The banking system has recently shown signs of moderate rise in instability due to increase in non-performing assets (NPAs), the Reserve Bank has said in a working paper.

"The movements in the banking stability indicator...that there are symptoms of a moderate rise in instability of the banking sector in recent periods perhaps due to the rise in the NPA," it said in a working paper on Banking Stability - A Precursor to Financial Stability.

The NPAs, or bad loans, of the Indian banking sector rose sharply to 1.28 per cent in 2011-12 from 0.97 per cent in the previous year, because of high interest rate and slowdown in the global economy.

For public sector banks, it rose to 1.53 per cent in 2011-12 from 1.09 per cent a year ago. Though private lenders reduced their NPAs to 0.46 per cent from 0.56 per cent. 

The paper said there is a need to exert precautionary measures to improve the overall performance of the banking sector and initiate regulatory measures appropriately. 

It said policymakers will need to work towards strengthening the banking sector to enable the banks to bear
the shocks resulting from an adverse turn in the real sector environment.

Also, it said there is a need to build enough safeguard in the banking sector to avoid the negative feed-back loop between the banking sector and the real sector which could lead to the germination and aggravation of a financial crisis.

Referring to the recent global economic crisis that began in 2008-09, the paper said, "the real act of the financial crisis was enacted in the courtyard of the banking sector where the trigger of financial crisis initially took place."

However, concerted efforts are being made by various organisations such as the IMF, BIS and World Bank as well as individual central banks to evolve various leading indicators of the financial stability, including banking sector, in order to make an informed judgement about the evolving risks to the financial system and initiate corrective policy measures.

The paper also observed that banking instability has immediate adverse effect on the financial markets stability as well as real sector output.

"...stability in the banking sector is a necessary condition for maintaining financial stability," it added.

It further said deterioration in the banking stability indicator has adverse impact on the real sector and similarly deceleration in the real sector performance will adversely affect banking sector.