The Indian financial sector, which weathered the credit crisis, faces headwinds as easy policies to avert the disaster led to some excesses, although stress tests show reasonable degree of resilience.

Rising bad loans, asset-liability mismatch at banks, widening current account deficit, hot-money flow, and fiscal deficit are among many factors that could shake the system, the Reserve Bank of India said.

Some soft-spots are discernible, the central bank said in its second Financial Stability Report. The current account deficit is widening while capital flows continue to be dominated by volatile components. External sector ratios have deteriorated, fiscal conditions are still under pressure, and inflationary pressures persist.

While the Indian banking system showed strength during the 2008 financial crisis unlike the developed nations, the easy policies adopted globally during the crisis are beginning to cause stress in the system. Gross domestic product growth is expected to be 9%, thanks to monetary and fiscal stimulus, but that has led to steep climb in commodity prices, record high overseas fund flows, surging government spending and some careless lending by banks for infrastructure projects.

Asset quality continued to pose some concerns as the growth in NPAs outstripped growth in advances, said the 126-page report. The maturity profile of deposits, advances and investments of banks indicates concentration of shorter-term deposits as against deployment of credit in the medium- to long-term tenure implying presence of inherent structural mismatches.

In the last two years, banks that get deposits ranging from 1-3 years have lent to roads, power plants and ports building, which take 5-7 years to yield returns. This practice, though it did not exert pressure on the system for two years since demand from other businesses was low, is beginning to stress banks that are forced to replace those low-cost funds at higher rates. Deposit rates have risen more than 3 percentage points this year.

Foreign fund flows, which touched a record $29 billion this year, though welcome for equity investors, has the potential to destabilise the markets when there is a reversal.

A potentially worrying feature of capital flows to India has been the dominance of portfolio flows and debt flows as compared to the more stable investment flows on gross basis, the RBI report said.

Increased borrowings by companies such as Reliance Industries and Axis Bank to exploit the interest arbitrage has led to the ratio between total external debt to foreign exchange reserves rising to levels not seen since the forex crisis in 1991, it said.

The two-track global recovery and divergent course of monetary policy actions have created push and pull factors for large capital inflows into emerging market economies, said the report. Such capital flows have the potential to create imbalances. They also leave the country vulnerable to sudden reversals.