India's Financial Sector Reforms: Fostering Growth While ... Monthly Bulletin December 2007 2201...

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December 2007 2199

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India's Financial SectorReforms: Fostering Growth

While Containing Risk

Rakesh Mohan

I am honoured to be back at Yale whereI got my basic economics grounding fromJames Tobin, Bill Nordhaus, and RobertEvenson, among others. In all these years,this is my first lecture at Yale, so I amparticularly pleased to have thisopportunity. Thank you ProfessorSrinivasan.

The turmoil in international financialmarkets since late July this year and theincreased uncertainty that financial marketsare currently experiencing have broughtissues relating to financial sector stabilityto the fore. In some ways, the recentdevelopments are unprecedented in theiroccurrence and in terms of the emergingmagnitude of financial sector losses. Thesudden loss of confidence among traditionalcounterparties reflects extreme informationasymmetry arising from the complexlayering of risk diffusion and highleveraging; and the breakdown of riskassessment by reputed rating agencies andthe like. The speed of contagion and theextensive involvement of large, reputed andregulated financial institutions are indicativeof regulatory shortcomings, which has thennecessitated unconventional responses ofcentral banks. All this has raised seriousconcerns relating to the ability and flexibilityof national financial systems to withstandshocks emanating from such unusualdevelopments. It has also spurred somereconsideration on some aspects ofmonetary policy and of financial regulation,particularly as they relate to themaintenance of financial stability.

India has so far remained relativelyinsulated from these developments and ourimpact analyses suggest that our exposureto troubled sub-prime assets and related

* Address by Dr.Rakesh Mohan, Deputy Governor, ReserveBank of India at Yale University on December 3, 2007.Assistance of Michael Patra, Muneesh Kapur and IndranilBhattacharya in preparing the speech is gratefullyacknowledged.

India's Financial SectorReforms: Fostering GrowthWhile Containing Risk*

Rakesh Mohan

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India's Financial SectorReforms: Fostering GrowthWhile Containing Risk

Rakesh Mohan

derivatives is negligible in comparison tomany other economies. Whereas this maybe regarded by some as fortuitous, it isperhaps our nuanced approach to financialsector reform and development that hasserved us well; our approach has beenmarked by conscious gradualism with theimplementation of coordinated andsequenced moves on several fronts that arepredicated on the preparedness for changeof the financial system in particular, and ofthe economy in general. We have also builtin appropriate safeguards to ensurestability, while taking account of theprevailing governance standards, riskmanagement systems and incentiveframeworks in financial institutions in thecountry. Overall, these progressive butcautious policies have contributed toefficiency of the financial system whilesustaining the growth momentum in anenvironment of macroeconomic andfinancial stability. Nevertheless, we in theReserve Bank are maintaining enhancedvigilance to be able to respond appropriatelyto the prevailing heightened uncertaintiesin global financial conditions. The policychallenge is to continue to ensure financialstability in India during this period ofinternational financial turbulence, whilemaintaining the momentum of high growthaccompanied by price stability.

Against this backdrop, I thought I wouldtake this opportunity to review India’sapproach to financial sector reforms, thepath we have traversed for over almost twodecades from a restrictive, even repressedpast, the nuances of our somewhatunorthodox approach to institutingcompetition and efficiency in financialintermediation and the challenges we face

in the development of our financial sectorin the years ahead.

II. Financial Sector Reforms andOutcomes

In retrospect, the key success offinancial sector reforms in India since theywere instituted in the early 1990s has beenthe maintenance of financial stabilitythrough a period marked by repeatedfinancial crises across the world. Theprocess of reforms is noteworthy not onlyfor the turbulence around its path but alsofor the sheer dimensions of the changeachieved from the position where westarted.

Until the beginning of the 1990s, thestate of the financial sector in India couldbe described as a classic example of“financial repression” (MacKinnon 1973;Shaw 1973). The sector was characterised,inter alia, by administered interest rates,large pre-emption of resources by theauthorities, extensive micro-regulationsdirecting the major portion of the flow offunds to and from financial intermediaries,relatively opaque accounting norms andlimited disclosure, and dominant publicownership. Compartmentalisation ofactivities of different types of financialintermediaries and strong entry barriersthwarted competition resulting in low levelsof efficiency and productivity and severecredit constraints on the private sector,especially in the absence of any access toexternal finance. Capitalisation levels werelow due to lack of commercial considerationsin credit planning and weak recovery culturewhich also resulted in large accumulation ofnon-performing loans. The predominance of

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evaluation of the financial sector reformsin terms of actual outcomes.

II.1 Monetary Policy

While assessing monetary policy, itwould be reasonable to assert that it hasbeen largely successful in meeting its keyobjectives in the post-reforms period sincethe early 1990s. Inflation has averaged closeto five per cent per annum in the decadegone by, notably lower than the average of7-8 per cent in the previous four decades. Structural reforms from the early 1990scoupled with improved monetary-fiscalinterface and reforms in the Governmentsecurities market enabled better monetarymanagement from the second half of the1990s onwards. A number of other factorssuch as increased competition, productivitygains and strong corporate balance sheetshave also contributed to this low and stableinflation environment, but it appears thatcalibrated monetary measures had asubstantial role to play as well. Moreimportantly, the regime of low and stableinflation has, in turn, stabilised inflationexpectations and the threshold level ofinflation tolerance in the economy has comedown significantly (Table 1).

It is encouraging to note that despite thehigh international crude oil prices, othercommodity prices and elevated food prices,inflation remains low and inflationexpectations appear to be consistent andstable. Consequently, both nominal andreal interest rates have fallen. Due to bothfinancial restructuring and low interestrates in recent years, the growth rate ininterest expenses of the corporates hasdeclined consistently since 1995-96; suchdecline has significant implications for the

Government securities in the fixed-incomesecurities market of India mainly reflectedthe captive nature of this market as mostfinancial intermediaries were mandated toinvest a sizeable portion of funds mobilisedby them in such securities to finance highGovernment borrowings at administered/concessional interest rates. In the capitalmarket, new equity issues were governedby a plethora of complex regulations andextensive restrictions with very littletransparency and depth in the secondarymarket trading of such securities.Comprehensive exchange control resultedin little depth in the foreign exchangemarket with most external transactionsgoverned by inflexible/low limits and priorapproval requirements. Monetary policywas subservient to the fisc. The provisionof fiscal accommodation through ad hoctreasury bills led to high levels ofmonetisation of fiscal deficit during themajor part of the 1980s. The expansionaryeffects of fiscal spending were sought to becurbed through interest rate regulations,credit rationing and high reserverequirements, effectively preventing thedevelopment of financial markets.

Elsewhere, I have attempted to documentthe various facets of India’s experience withfinancial sector reforms – the guidingobjectives and intellectual/analyticalunderpinnings; the choice of pace andsequencing; specific aspects of policymeasures for the banking sector, non-bankfinancial companies, term lendinginstitutions and other financialintermediaries; development of financialmarkets; and changes in the monetarypolicy framework (Mohan, 2004; Mohan,2006c). Today, I propose to undertake an


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improvement in bottom lines of thecorporate sector as a whole and theirresilience to financial shocks.

In terms of the monetary policyframework, India’s approach has beensomewhat unorthodox. Traditionally,central banks have pursued the twinobjectives of price stability and growth oremployment, while in recent years, greaterattention has been given to themaintenance of price stability throughinflation targeting regimes. Although thereis no explicit mandate for price stability inthe Indian context, the objectives ofmonetary policy in India have evolved asthose of maintaining a judicious balancebetween price stability and ensuringadequate flow of credit to the productivesectors of the economy. Considerations offinancial stability, however, have ascendedthe hierarchy of monetary policy objectivesin recent years in view of the increasingopenness of the Indian economy, financialintegration and the possibility of crossborder contagion. Accordingly, we believethat regulation, supervision anddevelopment of the financial system remain

within the legitimate ambit of overallmonetary policy broadly interpreted.

In the wake of financial sector reformsand opening up of the economy in the1990s, the Reserve Bank switched over in1998-99 to a multiple indicator approachwhereby macroeconomic and financialmarket data on both quantum and ratevariables are all examined, along withoutput, in framing monetary policy. Webelieve that the specific features of theIndian economy, including its socio-economic characteristics, make it necessaryfor the monetary authority to operate withmultiple objectives and indicators for sometime to come. A single objective formonetary policy, as is usually advocated,particularly in an inflation targeting (IT)framework, is a luxury that India cannotafford, at least over the medium term. Asregards IT, even though there has been anincrease in the number of central banksadopting IT since the early 1990s, a numberof central banks, notably the FederalReserve, retain multiple objectives.

