial ecosystem. Stress tests conducted by the IMF reveal that banks and NBFCs are generally resilient to severe macrofinancial shocks, with sufficient aggregate capital to support moderate lending even under adverse scenarios.

However, public sector banks (PSBs) remain vulnerable, with some requiring additional capital to sustain lending during economic downturns. The report also flags concentrated exposures in NBFCs, particularly to the power and infrastructure sectors, as a potential systemic risk. These sectors, which were a source of distress in 2016, continue to face structural challenges, compounded by climate transition risks.

Climate change risks

The report notes that financial stability risks from climate change are manageable but require careful monitoring. Banks’ exposures to monsoon-dependent agriculture and carbon-intensive industries, such as the coal-dependent power sector, pose moderate risks. While the impact of climate change on India’s economic growth is projected to remain moderate until the 2040s, the risks increase significantly toward the end of the century.

The IMF recommends enhancing climate risk analysis tools and integrating climate-related financial risks into systemic risk monitoring. It also suggests that India adopt more progressive transition paths to mitigate economic costs while addressing concentrated exposures in vulnerable sectors.

Policy recommendations

The IMF provides a comprehensive set of recommendations to strengthen India’s financial sector oversight and resilience:

Systemic risk monitoring: Authorities should collect granular data on household credit risks, liquidity indicators, and climate-related exposures. A centralized risk dashboard and periodic systemwide risk assessments are essential to manage inter-sectoral contagion and uneven climate impacts.

Capital buffers: The IMF advises building countercyclical capital buffers (CCyBs) to support faster recovery during downturns. While India’s CCyB is currently set at zero, the report suggests starting to build releasable buffers under favorable macroeconomic conditions.

Regulatory reforms: The report calls for aligning regulations for state-owned NBFCs with private-sector standards, eliminating exemptions from large exposure limits. It also recommends strengthening the independence and powers of regulators, particularly over state-owned institutions.

Crisis management: Finalizing and enacting the Financial Sector Development and Regulation (Resolution) Bill is critical to establishing a modern resolution regime. The IMF emphasizes the need for clear resolution triggers and comprehensive frameworks for voluntary and involuntary liquidation.

Digital and financial inclusion: The report highlights the success of India’s digital public infrastructure, such as the Unified Payments Interface (UPI), in improving financial inclusion. It recommends further development of digital lending platforms and credit enhancement tools to address underserved sectors.

Insurance sector challenges

The FSAP also assesses India’s insurance sector, noting significant growth in premiums and assets. However, structural solvency challenges persist among state-owned general insurers, with three operating below minimum solvency ratios despite government capital injections. The IMF recommends transitioning to a risk-based solvency regime and supervisory approach by 2025.

The report identifies gaps in corporate governance, particularly in state-owned insurers, and calls for clearer separation between board oversight and management functions. It also urges the Insurance Regulatory and Development Authority of India (IRDAI) to extend its powers over state-owned insurers and develop group-wide supervision frameworks.

Cybersecurity and emerging risks

India’s cybersecurity framework for banks is well-established, but the IMF suggests extending it to nonbanks and conducting cross-sectoral crisis simulations. The report also highlights the need for enhanced supervision of emerging risks in securities markets, including mutual fund stress tests and conduct risk analysis.

Authorities’ response

Indian authorities welcomed the IMF’s recommendations, emphasizing ongoing reforms to strengthen governance and promote financial inclusion. The IRDAI highlighted recent measures, such as mandating independent directors to chair critical committees, as steps toward improving corporate governance.

Looking ahead

India’s financial sector stands at a crossroads, with opportunities to leverage its resilience and diversity for sustainable growth. The IMF’s recommendations provide a roadmap for addressing vulnerabilities, enhancing oversight, and aligning policies with international standards. As India continues to navigate global economic uncertainties and climate challenges, implementing these reforms will be crucial to ensuring long-term financial stability and inclusive development.

This report underscores the importance of proactive measures to safeguard India’s financial system while fostering innovation and growth. With strong macroeconomic fundamentals and a commitment to reform, India is well-positioned to strengthen its financial sector and achieve its vision of becoming a global economic powerhouse.