Financial regulation more complex than other sectors as it ensures system stability: RBI Governor

Malhotra says financial institutions are interconnected in ways that non-financial entities rarely are, making the financial system highly sensitive to shocks. | Photo credit: Bloomberg

Delivering his second VKRV Rao Memorial Lecture at the Delhi School of Economics in New Delhi, the Governor on Thursday emphasized that financial regulation plays a crucial role in maintaining the health of the economy as a whole.

He stated: “Financial regulation is more complex and consequential than regulation in other sectors. It is not just about protecting individual consumers and promoting efficiency – although these are of paramount importance – but also about ensuring system stability.”

Malhotra said financial institutions are interconnected in ways that non-financial entities rarely are, making the financial system highly sensitive to shocks.

“When a bank fails, it has a cascading effect: depositors lose their savings, interbank markets freeze, lending contracts and payment systems falter,” he said. Such disruptions, he added, ripple into the broader economy and could ultimately trigger a systemic crisis. He pointed out that the 2008 global financial crisis in advanced economies (AEs) demonstrated this with devastating clarity.

The RBI Governor further explained that the inherent fragility of financial institutions adds to the regulatory challenges. Banks are active in the field of maturity and liquidity transformation, where they accept short-term deposits and provide long-term loans. While this function is economically valuable, it creates vulnerabilities that can quickly escalate during periods of uncertainty.

“A loss of confidence can lead to bank runs, turning liquidity problems into solvency crises within days,” he said. Unlike a manufacturing unit that can be temporarily shut down, a bank that faces a run must be resolved immediately to avoid contagion. Malhotra also highlighted the pro-cyclical and herd-driven nature of the financial markets.

During boom periods, risks are underpriced, credit conditions weaken, and asset bubbles emerge. Conversely, during recessions, lending declines precisely when it is most needed. This strengthening of business cycles, he said, makes financial markets markedly more volatile compared to most other sectors.

He emphasized that financial stability remains the “north star” for the Reserve Bank. Short-term growth that comes at the expense of stability, he warned, could lead to deeper long-term damage. He said financial instability could not only wipe out gains from high short-term growth but also make economic recovery slower and more worrying.

Defining financial stability, the Governor said it is a condition where the financial system, consisting of financial intermediaries, markets and market infrastructure, is able to withstand shocks and the unraveling of financial imbalances, thereby reducing the likelihood of disruptions that significantly hinder the allocation of savings to profitable investment opportunities.

Published on November 21, 2025