Internationally, there is no unique oreven best way of monetary policy makingand different approaches or frameworks canlead to successful policies by adaptingappropriately to diverse institutional,economic and social environments (Issing,2004). Moreover, some evidence suggeststhat average inflation as well as its volatilityin prominent non-IT industrial countrieshas, in fact, been somewhat lower than thatin prominent IT industrial countries. IT isnot found to have any beneficial effect onthe level of long-term interest rates either(Gramlich, 2003; Ball and Sheridan, 2003).Furthermore, an IT framework reduces theflexibility available to a central bank in

Table 1: Growth and Inflation in India –A Historical Record

(Per cent)

Period (Averages) GDP Growth WPI InflationRate Rate

1 2 3

1951-52 to 1959-60 3.6 1.21960-61 to 1969-70 4.0 6.41970-71 to 1979-80 2.9 9.01980-81 to 1990-91 5.6 8.21991-92 (Crisis Year) 1.4 13.71992-93 to 1999-00 6.3 7.22000-01 to 2006-07 6.9 5.12003-04 to 2006-07 8.6 4.9

Source: Reddy (2007).

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reacting to shocks (Kohn, 2003). EmergingMarket Economies (EMEs) face additionalproblems in an IT regime. These economiesare typically more open and it exposes themto large exchange rate shocks which canhave a significant influence on short-runinflation. A boom-bust pattern of capitalflows can lead to substantial movements inexchange rates. EMEs may have to manageexchange rates more heavily since they aremore commodity-price sensitive thanadvanced economies and commodity pricefluctuations can wreak havoc with theforecastability of consumer price inflation(Eichengreen, 2002). An empiricalevaluation of the experience of EMEs thathave adopted IT confirms that IT is a morechallenging task in such economiescompared to developed economies that haveadopted IT. While inflation in EMEs wasindeed lower after they adopted IT, theirperformance was not as good as thatexperienced in developed IT countries.Deviation of inflation from its targets isfound to be larger and more common inEMEs (Fraga, Minella and Goldfaj, 2003).Inflation targeting by itself is not a sufficientcondition for success. In view of the above,the characterisation of inflation targeting as“the gold standard for stabilising monetarypolicy” is misleading. Indeed, in the recentepisode of financial market turmoil, evencentral banks with explicit inflationtargeting or price stability as thepredominant objective were forced to scaledown the emphasis on price stability,notwithstanding continued inflationarypressures. Such central banks had to injectliquidity and reduce policy rates – in somecases, holding back the earlier expectationsof tightening – as they had to lay greateremphasis on financial stability and growth.

The overall macroeconomic record ofthe Indian economy since the early 1990sindicates an acceleration in growth and asignificant reduction in inflation. Inflationhas averaged below 5 per cent in the currentdecade so far, substantially lower than thatof around 8 per cent in the preceding twoand a half decades. Pre-emptive monetaryand prudential measures have led to thiswelcome situation of a reduction ininflation and acceleration in growth whileensuring financial stability. Indeed, a cross-country comparison of major EMEs thathave adopted IT indicates that growth inIndia has been amongst the highest whileinflation remains relatively low (Table 2).Amongst the sample of G-20 and majorAsian countries, growth in India during2000-2007 was the second highest afterChina. Inflation in India during thecurrent decade has halved from thatprevailing during the 1990s and is, atpresent, lower than many developingeconomies. A recent survey by McKinseyand Company of CEOs across the world,in both developed countries and EMEs,found that among all the countriessurveyed, India had the highest proportionof CEOs, 40 per cent, who did not expectinflation to increase in coming years(McKinsey Quarterly, 2007). Thus, itwould appear that, at least, amongbusiness leaders, inflation expectations arewell-anchored in India. Although there hasbeen above average growth in monetaryand credit aggregates in the past 3-4 years,financial stability has been maintainedthrough a judicious use of monetary andprudential measures. Thus, the recentrecord of macroeconomic management inIndia is exemplary, even amongst theEMEs that target inflation. The challenge


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for monetary policy now is to reduceinflation further in the medium termtowards international levels, whilemaintaining the momentum of highgrowth and preserving financial stability.

II.2 Banking Sector

In the post-reform period, banks haveexperienced strong balance sheet growth inan environment of operational flexibility.Concomitantly, the financial health of bankshas improved significantly, both in termsof capital adequacy and asset quality.Moreover, this progress has been achieved

while setting the groundwork for theadoption of international best practices inprudential and accounting norms. Increasedcompetitiveness and productivity gainshave also been enabled by proactivetechnological deepening and flexible humanresource management. These significantgains have been achieved even whilerenewing our commitment to social bankingviz., maintaining the wide reach of thebanking system and directing credit towardsimportant but disadvantaged sectors ofsociety. The banking system’s wide reach,judged in terms of expansion of branches

Table 2: Real GDP Growth and Consumer Price Inflation: Cross-Country Comparison

(Annual Averages, per cent)

Real GDP Growth Consumer Price Inflation

Country 1990-1999 2000-2007 2003-2007 1990-1999 2000-2007 2003-2007

1 2 3 4 5 6 7

Developing Economies

Argentina 4.3 3.4 8.6 253.7 9.0 9.6Brazil 1.7 3.3 3.6 854.8 7.3 7.2China 10.0 9.9 10.6 7.8 1.7 2.6India 5.7 7.0 8.5 9.6 4.5 4.8Indonesia 4.3 5.1 5.4 14.4 8.7 8.6Korea 6.3 5.1 4.4 5.7 3.0 2.9Malaysia 7.2 5.4 5.9 3.7 2.0 2.2Mexico 3.4 2.9 3.2 20.4 5.2 4.1Philippines 2.8 5.0 5.6 9.7 5.0 5.3Russia -3.8 6.8 6.9 222.2 14.2 11.0South Africa 1.4 4.2 4.5 9.9 5.3 4.4Thailand 5.3 4.9 5.4 5.0 2.5 3.1Turkey 3.9 5.1 6.6 76.7 26.8 12.0

Developed Economies

Australia 3.3 3.3 3.3 2.5 3.2 2.7Canada 2.4 2.9 2.7 2.2 2.3 2.2France 1.9 2.0 1.8 1.9 1.9 2.0Germany 2.3 1.4 1.4 2.4 1.7 1.7Italy 1.4 1.3 1.0 4.1 2.4 2.3Japan 1.5 1.7 2.0 1.2 -0.3 -0.1United Kingdom 2.1 2.8 2.8 3.3 1.6 1.9United States 3.1 2.5 2.8 3.0 2.8 2.9

Source: World Economic Outlook Database, IMF.

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and the growth of credit and depositsindicates continued financial deepening(Mohan, 2006a).

On the liability side, deposits continueto account for about 80 per cent of the totalliabilities while on the asset side, the sharesof loans and advances and investments haveseen marked cycles, reflecting banks’portfolio preferences as well as growthcycles in the economy. In this regard, whilethe share of loans and advances declinedin the second half of 1990s on account ofthe industrial slowdown as well astightening of prudential norms, banks’credit portfolio has witnessed sharp growthin the period 2003-07.

The overall capital position ofcommercial banks has witnessed a markedimprovement during the reform period(Table 3). Illustratively, as at end-March2007, all 81 scheduled commercial banksoperating in India maintained CRAR at orabove 9 per cent relative to the Basel I normof 8 per cent. For the Indian bankingsystem, the ratio of capital to risk weightedassets works out to 13 per cent currently.While improved capitalisation of publicsector banks was initially brought through

infusion of funds by government torecapitalise these banks, subsequently,public sector banks were allowed to raisefunds from the market through equityissuance subject to the maintenance of 51per cent public ownership. As a result,ownership in public sector banks is nowwell diversified.

Despite tightening prudential norms interms of classification of non-performingassets, the resulting measured asset qualityof banks has improved considerably as theshare of non-performing loans (NPLs) (asratios of both total advances and assets) havedeclined substantially and consistentlysince the mid-1990s. In fact, the ratio ofnet NPLs to net advances at 1.0 per cent inIndia is now comparable to that of severaladvanced economies (Table 4). Improvementin the credit appraisal process, upturn ofthe business cycle, new initiatives forresolution of NPLs (including promulgationof the Securitisation and Reconstruction ofFinancial Assets and Enforcement ofSecurity Interest (SARFAESI) Act), andgreater provisioning and write-off of NPLsenabled by greater profitability, havecontributed to the reduction inincremental NPLs.

Table 3: Distribution of Commercial Banks According to Risk-weighted Capital Adequacy

(Number of banks)

End-March Capital Adequacy

Below 4 Between Between Above Totalper cent 4-9 per cent* 9-10 per cent @ 10 per cent

1 2 3 4 5 6

1996 8 9 33 42 922001 3 2 11 84 1002007 — — 2 79 81

* : Relates to 4-8 per cent before 1999-2000,@ : Relates to 8-10 per cent before 1999-2000.Source: Reserve Bank of India.


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Efficiency gains are reflected incontainment of the operating expenditureas a proportion of total assets (Table 5). Thishas been achieved in spite of largeexpenditures incurred by Indian banks in

installation and upgradation of informationtechnology and, in the case of public sectorbanks, large expenditures under voluntarypre-mature retirement of nearly 12 per centof their total staff strength.

