Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 7 Financial Stability

Introduction

The significant decline in global inflation in the 1990s can be regarded as a distinctive feature of macroeconomic developments in this period. The lowering of inflation is attributed in large part to anti-inflationary monetary policy practised worldwide in the 1990s, supported by a mutually reinforcing mix of freer trade, globalisation, deregulation and productivity gains. The decline in inflation has generally been accompanied with reduced output volatility (see Module 4). Even as macroeconomic stability - low and stable inflation with reduced output volatility - has been achieved during the 1990s, the same period has also been witness to an increase in frequency of episodes of banking and currency crises. The expected 'peace dividend' of war against inflation has been, to some extent, neutralised by such crises episodes. Issues related to financial stability and the role of the central banks in contributing to financial stability have, therefore, come to the forefront in the latter half of the 1990s. Financial stability, apart from price stability, has thus become a major focus of most central banks. At a number of central banks, the growing emphasis given to financial stability has led to significant changes, such as the establishment of departments dedicated to financial stability. Reports on financial stability published by a large number of central banks also bear testimony to these changes.

Concerns related to financial stability have attracted renewed focus during the 1990s, mainly on account of the forces of financial liberalisation and globalisation. Financial liberalisation has led to the emergence of financial conglomerates. These financial conglomerates cut across not only various financial sectors such as banking and insurance, but also a number of countries. Moreover, the progressive opening up of the economies to external flows since 1990s has led to massive cross-border capital flows. As discussed in Module: 3, such flows display a boom-bust pattern. During periods of excessive capital inflows, such flows are often intermediated to speculative activities such as real estate and stock markets. This can lead to asset price bubbles. As these bubbles burst over a period of time, they pose serious risks to the balance sheets of financial institutions as well as non-financial corporations. Finally, the volatility in capital flows is reflected in sharp movements in exchange rates. Large devaluations also have an adverse impact upon the balance sheets of residents. This is especially true for emerging economies as they are usually forced to borrow in foreign currencies. Large devaluations can create serious currency mismatches and, as the Asian financial crisis showed, even banking crises. Such crises have large costs in terms of output and employment losses. In addition, governments are forced to bear the large costs entailed in restructuring of the financial institutions. For all these reasons, maintenance of financial stability has emerged as a key objective for a number of central banks.

As noted before, the concerns with financial stability have arisen in a decade that has been characterised by price stability. Traditionally, it has been believed that monetary stability leads to financial stability. However, as the events of the 1990s show, it need not necessarily be the case. On the contrary, it has been argued that the achievement of price stability itself may sow seeds of financial imbalances. In a low inflation environment, imbalances do not get reflected in inflationary pressures. Rather, they exhibit themselves in asset price bubbles, which over time, can turn into financial crises. This weakens the financial system and, in turn, the efficacy of the monetary transmission mechanism. If the health of the financial sector is weak, an increase in interest rates can aggravate the fragility of the financial sector. Accordingly, the monetary authority may be constrained in its efforts to raise interest rates in order to fight inflationary pressures. A sound financial system is thus an important pre-condition for effective implementation of monetary policy. Concomitantly, a debate has emerged on the role of monetary policy in responding to asset price bubbles. More or less, it is agreed that monetary policy measures, by themselves, may not be effective in correcting misalignments. Given the limitations of monetary policy per se, central banks can still contribute to financial stability by making the financial system resilient to various shocks. Central banks can do so through effective regulation and supervision of the financial system, encouraging corporate governance, promoting accounting standards and maintaining integrity of payments and settlement systems.

As in the rest of the world, in India too, issues related to financial stability have come to the forefront since the 1990s. This development is largely on account of the structural reforms initiated in the early 1990s. The process of financial liberalisation and deregulation has led to emergence of some financial conglomerates in the Indian economy. In view of the possibility of contagion arising from such conglomerates and their systemic implications, regulation of such systemically important financial intermediaries necessitates a focused attention from the perspective of financial stability. Furthermore, with interest rates emerging as the key channel of monetary policy signals, the efficacy of monetary transmission depends upon the health of the financial sector. Finally, with the gradual opening up of the external sector, developments in India are increasingly influenced by developments abroad. Capital flows have increased substantially since 1993-94. Although these flows have, by and large, been stable reflecting the cautious approach to liberalisation, there have nonetheless been episodes of volatility in these flows. These vicissitudes of capital movements show up in volatility in exchange rate movements. Large swings in exchange rates affect not only demand and inflation, but also, more importantly, given the foreign-currency denominated liabilities, affect balance sheets of a range of financial as well as non-financial borrowers. This can induce large scale financial instability, as was evidenced during the Asian financial crisis. Often emerging market economies do not have adequate self-correcting mechanisms in respect of cross border capital flows. This would suggest the need to institute special defences for ensuring financial stability in the case of countries like India that are faced with the prospect of volatile capital flows.