Table 4: Non-Performing Loans (NPL) of Scheduled Commercial Banks

(Per cent)

End-March Gross NPL/ Gross NPL/ Net NPL/ Net NPL/Gross Advances Assets Net Advances Assets

1 2 3 4 5

1996-97 15.7 7 8.1 3.31997-98 14.4 6.4 7.3 3.01998-99 14.7 6.2 7.6 2.91999-00 12.7 5.5 6.8 2.72000-01 11.4 4.9 6.2 2.52001-02 10.4 4.6 5.5 2.32002-03 8.8 4.0 4.4 1.92003-04 7.2 3.3 2.8 1.22004-05 5.2 2.5 2.0 0.92005-06 3.1 1.8 1.2 0.72006-07 2.4 1.5 1.0 0.6

Source : Reserve Bank of India.

Table 5: Earnings and Expenses of Scheduled Commercial Banks

(Rs. billion)

Year Total Total Interest Total Interest Establish- Net InterestAssets Earnings Earnings Expenses Expenses ment Earnings

Expenses

1 2 3 4 5 7 8 9

1969 68 4 4 4 2 1 2(6.2) (5.3) (5.5) (2.8) (2.1) (2.5)

1980 582 42 38 42 27 10 10(7.3) (6.4) (7.2) (4.7) (1.7) (1.8)

1991 3,275 304 275 297 190 76 86(9.3) (8.4) (9.1) (5.8) (2.3) (2.6)

2000 11,055 1,149 992 1,077 690 276 301(10.4) (9.0) (9.7) (6.2) (2.5) (2.7)

2005 22,746 1,902 1,558 1,693 891 501 667(8.1) (6.6) (7.2) (3.8) (2.1) (2.8)

2006 25,865 2,208 1,854 1,962 1,072 592 783(7.9) (6.7) (7.0) (3.9) (2.1) (2.8)

2007 31,854 2,762 2,373 2,450 1,440 663 933(8.0) (6.9) (7.1) (4.2) (1.9) (2.7)

Note : Figures in brackets are ratios to total assets.Source : Reserve Bank of India.

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In consonance with the objective ofenhancing efficiency and productivity ofbanks through greater competition, therehas been a consistent decline in the shareof public sector banks in total assets ofcommercial banks. Nevertheless, publicsector banks appear to have responded tothe new challenges of competition, asreflected in their increased share in theoverall profit of the banking sector. Thissuggests that, with operational flexibility,public sector banks are competing relativelyeffectively with private sector and foreignbanks. Shares of Indian private sector banks,especially new private sector banksestablished in the 1990s, in the total incomeand assets of the banking system haveincreased considerably since the mid-1990s(Table 6).

Indian private sector banks, particularlynew private sector banks, have made rapidprogress in terms of increasing their incomeand asset size since the mid-1990s. In termsof branch expansion, the compound growthrate of private sector banks over the period2002-07 was almost three times that of allscheduled commercial banks and more thanfour times that of public sector banks (Table7). Among the private sector banks, the fourbig banks viz., Centurion Bank of Punjab,HDFC Bank, ICICI Bank and UTI/Axis bankhave experienced rapid branch expansion inthe range of 16-46 per cent per annum interms of compound growth rates. Whileprivate sector banks, as a group, haverecorded a compound growth of 24 per centper annum in their staff, public sector bankshave witnessed a decline in the staff strength

Table 6: Bank Group-wise Shares: Select Indicators

(Per cent)

Item 1995-96 2000-01 2004-05 2005-06 2006-07

1 2 3 4 5 6

Public Sector Banks Income 82.5 78.4 75.6 72.4 68.4Expenditure 84.2 78.9 75.8 73.0 68.9Total Assets 84.4 79.5 74.4 72.3 70.5Net Profit -39.1@ 67.4 73.3 67.3 64.6Gross Profit 74.3 69.9 75.9 69.8 64.1

New Private Sector Banks Income 1.5 5.7 11.8 14.4 17.8Expenditure 1.3 5.5 11.4 14.1 17.9Total Assets 1.5 6.1 12.9 15.1 16.9Net Profit 17.8 10.0 15.0 16.7 17.1Gross Profit 2.5 6.9 10.7 13.8 16.7

Foreign Banks Income 9.4 9.1 7.0 8.0 9.0Expenditure 8.3 8.8 6.6 7.4 8.3Total Assets 7.9 7.9 6.8 7.2 8.0Net Profit 79.8 14.8 9.7 12.5 14.7Gross Profit 15.6 15.7 9.0 12.2 14.6

@ : Public sector banks, as a group, had recorded net losses during 1995-96.Source : Reserve Bank of India.


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Table 7: Operations of Private Sector Banks: Progress

Item 2002-03 2003-04 2004-05 2005-06 2006-07 Compoundgrowth

(per centper annum)

(2006-07/2002-03)

1 2 3 4 5 6 7

No. of branches Centurion Bank of Punjab 62 63 77 242 279 45.6HDFC Bank 215 295 446 515 638 31.2ICICI Bank 392 419 515 569 713 16.1UTI Bank/Axis Bank 137 185 250 352 501 38.3All Private Sector Banks 5,592 5,950 6,453 6,813 7,363 7.1All Public Sector Banks 47,963 48,299 48,970 49,817 51,392 1.7All Scheduled Commercial Banks 53,768 54,474 55,669 56,893 59,031 2.4

No. of employees Centurion Bank of Punjab 945 1112 1,374 4,471 14,458 97.8HDFC Bank 4,791 5673 9,030 14,878 21,477 45.5ICICI Bank 11,544 13,609 18,029 25,384 33,321 30.3UTI Bank/Axis Bank 2,338 3,447 4,761 6,553 9,980 43.7All Private Sector Banks 59,374 81,120 90,530 110,505 139,285 23.8All Public Sector Banks 757,251 752,627 738,110 744,333 729,172 -0.9All Scheduled Commercial Banks 828,328 847,945 856,671 876,955 896,307 2.0

Net profits (Rupees billion) Centurion Bank of Punjab -0 -1 0 1 1 —HDFC Bank 4 5 7 9 11 31.0ICICI Bank 12 16 20 25 31 26.7UTI Bank/Axis Bank 2 3 3 5 7 36.1All Private Sector Banks 29 35 35 50 65 22.1All Public Sector Banks 123 16 154 165 201 13.1All Scheduled Commercial Banks 170 223 210 246 312 16.4

Deposits (Rupees billion) Centurion Bank of Punjab 28 30 35 94 149 51.3HDFC Bank 224 304 434 558 683 32.2ICICI Bank 482 681 998 1,651 2,305 47.9UTI Bank/Axis Bank 170 210 317 401 588 36.4All Private Sector Banks 2069 2,686 3,146 4,285 5,520 27.8All Public Sector Banks 10,794 12,268 14,365 16,225 19,942 16.6All Scheduled Commercial Banks 14,045 15,755 18,376 21,647 26,970 17.7

Advances (Rupees billion) Centurion Bank of Punjab 13 16 22 65 1,122 70.9HDFC Bank 118 178 256 351 470 41.4ICICI Bank 533 627 914 1,462 1,959 38.5UTI Bank/Axis Bank 72 94 156 223 369 50.5All Private Sector Banks 1,377 1,704 2,213 3,130 4,148 31.7All Public Sector Banks 5,493 6,327 8,542 11,063 14,401 27.2All Scheduled Commercial Banks 7,600 8,636 11,508 15,168 19,812 27.1

Note : Centurion Bank of Punjab was formed in October 2005 as a result of the merger of Centurion Bank withBank of Punjab. Data for Centurion Bank of Punjab for 2005-06 and 2006-07 reflect the data of the combinedentity, while that for the prior period pertain only to the Centurion Bank.

Sources : 1. Annual Accounts of Scheduled Commercial Banks, 1979-2004, Reserve Bank of India.2. A Profile of Banks, 2006-07, Reserve Bank of India.

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over the same period reflecting, inter alia,restructuring facilitated by greater use oftechnology and computerisation. In terms ofgrowth of capital and reserves and surplus,the new private sector banks experiencedannual growth in the range of 30-68 per cent,while deposits and advances have increasedby 32-51 per cent and 39-71 per cent,respectively. Net profits recorded a compoundannual growth of 27-36 per cent. In terms ofall these parameters, new private sector banksgrew much faster than the existing privatesector banks, as might be expected.

There has been some discussion inrecent times on the policy of branchlicensing of banks by the Reserve Bank ofIndia: that it could have restrictedcompetition and growth of new banks. These data exhibit the very high growthexperienced by the leading private sectorbanks and it is arguable whether there couldhave been much faster expansion withoutimpairing their prudential quality andintegrity of their balance sheets.

What is most encouraging is the verysignificant improvement in the productivityof the Indian banking system in terms ofvarious productivity indicators (Mohan,2006a). These improvements could bedriven by two factors: technologicalimprovement, which expands the range ofproduction possibilities and a catching upeffect, as peer pressure amongst bankscompels them to raise productivity levels.Here, the role of new business practices,new approaches and expansion of thebusiness introduced by the new privatebanks have been of the utmost importance.

To sum up, significant improvement inthe performance of public sector banks has

been witnessed over the past decade or so,facilitated by the phased introduction ofwide-ranging financial sector reforms sincethe early 1990s. Gradual introduction of bestinternational practices and norms,refinements in the supervisory practices,tightening of risk weights/provisioningnorms in regard to sectors witnessing highcredit growth, greater market disciplinebrought about by raising of capital from thecapital markets and listing on the stockexchanges, interest rate deregulation, andscaling down of statutory pre-emptions areamongst the key factors that have led tobetter performance. Concomitantly, greatercompetition has been induced in thedomestic banking sector by successfulintroduction of new generation private sectorbanks. Despite strong growth in balancesheets of the new banks, the banking systemhas exhibited remarkable stability. Althoughthere have been a few instances ofweaknesses in a few new private sectorbanks, pre-emptive measures in the form ofthe mergers of such banks with strongerbanks, or infusion of new capital and changein ownership, on a voluntary or involuntarybasis, have contributed to the strength of thedomestic banking system, engenderedconfidence in the depositors and enabledmaintenance of overall financial stability.Notwithstanding the substantialimprovement, the domestic banking systemwill need to be further strengthened to facegreater external competition andintroduction of financial innovations andfuller capital account convertibility.

II.3 Financial Markets

The most notable impact of financialsector reforms is clearly discernible in the


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development of various segments offinancial markets in India. The reformssince the early 1990s have led to a regimecharacterised by market-determinedinterest and exchange rates, price-basedinstruments of monetary policy, currentaccount convertibility, substantial capitalaccount liberalisation and vibrantgovernment securities and capital markets.Derivative instruments have beencautiously introduced in a phased manner,both for product diversity and, moreimportantly, as a risk management tool. Allthese developments have facilitated theprocess of price discovery in variousfinancial market segments.

There has been a significant increasein trading volumes and market liquidity(Table 8). Illustratively, average dailyturnover in the money market has increasedfrom Rs.427 billion in 1997-98 to over Rs.888billion by 2006-07. The operations under theliquidity adjustment facility (LAF) have

largely been able to steer overnight rateswithin the corridor set by the policy rates.Under the LAF, the Reserve Bank absorbs(reverse repo) as well as injects (repo)liquidity, depending upon the liquidityconditions and consistent with the overallmonetary policy stance. Changes in fixedreverse repo/repo rates set by the ReserveBank from time to time for the conduct ofLAF, under which the central bank conductsdaily auctions for the banks, have emergedas the main instruments for interest ratesignalling in the Indian economy.

Inter-bank turnover in the foreignexchange market has nearly quadrupledbetween 2000-01 and 2006-07 to Rs. 840billion. Average daily turnover in the foreignexchange market (inter-bank as well asmerchant) has increased from US $ 5 billionin 1997-98 to US $ 23 billion by 2006-07. Theexchange rate of the Indian rupee hasexhibited significant two-way movementsin the recent years. Efficiency in the foreign

Table 8: Depth of Financial Markets in India – Average Daily Turnover

(Rs. billion)

Year Money Market* Government Foreign Exchange Equity Market Equity MarketSecurities Market # (Cash (Derivative

Market Segment) ** Segment—NSE)

1 2 3 4 5 6

1991-92@ 66 4 n.a n.a. n.a.2000-01 427 28 212 93 0.12001-02 655 63 232 33 42002-03 768 71 242 37 182003-04 287 84 307 63 842004-05 385 48 400 66 1012005-06 600 36 564 95 1922006-07 888 49 840 118 298

* : Includes the call money, the notice money, the term money, the CBLO and the repo markets.# : Inter-bank turnover only.@ : Data for G-Sec and equity market relate to 1995-96.** : Include both BSE and NSE.n.a.: not available

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exchange market has also improved asreflected in the decline in bid-ask spreads.

In the government securities market, theissuance of long-term securities has enabledthe development of yield curve across 30-year maturity. In the government securitiesmarket, the drop in turnover in 2004-05 and2005-06 could be attributed to factors suchas ‘buy and hold’ tendency of the participantssuch as insurance companies, which nowhold a substantial portion of governmentsecurities, particularly those of longermaturities. Furthermore, certain regulatorychanges introduced in late 2004 allowingbanks to hold a larger proportion of theirinvestment portfolio in the “held tomaturity” (HTM) category reduced theproportion of portfolio used for trading,thereby affecting the magnitude of G-sectrading. The decline could also be attributedto the increase in interest rates over theperiod, which prompted banks and otherplayers to hold rather than trade, so as toavoid trading losses. To keep the marketsliquid and active, the Reserve Bank hasrecently allowed short selling in governmentsecurities among eligible participants, andtrading in the ‘when issued’ segment, butthese facilities have not seen much activityyet. Efforts are also on to increase liquidity

through the active consolidation of existingsecurities.

The derivatives market has also gainedvibrancy during the last couple of years. Thetotal notional principal amount outstandinghas more than trebled between March 2005and June 2007 led by a significant jump ininterest rate related contracts. Over thisperiod, while the notional amount underinterest rate related contracts quadrupled,that in foreign exchange contracts nearlytrebled (Table 9). Certain legislative changesin 2006 provided clear legal legitimacy toOTC derivative contracts, which wassomewhat ambiguous earlier.

The Government and the Securities andExchange Board of India along with theReserve Bank are taking steps to activate thecorporate debt market. As has beenexperienced elsewhere, among the variousfinancial markets, the corporate debtmarket is indeed the most difficult todevelop for a variety of reasons. Theexpansion of the pension fund andinsurance industries will progressivelyresult in the presence of a larger financialinvestor base, which will help in the overallexpansion of financial markets and inparticular the corporate debt market.

Table 9: Outstanding Derivatives: Notional Principal Amount

(Rupees billion)

S. No Description March 2005 March 2006 March 2007 June 2007

1 Foreign exchange contracts (outstanding) 13,013 17,285 29,254 37,6252 Forward forex contracts 12,487 15,286 24,653 32,0443 Currency options purchased 526 1,998 4,601 5,5814 Futures 732 1,430 2,290 2,0685 Interest rate related contracts 13,119 21,842 41,958 54,9986 Of which: single currency interest rate swaps 12,817 21,530 41,597 54,5907 Total -Contracts/Derivatives 26,864 40,558 73,502 94,691

Note: Data pertain to scheduled commercial banks.


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It is quite apparent that there exist well-functioning, deep, liquid, and well-integrated markets for bonds, currency andderivatives in India, contrary to what isoften asserted. The trading volumes havegenerally witnessed significant growth inthe various segments of the financialmarket. It is noteworthy that the increasein foreign exchange market turnover inIndia between April 2004 and April 2007was the highest amongst the 54 countriescovered in the latest Triennial Central BankSurvey of Foreign Exchange and DerivativesMarket Activity conducted by the Bank forInternational Settlements (BIS). Accordingto the survey, daily average turnover inIndia jumped almost 5-fold from US $ 7billion in April 2004 to US $ 34 billion inApril 2007; global turnover over the sameperiod rose by only 66 per cent from US $2.4 trillion to US $ 4.0 trillion. Reflectingthese trends, the share of India in globalforeign exchange market turnover trebledfrom 0.3 per cent in April 2004 to 0.9 percent in April 2007. In view of the above,comments that are often made regardingmissing financial markets are rathermisleading. Moreover, empirical evidencepoints towards greater market integration(Mohan, 2007c). A good deal ofdevelopment has indeed taken place in thegovernment securities market, the forexmarket, OTC interest rate derivatives andthe like. The corporate bond market isindeed in its infancy; and, more efforts haveto be made to develop various exchangetraded derivative markets.

It, however, needs to be recognised thatfinancial markets are often governed by herdbehaviour and contagion. Deregulation,liberalisation, emergence of financial

conglomerates and globalisation of financialmarkets pose growing risks to financialstability. In this regard, it needs to bestressed that volatility in currency and bondmarkets can have significantly more adverseemployment, output and distributionalconsequences compared to volatility inequity markets. Premature liberalisation ofmoney and bond markets can lead to largeand volatile capital inflows, which couldpotentially exacerbate complications formacroeconomic and monetary management.Furthermore, excessive fluctuations andvolatility in financial markets can mask theunderlying value and give confusing signals,as has happened in developed markets,thereby hindering efficient price discovery(Mohan, 2006c). As large segments ofeconomic agents in India may not haveadequate resilience to withstand volatilityin currency and money markets, the ReserveBank’s policy approach has been to beincreasingly vigilant and proactive to anyincipient signs of volatility in financialmarkets.