Like other central banks, financial stability has, therefore, emerged as a key consideration in the conduct of monetary policy in India, apart from price stability and provision of adequate credit for growth. While there are complementarities between the objectives, especially in the long run, it cannot be denied that there are certain trade-offs, particularly in the short run. The overall approach of the Reserve Bank to maintain financial stability is three-pronged: maintenance of overall macroeconomic balance; improvement in the macro-prudential functioning of institutions and markets; and, strengthening micro-prudential institutional soundness through regulation and supervision

In light of the aforesaid discussion, Section I of this Module provides an international perspective on the key issues relating to financial stability. It discusses the concepts of monetary and financial stability followed by various theories of financial stability. A critical assessment of the appropriate response of monetary policy to asset price misalignments is undertaken. This is followed by a cross-country survey of the role of central banks in contributing to financial stability in critical areas such as regulation and supervision, payments and settlement systems, accounting standards and governance norms. Section II of the Module focuses on the Indian approach to financial stability. Accordingly, it provides an overview of the financial system, highlighting the measures initiated to nurture stability of financial institutions and markets and their performance. Concluding observations are contained in the final section.

This Module has discussed issues related to financial stability, with a focus on the role of central banks in maintaining financial stability. The conventional view is that price stability is a sufficient condition for financial stability. Developments during the 1990s suggest that this may not be the case, at least in the short-run. Ironically, price stability itself may lead to "irrational exuberance" which could over time be reflected in financial imbalances. Thus, although central banks have always been concerned with maintenance of financial stability, recent developments have placed renewed emphasis on financial stability as a key consideration in the conduct of monetary policy. Apart from lengthening their monetary policy horizons beyond the usual two-year framework, central banks can contribute to financial stability through regulation and supervision ensuring that banks are well-capitalised and well-diversified. Encouraging greater transparency in accounting and disclosure practices can also contribute to financial stability.

In India, prudential norms have been gradually brought on par with international standards and best practices, with suitable country specific adaptations. More recently, the Reserve Bank has undertaken significant initiatives on graduating towards Basel II, keeping in view the country-specific requirements. These include, inter alia, ensuring the institution of suitable risk management framework by banks, introduction of risk-based supervision, encouraging banks to formalise their Capital Adequacy Assessment Programme (CAAP) in alignment with business plan and performance budgeting system and enhancing the area of disclosures. At the same time, several challenges such as encouraging ratings of issuers, assessing the level of additional capital requirement by banks, capital requirement for operational risk and addressing the systemic risk posed by large conglomerates would all need to be satisfactorily addressed before the transition to Basel II can occur.

The survey of the Indian financial sector undertaken in this Module suggests that India's approach to financial sector reforms has served the country well, in terms of aiding growth, avoiding crises, enhancing efficiency and imparting resilience to the system. The development of financial markets has been, by and large, healthy. The basic features of the Indian approach are gradualism; co-ordination with other economic policies; pragmatism rather than ideology; relevance to the context; consultative processes; dynamism and good sequencing so as to be able to meet the emerging domestic and international trends. In the banking system, diversified ownership of public sector banks has been promoted over the years and the performance of their listed stocks in the face of intense competition indicates improvements in the system. Since the initiation of reforms, financial health as well as efficiency of the banking sector has improved. From the vantage point of 2004, one of the successes of the Indian financial sector reform has been the maintenance of financial stability and avoidance of any major financial crisis during the reform period - a period that has been turbulent for the financial sector in most emerging market countries.

At the same time, there remains scope for improvements in the operational efficiency of the banking sector. Moreover, despite the decline in the stock of NPLs in the banking system, these figures remain high compared to international standards. The improved institutional and legal arrangements accompanied by concomitant strengthening of risk management practices by banks are likely to keep incremental NPLs low. Initiatives such as setting up of Asset Reconstruction Companies and greater emphasis on compromise settlements are likely to deal with the stock problem for NPLs. Banks may need to adopt a more pro-active approach in dealing with these issues. Enforcement of creditors rights will need continuous strengthening. The legal provisions and practice in bankruptcy of the real sector are still inadequate and need further reform.

To conclude, ensuring an acceptable degree of financial stability is a never-ending process. In an ideal world, there is often a smattering of small disturbances. The real world, however, is often far divorced from idealism: there are long periods of quiescence when virtually no financial disturbance takes place, creating a false sense of security which eventually leads to periods that contain several failures and the threat of many more. The task for all involved in ensuring financial stability is to remain alert and proactive during such tranquil periods, to identify and monitor newer risks, eschew harmful incentives and adjust the regulatory environment to keep abreast with fast-paced changes in the economic environment.