Notwithstanding the progress madesince the early 1990s, the Reserve Bankrecognises that domestic financial marketsneed to develop much further, especially inorder to support the recent acceleration ingrowth momentum of the Indian economyand in the context of the envisaged movetowards fuller capital account convertibility.The Indian experience demonstrates thatdevelopment of markets is an arduous andtime consuming task that requiresconscious policy actions and effectiveimplementation. Without real sectordevelopment in terms of the physicalinfrastructure and improvement in supplyelasticities, the financial sector can

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misallocate resources, potentially generatebubbles and possibly amplify the risks.Hence, financial sector reforms havecomplementarity with the pace and processof reforms in the real sector in India.

Given the large weight on stability,especially in view of low income levels fora large segment of the population, thecareful and cautious approach todevelopment of financial markets followedso far would need to be pursued in thecoming years. The pace of further progresswould depend upon the development of thenecessary expertise in the public sectorbanks, further expansion of private sectorbanks and foreign banks. We recognise theneed to develop further various segmentsof the domestic financial market to help inbetter risk management by various marketparticipants. The demand for various riskmanagement tools could be expected toincrease, especially in the presence ofpotentially larger fluctuations in exchangerate and interest rates in the future. Inrecognition of the need to widen the rangeof instruments available to marketparticipants, the Reserve Bank has placeddraft guidelines on introduction of creditderivatives in the country. More recently, adraft report on the introduction of currencyfutures in India has also been put in thepublic domain for comments and feedback;and work is in progress on the introductionof interest rate futures.

Summing up, it is widely recognisedthat the Indian financial sector over the lastdecade has been transformed into areasonably sophisticated, diverse andresilient system delivering a wide varietyof financial services efficiently andprofitably, with a spectrum of financial

market segments in which financialinstitutions are able to participate withoperational and functional autonomy in anenvironment of increasing deregulation andinternational competition. The accelerationof growth in the real economy suggests thatthe financial system has served well theoverall needs of the economy. During thisperiod, while the global financialenvironment has become more risky in thewake of new instruments and participantsand the rapid advance in communicationtechnology integrating markets worldwide,a unique feature of the Indian reformprocess is that it has been instituted andcarried forward with the objective ofsustaining and accelerating the growthmomentum while containing risk andentrenching financial stability.

III. Indian Reform Outcomes in theInternational Context

Some commentators have criticised theIndian approach to financial sector reformsas unclear, timid and conservative in thecontext of the cross-country experience andhave advocated more bold and drasticmeasures so as to speed up the transitionto higher growth. There is also somediscomfort with our approach to foreignbanks, although even in this regard, we areahead of WTO norms and we have set uproadmaps and review deadlines conditionalupon broader consensus on internationalcommerce in financial services. Admittedly,we have been cautious and somewhatconservative in our approach to financialsector reforms relative to some other EMEs.In this regard, it is important to note thatnot only has there been a steady upwardshift in India’s growth path, but this has also


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been accompanied by enduring stability. Aremarkable feature of India’s growthexperience has been its resilience to bothglobal and domestic shocks. In this regard,while the broad objectives of financial sectorreforms were to enhance efficiency andproductivity, the process of reforms wasinitiated in a gradual and properlysequenced manner so as to have areinforcing effect. The approach has beento consistently upgrade the financial sectorby adopting the international best practicesthrough a consultative process.

With increased deregulation of financialmarkets and increased integration of theglobal economy, the 1990s were turbulentfor global financial markets: 63 countriessuffered from systemic banking crises inthat decade, and 45 in the 1980s. Amongcountries that experienced such crises, thedirect cost of reconstructing the financialsystem was typically very high: for example,recapitalisation of banks had cost 55 percent of GDP in Argentina, 42 per cent inThailand, 35 per cent in Korea and 10 percent in Turkey. There were high indirectcosts of lost opportunities and sloweconomic growth in addition (McKinsey &Co., 2005). It is therefore particularlynoteworthy that India could pursue itsprocess of financial deregulation andopening of the economy without sufferingfinancial crises during this turbulentperiod in world financial markets. The costof recapitalisation of public sector banksat less than 1 per cent of GDP is thereforelow in comparison.

In our own assessment, the gradualistapproach has been appropriate, particularlyin the context of democratic polity, andgiven the multi-ethnic and linguistic

composition of the country. The steady paceof reforms has borne fruit, including largersections of society within the reformprocess. What is remarkable is the sheermagnitude and quality of the reform effortas evident in actual outcomes. The bankingsystem in India has undergone significantchanges during the last 16 years. A cross-country survey of crucial bankingindicators reveals that the Indian bankingsystem is now comparable to those ofdeveloped economies in terms of keyindicators (Table 10). The capital adequacyratio at 12.4 per cent for the system as awhole at end March 2006 is comparable tothat of most advanced economies. Similarly,banks’ non-performing loans to total loanshave steadily declined and are lower thanmany emerging economies. In terms ofreturn on assets, the Indian bankingsystem’s performance is comparable to thatof advanced economies such as Germanyand the U.K.

Cross-country comparisons indicatethat many other countries have alsoachieved considerable progress instrengthening their banking sector.However, a noteworthy aspect of the Indianexperience is that we have been able tostrengthen our banking system without anycrisis and with negligible cost to the fisc,while simultaneously achieving accelerationin growth, price stability and consistentdevelopment of financial markets. Ourbanking sector reform has been unique inthe world in that it combines acomprehensive reorientation ofcompetition, regulation and ownership ina non-disruptive and cost-effective manner.Indeed, our banking reform is a goodillustration of the dynamism of the public

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sector in managing the overhang problemsand the pragmatism of public policy inenabling the domestic and foreign privatesectors to compete and expand (Reddy,2007).

The overall stability that has beenimparted to a system undergoing reformshas served us well so far in the face of therecent financial developments. Toexemplify the argument, I thought I wouldspend some time on the recent financialdevelopments, possible causes and likelyconsequences so as to better appreciate theconduct of India’s financial sector reforms.

IV. Recent International FinancialDevelopers: Issues in MonetaryPolicy and Financial SectorRegulation

In contrast to earlier crises, the cause-and-effect sequences are blurred in thecurrent turmoil in view of the extremeinformation asymmetry. Some definingfeatures of the global economy which couldhave a direct bearing on the current crisesare: the ‘Great Moderation’ – i.e., thesustained decline in inflation/inflationvolatility and consequently, a secularlowering of nominal and real interest rates

Table 10: Cross-Country Select Banking Indictors – A comparison

(Per cent)

Country Regulatory Capital Nonperforming Provisions to Return onto Risk-Weighted Loans to Total Non-performing Assets

Assets (CRAR) Loans Loans (ROA)2002 2006 2002 2006 2002 2006 2002 2006

1 2 3 4 5 6 7 8 9

Developing EconomiesArgentina - - 18.1 3.4 73.8 130.2 -8.9 2.0Brazil 16.6 18.9 4.5 4.1 155.9 152.8 2.1 2.5China - - 26.0 7.5 - - - 0.9India 12.0 12.4 10.4 3.5 - 58.9 0.8 0.9Indonesia 20.1 21.3 24.0 13.1 130.0 99.7 1.4 2.6Korea 11.2 12.8 2.4 0.8 89.6 175.2 0.6 1.1Malaysia 13.2 13.5 15.9 8.5 38.1 50.7 1.3 1.3Mexico 15.7 16.3 3.7 2.1 138.1 207.4 0.7 3.1Philippines 16.9 - 26.5 18.6 30.1 37.4 0.8 1.3Russia 19.1 14.9 5.6 2.6 112.5 159.3 2.6 3.2South Africa 12.6 12.3 2.8 1.2 46.0 - 0.4 1.4Thailand 13.0 13.8 15.7 7.5 62.9 79.4 - 2.3Turkey 24.4 21.1 12.7 3.2 64.2 90.8 1.2 2.4

Developed EconomiesAustralia 9.6 10.4 0.4 0.2 106.2 204.5 1.4 -Canada 12.4 12.5 1.6 0.4 41.1 55.3 0.4 1.0France 11.5 - 4.2 3.2 58.4 58.7 0.5 -Germany 12.7 - 5.0 4.0 - - 0.1 0.5Italy 11.2 10.7 6.5 5.3 - 46.0 0.5 0.8Japan 9.4 13.1 7.4 2.5 - 30.3 -0.7 0.4United Kingdom 13.1 12.9 2.6 0.9 75.0 - 0.4 0.5United States 13.0 13.0 1.4 0.8 123.7 137.2 1.3 1.3

Source : Global Financial Stability Report, 2007, IMF.


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across the world which could haveenhanced the appetite for risk; significantmonetary accommodation by the majoreconomies – the US, Euro area and Japan –since 2000 reflected in abundant liquidityin financial markets, macro imbalancesbetween the US and Asia, sizeable currencymisalignments and carry trades,compression of risk spreads, mispricing ofwidely diffused risks and even real sectorimplications for several emergingeconomies; and the strong macroeconomicperformance of Asia which has contributedto the relentless search for yields and theincreasing appetite for risk (Mohan, 2007e).

The combination of sustained lowinflation accompanied by accommodativemonetary policy worldwide could havegenerated excessive confidence in theability of central banks and monetary policyto keep inflation rates and interest rates lowindefinitely, leading to under pricing of riskand hence excessive risk taking. This resultis analogous to the excessive foreignborrowing undertaken by private sectorborrowers and banks in East Asian countriesin the 1990s when exchange rates were seenas relatively fixed, and hence their riskperceptions were low, and hence risk wasunder priced. It may be ironic that theperceived success of central banks andincreased credibility of monetary policy,giving rise to enhanced expectations withregard to stability in both inflation andinterest rates, could have led to themispricing of risk and hence enhanced risktaking. Yet another view is that more thansuccess or failure of central banks, therepeated assurances of stability andguidance to markets about the future pathof interest rates, coupled with the

availability of ample liquidity were aninvitation to markets to underprice risks. This view, consequently, puts the blame onthose central banks that failed to give spaceto markets to assess risks by eschewingsurprise elements in policy. It is possiblethat with increased globalisation resultingin the containment of prices of tradablegoods during this period and hence ofmeasured inflation, the excess liquidity hasshown up in elevated asset pricesworldwide, along with increased crossborder capital flows in search of yields.

As some withdrawal of monetaryaccommodation commenced in response toperceived or visible inflationary pressures,the sub-prime crisis revealed thesevulnerabilities starkly as confidenceplunged, markets froze and triggered offpanic among investors and lendersregarding their inability to value complexrisky assets and structured derivativeproducts. According to some estimates, totallosses related to sub-prime could exceed US$ 200 billion (The Economist, 2007), over afifth of India’s GDP measured at marketexchange rates. According to the OECDestimates, losses could amount to US $ 300billion. With the deterioration in creditconfidence, banks have been forced toadvance loans to their off-balance sheet“special investment vehicles (SIVs)” whichused up their capital thereby renderingother borrowers credit constrained. Thus,it can be argued that the sub-prime is asymptom rather than a cause. Arguably, theoutcome could have been quite different if,for instance, interest rates declined on theback of ebbing inflation but there was noaccommodation in monetary policy andtherefore no excess liquidity. There is also

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a persuasive opposite view, as bestarticulated by Alan Greenspan, that thegreat moderation in inflation could beattributed to real economy phenomena: thelong run of productivity growth in the US;and the impact of new workers in China andIndia in dampening wage growth worldwideand hence inflation.

It is widely understood that the creditmarket is characterised by informationasymmetry. First, the availability ofinformation technology has reduced thecost of information collection andmaintenance considerably. Thus, awidespread belief has arisen thatinformation on credit quality of smallborrowers who may be widely dispersedacross jurisdictions can be madeimpersonal, packaged, processed, andsold. Second, with the availability of suchtechnology, and the belief that suchinformation was available on a structuredbasis, a great deal of financial innovationcould take place which essentially enabledthe investor or risk taker to becomeprogressively remote from the ultimateborrowers where the actual risks lay. Awhole host of intermediaries in the formof mortgage brokers, mortgage companies,societies and the like were then able topackage their mortgage assets includingnon conforming loans and sell down todifferent categories of investors, includingSpecial Investment Vehicles (SIVs), hedgefunds and the like, most of whom were notregulated. The guiding principle behindthis activity was that it is feasible for creditrating agencies to have enough informationon a continuous basis to rate theinstruments that had been packaged. It cancertainly be argued that this is not a new

development since mortgage backedsecurities (MBS) and asset backedsecurities (ABS) have been with us for sometime and have been successful in providingliquidity to credit markets on a continuousbasis without any accidents. Thedifference perhaps is that MBS packagedby the government sponsored entities(GSEs) were subject to certain relativelywell enforced norms that presumablyreduced the potential risk embedded inthese instruments.

These considerations lead to the thirdset of issues that relate to the role ofeffective financial regulation andsupervision. Has the recent crisisunderscored the need for strengthening ofoversight of financial markets in advancedcountries? Traditionally, financialsurveillance has placed relatively moreemphasis on banking regulation. Banks areleveraged financial entities who are alsoeffective trustees of public money by virtueof holding deposits. Hence, they have tobe effectively regulated and supervised inorder to maintain public confidence in thebanking system and depositors have to beprotected from excessive risk-taking bybanks. On the other hand, investors inhedge funds are high net worth individualswho do not need such protection. They areinformed investors who are able to exploitthe information efficiency of markets and,therefore, should be able to understand therisks implied by information asymmetry.The current crisis was, however, triggeredby the difficulties encountered by theseinvestors who had taken large exposures tosub-prime mortgage investments withouthaving accounted for the potential risksembedded in these instruments.


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What has been our approach to theseissues? Although there is a current move insome jurisdictions, particularly in the U.K.,to move towards “principles-based”regulation, from the traditional “rules-based” regulation, we are continuing withthe traditional rules-based regulatoryapproach for now. While progressivelyproviding greater flexibility to banks in theirportfolio decisions, relative to the situationbefore the reforms, we have kept a close eyeon the risk exposure of regulated financialinstitutions. We have therefore beencautious about derivatives and areintroducing them gradually, based on ourperception of the risk managementcapabilities of the various regulatedinstitutions. Admittedly, this does causeimpatience in those institutions that believetheir risk management capacities to be of ahigh order. However, the issue that we haveto consider is the reality of the large variancebetween different institutions in suchcapabilities. It is true that financial marketscannot be held hostage to the most laggardinstitutions. So, we have adopted ameasured approach to the introduction ofmodern financial innovations.

Second, we do monitor the exposuresof banks to risky sectors and seek to limittheir exposure to such sectors throughprudential regulations. Banks exposure tocapital markets in all forms (both fundbased and non-fund based) cannot exceed40 per cent of their net worth. Similarly, aswe observed very high credit growth incertain segments such as real estate,housing, non banking finance companies(NBFCs) and other retail credit, risk weightswere increased, along with provisioningnorms for standard assets.

Third, in terms of the evolving globalprudential framework, the emphasis hasgenerally been more on capital, as a meansof reducing vulnerability to risks, than onprudential requirements for liquidity risk.Aspects relating to liquidity have been largelyleft to each regulator to assess and prescribea suitable framework under Pillar II of BaselII. In the Indian context, while banks haveflexibility in devising their own riskmanagement strategies as per Board approvedpolicy, the Reserve Bank has taken steps tomitigate liquidity risks at the very short-end,risks at the systemic level and at theinstitution level as well (Reddy, 2007c). Someof the important measures in this regard are:

● Overnight unsecured market for fundsis restricted only to banks and primarydealers (PD). Repo markets - bothbilateral repos and collateralisedborrowing and lending obligations (aform of tripartite repos) weredeveloped. As a result, volumes haveshifted from the overnight unsecuredmarket to the collateralised market.

● As greater inter-linkages and excessivereliance on call money borrowings bybanks could cause systemic problems,prudential measures have beenintroduced to address the extent towhich banks can borrow and lend in thecall money market. On a fortnightlyaverage basis, call market borrowingsoutstanding should not exceed 100 percent of capital funds (i.e., sum of Tier Iand Tier II capital) of latest auditedbalance sheet. However, banks areallowed to borrow a maximum of 125per cent of their capital funds on anyday, during a fortnight. Similarly, on afortnightly average basis, lending in the

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call market should not exceed 25 percent of their capital funds; however,banks are allowed to lend a maximumof 50 per cent of their capital funds onany day, during a fortnight.

● ‘Purchased inter-bank liabilities’ (IBL) ofa bank should not exceed 200 per centof its net worth (300 per cent for bankswith CRAR more than 11.25 per cent).

● Like other supervisors, the Reserve Bankhas issued asset liability managementguidelines for dealing with overall asset-liability mismatches taking into accountboth on and off balance sheet items.

● The Reserve Bank, in its supervisoryoversight of banks’ activities, alsomonitors the incremental creditdeposit ratio of banks. Although banksmay implement sophisticated riskmanagement strategies, this single ratiowith a minimum lag indicates the extentto which banks are funding credit withborrowings from wholesale markets orwhat is now known as purchased funds.

● The Reserve Bank guidelines onsecuritisation of standard assets havelaid down detailed policy on provisionof liquidity support to Special PurposeVehicles (SPVs). The liquidity provisionis subject to conditions to ensure thatthe liquidity support is only temporaryand invoked to meet cash flowmismatches. Any commitment toprovide such liquidity facility is to betreated as an off-balance sheet item andattracts 100 per cent credit conversionfactor as well as 100 per cent risk weight.

Fourth, since the Reserve Bank also hasregulatory responsibility for NBFCs, we have

also acted to introduce various prudentialnorms in their activities where we believethere could be systemic effects. Theregulatory interventions are graded: higherin deposit taking institutions and lower innon-deposit taking institutions. The recentcrises in developed financial markets havealso illustrated how thin these lines ofseparation are: difficulties experienced bynon-deposit intermediaries such as the SIVsare eventually falling on the deposit takingregulated institution such as banks.

Thus, we do feel that judiciousprudential regulation and supervision andheightened market surveillance andanticipation are necessary for the healthygovernance of financial markets. We have,of course, to be careful to not stifleentrepreneurship and financial innovation. But we do need to constantly ask thequestion: “Financial innovation towardswhat objective?” As long as financialinnovation is seen to promote pricediscovery, greater intermediation efficiency,and hence, overall efficiency and growth, itmust be encouraged, but with appropriatesafeguards to maintain financial stability.

The lessons from the current financialmarket crisis go both ways. On the onehand, market innovation has indeed helpedin bringing financial markets closer to thosewho need credit and did not have access toit earlier. Despite all the problemsassociated with sub-prime borrowers, itmust be recognised that almost 10 millionborrowers benefited from this market andwere enabled access to housing finance,which had not been deemed possibleearlier. With about 20 per cent of theseborrowers reported to be delinquent, and


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in difficulty, it still means that about 8million people clearly benefited from thismarket. On the other hand, the difficultiesencountered draw attention to the kind ofissues that can arise when the speed ofinnovation and incentive structures areflawed such that malpractices occur, andintrinsic difficulties arise in capturing andcommoditising information that isperhaps not yet susceptible to suchcommoditisation.

A key question that has emerged fromthe current developments in financialmarkets relates to the role of monetaryauthorities in the context of such a crisis. This issue is of concern to all of us in centralbanking. Over the last decade or two, itwould appear that the focus of central bankshas been narrowing, relative to the morecomplex responsibilities that they havetraditionally shouldered. A great deal hasbeen written on this issue, a great deal haschanged in terms of practices and, in somecountries, the regulatory structure itself hasbeen altered to move central banks to beingrelatively pure monetary authorities. According to this view, central banks shouldfocus largely on keeping inflation low andstable, and in doing this also contribute tofinancial stability. To quote Harvardeconomist Kenneth Rogoff: “Indeed manyeconomists believe that central bankerscould perfectly well be replaced with acomputer programmed to implement asimple rule that adjusts interest rates inresponse to output and inflation. But while[this] view is theoretically rigorous, realityis not” (Businessworld, September 17,2007). Although some central banks, suchas the US Federal Reserve, have an explicitmandate to also promote growth, a good

deal of thinking in recent times tends toargue that inflation control by itself wouldpromote growth and that central bankswould be better off to concentrate on thisobjective alone.

It is instructive to examine what centralbanks have done in the current context. The responses of the central banks to therecent events in financial markets haveshown that concerns for financial stabilitycan assume overriding importance,irrespective of the legislative mandatehanded down to central banks as part ofongoing reforms. This is evident in the factthat central banks initially reacted throughthe injection of liquidity, including throughspecial facilities and the expansion of listof eligible collateral. Discussions involvingcentral bankers in various fora indicate theirwillingness to consider other courses ofaction in favour of protecting growth. Aswe all know, the US Federal Reserve hasgone further in cutting interest rates topromote both growth and in the interest offinancial stability; the U.K. authorities havehad to provide liquidity to a specificinstitution, while giving a blanketguarantee to depositors on the safety oftheir deposits. Accordingly, it is becomingevident that central banks do have a rolebeyond inflation targeting. Evidently, bothgrowth and financial stability matter forcentral banks.

When it comes to the crunch, in theirroles as lenders of last resort (LOLR), andin discharging their responsibilities as theguardians of financial stability, centralbanks do need to perform functions that aremore complex. Should central banks belenders of last resort to the system as a

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whole by injecting systemic liquiditythrough open market operations only, orshould they also provide liquidity toindividual financial institutions that arejudged to be solvent but illiquid? How dothey arrive at such judgments if they do nothave adequate information on individualinstitutions? Can they have such detailedinformation without ongoingresponsibilities for regulation andsupervision? This issue is not dissimilar,in terms of the existence of asymmetricinformation, to that of the problem ofadequate transparency of informationrelated to the value of collateral underlyingasset backed securities.

Banks and financial institutions aretypically leveraged institutions: thusjudgements related to their solvency dependon the valuation of their assets at the timewhen difficulties arise. In the current case,banks have invested through a chain ofvehicles in securities whose values are indoubt. Banks also have commitments tovehicles whose liquidity and/or viability arein doubt. When providing LOLR liquiditysupport, how is the central bank to make ajudgement on the solvency of institutionsto whom it is providing liquidity? As agreater recognition and appreciation of theappropriate role of central banks gainsground, it is possible that this will result infurther rethinking on the functioning ofcentral banks. A case in point is theseparation of financial regulation andsupervision from monetary policy whichcould have contributed to ineffective andinadequate surveillance in the context ofthe current crisis. There is a view thatproblems of information asymmetry mighthave got further aggravated with banks

reporting both to the monetary authorityand the regulatory body in charge of bankingsupervision.

Since the Reserve Bank of India is alsothe banking regulator and supervisor, wereceive continuing information on thebanking activities; moreover, in times suchas the current turmoil, we can also obtaininformation quickly from leadingsystematically important institutions onexposures of relevance. Thus, there is ahigh scope for prompt corrective action.

V. Challenges for the Future

Let me conclude by turning to theemerging challenges facing the financialsector in India that could shape the path ofthe next generation of reforms. Thesustained acceleration in growth, supportedby a range of anecdotal indications, isresulting in the movement of large numbersof households into higher income andconsumption categories, with enhanceddemand for financial services. Alongside,industrial production and export growthhave remained buoyant and the risingprominence of services in the economy isgenerating a surge in demand for financialintermediation. A lead indicator is thesizeable expansion already underway indomestic bank lending to households andsmall and medium industrial and serviceenterprises which are poised to emerge asthe new growth drivers of financial sectoractivity. For the Indian financial system, thebiggest challenge is how to extend itself andinnovate to meet these new demands forfinancial inclusion and respond adequatelyto new opportunities and risks. Innovativechannels for credit delivery for serving the


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new credit needs have to be developed,perhaps with greater use of informationtechnology and intensified skillsdevelopment in human capital.

Acceleration in growth over the past fewyears has brightened medium-termprospects for growth of the Indian economy.As in the past, domestic savings areexpected to finance the bulk of theinvestment requirements. In this context,the banking system will continue to be animportant source of financing and therecould be strong demand for bank credit.Although bank credit has witnessed sharpgrowth since 2003-04 onwards, it needs tobe recognised that the credit-GDP ratio stillremains relatively low. Moreover, asignificant segment of the populationremains excluded from banking services. Asthe growth process strengthens andbecomes more inclusive, it is expected thatdemand for financial products couldcontinue to witness high growth in thecoming years. Thus, it is likely that growthin bank credit and monetary aggregatescould be higher than what might beexpected from historical relationships andelasticities in view of ongoing structuralchanges. This, however, raises critical issuesfor the central bank such as the appropriateorder of monetary/credit expansion. In theabsence of a yardstick, excessive growth inmoney supply could potentially show up ininflationary pressures over course of time,given the monetary lags. Indeed, recentinflationary pressures across the globe areattributable, in part, to global liquidity glut.In the absence of inflationary pressures asconventionally measured, excessive moneyand credit growth could also lead to assetprice bubbles, with adverse implications for

banking sector stability and laggedconventional inflation. Thus, the ReserveBank will have to face ongoing challengesto provide appropriate liquidity to thesystem so as to ensure growth in non-inflationary environment.

Demand for housing finance hasemerged as a key driver of bank credit inthe past few years. As incomes grow furtherand the pace of urbanisation picks up, and,in view of the substantial backlog, demandfor housing and housing finance can beexpected to record continuous high growthover the next few years. In view of theexpected high demand, pressure on realestate prices may continue. Moreover, realestate markets are characterised by opacityand other imperfections in developingcountries, and certainly in India. Suchdevelopments can easily generate bubblesin the real estate market, because ofproblems in the elasticity of supply, andinformation asymmetries. Strong demandfor housing and buoyancy in real estateprices in an environment of non-transparency, thus, could potentially poserisks to the banking system. In conjunctionwith interest rate cycles, the banking systemas well as the regulator would need to bevigilant to future NPAs and the US-like sub-prime woes.

Higher investment needs of the growingeconomy will depend heavily upon theability of the financial markets to raiseresources from savers and allocate themefficiently for the most productivepurposes. In view of the acceleration ingrowth as well as the focus on inclusivegrowth, financial markets will have to playa greater role in efficient allocation of

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resources. Further development of financialmarkets will also be needed in view of thegrowing openness and the envisaged movetowards fuller capital account convertibility.The Reserve Bank will therefore continueto take measures to further deepen, widenand integrate the financial markets. Whilepermitting a wider range of instrumentsand players in the financial markets, it willneed to be ensured that development takesplace in an orderly manner so as to avoidsub-prime like accidents and ensurestability. There is a premium on ensuringstability in low-income countries like India,with a significant share of population notin a position to withstand large changes ininterest rates and exchange rates. Prudentialexposure norms on exposures of banks andNBFCs will need to be fine-tuned so as toprotect the balance sheets of banks andinterests of depositors. The formation ofcredit information bureaus is expected toprovide credit histories of borrowers andthis could allow greater flow of bank creditto the relatively neglected sectors, while alsoimparting stability to the financial sector.

So far, financial sector reforms havebeen calibrated with a progressiveintegration into the world economy. A keyconsideration in the choice of pace andsequencing has been the management ofvolatility in financial markets andimplications for the conduct of monetaryoperations. Fuller capital account opennesswill inevitably lead up to the challenge ofmanaging the impossible trinity ofindependent monetary policy, open capitalaccount, and managed exchange rate. Inthe context of the ongoing financial sectorreforms, it needs to be recognised that theimpact of financial fluctuations on the real

sector in developing economies issignificantly different from matureeconomies which specialise in technologyintensive products in which the degree ofexchange rate pass through is low, enablingexporters and importers to ignoretemporary shocks and set stable productprices to maintain monopolistic positions,despite large currency fluctuations. Matureand well developed financial markets inthese countries absorb the risks associatedwith exchange rate fluctuations withnegligible spillover on real activity. On theother hand, for the majority of developingcountries which specialise in labour-intensive and low and intermediatetechnology products vulnerable to pricingpower by large retail chains, exchange rateand financial price volatility has significantemployment, output and distributionalconsequences which in turn, haveimplications for financial sector stabilityand soundness.

A further challenge for policy in thecontext of fuller capital account opennesswill be to preserve the financial stability ofdifferent markets as greater deregulation ofcapital outflows and debt inflows occurs. The vulnerability of financial intermediariescan perhaps be addressed throughprudential regulations and theirsupervision; risk management of non-financial entities will have to be throughfurther developments in both the corporatedebt market and the forex market, whichenable them to manage their risks throughthe use of newer market instruments. Thiswill require market development,enhancement of regulatory capacity inthese areas, as well as human resourcedevelopment in both financial


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intermediaries and non-financial entities. Given the volatility of capital flows, itremains to be seen whether financialmarket development in a country like Indiacan be such that this volatility does notresult in unacceptable disruption inexchange rate determination with inevitablereal sector consequences, and in domesticmonetary conditions.

Going forward, there will be acontinuous need to adapt the strategy ofliquidity management as well as exchangerate management for effective monetarymanagement and short-term interest ratesmoothening. The key questions wecontinue to face with are what should bethe instruments and modes of managementof liquidity in the interest of growth andfinancial stability and how much shouldcapital flows affect exchange rate. Theseissues become even more relevant under afreer regime of capital flows. Globaldevelopments are expected to have anincreasing role in determining the conductof monetary and exchange rate policies inour country. In an environment of globalconvergence, retaining independence ofmonetary policy may become increasinglydifficult, calling for hard choices in termsof goals and instruments.

In India, we have not favoured theadoption of inflation targeting, while keepingthe attainment of low inflation as a centralobjective of monetary policy, along with thatof high and sustained growth that is soimportant for a developing economy. Apartfrom the legitimate concern regarding growthas a key objective, there are other factors thatsuggest that inflation targeting may not beappropriate for India. First, unlike manyother developing countries we have had a

record of moderate inflation, with doubledigit inflation being the exception, and whichis largely socially unacceptable. Second,adoption of inflation targeting requires theexistence of an efficient monetarytransmission mechanism through theoperation of efficient financial markets andabsence of interest rate distortions. Third,inflationary pressures still often emanatefrom significant supply shocks related to theeffect of the monsoon on agriculture, wheremonetary policy action may have little role.Finally, in an economy as large as that ofIndia, with various regional differences, andcontinued existence of market imperfectionsin factor and product markets betweenregions, the choice of a universally acceptablemeasure of inflation is also difficult.

As regards banking regulation andsupervision, there is no unique theoreticalmodel or just one practical approach to theregulation and supervision of a financialsystem. India has traditionally followed aninstitution-based system of regulation. InIndia, the current model of regulation withthe Reserve Bank exchanging relevantinformation with other regulators in asynchronised manner is functioningeffectively. The supervisory activities of theReserve Bank have benefited from its pricestability objective, and it is recognised thatsafety and soundness of banks must beevaluated jointly with its responsibility toensuring stability and growth in theeconomy. In this regard, the Reserve Bankwith joint responsibilities for monetarypolicy and supervision has both the insightand the authority to use techniques that areless blunt and more precisely calibrated tothe problem at hand. Such tools improve itsability to manage crises and, more

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importantly, to avoid them. In thisbackdrop, the recommendations ofseparating banking sector regulation fromthe conduct of monetary policy by someobservers appear to be independent of thehistory, legacy and efficiency of the currentregulatory system in India. Suchrecommendations are essentially based onthe UK experience – which itself has nowbeen subject to severe criticism in theepisode involving the Northern Rock – andcompletely ignore the huge diversity of theregulatory system in other countries includingthose prevailing in successful internationalfinancial centres such as the US.

As noted in several policy statementsin the Indian context, the principalchallenge for public policy is to ensure asmooth transition to higher growth path,accompanied by low and stable inflationand well anchored inflation expectations.From a central banking perspective, the newchallenges facing us are many. First, if theIndian banking system is to attaininternational excellence, it will requireaction on several fronts like introduction ofgreater competition; convergence ofactivities and supervision of financialconglomerates; induction of newtechnology; improvement in credit riskappraisal; encouragement of financialinnovations; improvement in internalcontrols; and establishment of anappropriate legal framework. The role of theReserve Bank in this context amounts topromoting safety and soundness whileallowing the banking system to competeand innovate. Second, as a central bank, theReserve Bank would further need todevelop the financial markets, especially themoney, government securities and foreign

exchange markets to enhance the efficiencyof the transmission mechanism, along withthe corporate debt market. Third, pricestability and financial stability wouldcontinue to be of concern with expectedincrease in credit expansion and globalintegration.

References

Ball, L and N. Sheridan (2003), “DoesInflation Targeting Matter?”, NBER WorkingPaper No 9577.

Economist (2007), “Banks: CapitalPunishment”, November 8.

Eichengreen, Barry (2002), “Can EmergingMarkets Float? Should They InflationTarget?”, Working Paper Series 36, BancoCentral do Brasil, February.

Fraga, A.; Minella, A. and Goldfajn, I (2003),“Inflation Targeting in Emerging MarketEconomies”, NBER Working Paper 10019,October.

Gramlich, Edward (2003), “Maintaining PriceStability”, Remarks before the Economic Clubof Toronto, Toronto, Canada, October.

Issing, O (2004), “Inflation targeting: A Viewfrom the ECB”, Federal Reserve Bank of St.Louis Review, Vol. 86, No.4, July/August.

Jalan, B (2002), “Monetary Policy: Is a SingleTarget Relevant?”, In India’s Economy in theNew Millennium: Selected Essays (ed.). B.Jalan, Mumbai: UBS Publishers Distributors.

Kohn, Donald L (2004), “Panel Discussion:Inflation Targeting”, Federal Reserve Bankof St. Louis, July-August

McKinnon, Ronald I. 1973. Money andCapital in Economic Development.Washington, D.C.: Brookings Institution.


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McKinsey Quarterly (2007), “India’sExecutives: Confident in their Economy andEager to Hire”.

Mohan, Rakesh (2004), “Challenges toMonetary Policy in a Globalising Context”,Reserve Bank of India Bulletin, January.

(2006a), “Reforms, Productivity andEfficiency in Banking: The Indian Experience”,Reserve Bank of India Bulletin, March.

(2006b), “Evolution of CentralBanking in India”, Reserve Bank of IndiaBulletin, June.

(2006c), “Monetary Policy andExchange Rate Frameworks: The IndianExperience”, Reserve Bank of India Bulletin,June.

(2007a), “Current Challenges toMonetary Policy Making in India”, ReserveBank of India Bulletin, March.

(2007b), “Monetary PolicyTransmission in India”, Reserve Bank ofIndia Bulletin, April.

(2007c), Development of FinancialMarkets in India, Reserve Bank of IndiaBulletin, June.

(2007d), “Capital AccountLiberalisation and Conduct of MonetaryPolicy: The Indian Experience”, ReserveBank of India Bulletin, July.

(2007e), “Recent Financial MarketDevelopments and Implications forMonetary Policy”, Reserve Bank of IndiaBulletin, October.

Reddy, Y.V. (2004), “Financial Stability:Indian Experience”, Reserve Bank of IndiaBulletin, July.

(2007a), “Globalisation and MonetaryPolicy: Some Emerging Issues”, ReserveBank of India Bulletin, April.

(2007b), “Some Perspectives on theIndian Economy”, Reserve Bank of IndiaBulletin, November.

(2007b), “Global Developments andIndian Perspectives: Some RandomThoughts”, Valedictory address at theBankers’ Conference 2007 on November 27,2007 at Mumbai.

Shaw, Edward S. 1973. Financial Deepeningin Economic Development. New York:Oxford University Press.

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