Rakesh Mohan: Central banks and risk management - pursuing financial
stability
Address by Dr Rakesh Mohan, Deputy Governor of the Reserve Bank of India, at the 4th Annual
Conference on Cash, Treasury and Risk Management in India, New Delhi, 21 November 2006.
* * *
I have chosen to speak on "Financial Stability" for a number of reasons. Although financial stability has
always been of concern to central banks, it is a relatively new concept in terms of the widespread
attention being given to it in recent years. I thought it would be useful to discuss why it has become so
important to central banks. Achieving this understanding would also help in explaining some of the
behaviour of central banks. I will also try to explain why it is important for us.
Financial stability - what is it?
What is financial stability? Despite widespread usage of the term, there is no widespread agreement
on a useful working definition of the term. Some define financial stability in terms of what it is not - the
absence of financial instability. Others take a more macro-prudential view and specify financial stability
in terms of limitation of risks of significant real output losses in the presence of episodes of system
wide financial distress.
In the absence of a widely accepted definition it is useful to discuss what we expect a financial system
to do.
The primary function of the financial system is to smoothly and efficiently facilitate inter-temporal
allocation of resources from savers to the ultimate users. This process of intermediation of funds
enables the utilisation of available resources to their most productive uses. Such a process implies
management of financial risk on an inter-temporal basis. In doing so however, the financial system is
expected to absorb real economic surprises and shocks. If for some reason this is not done well, it
could impair the efficient functioning of the financial system as a whole and engender financial
instability.
But we need to be careful in thinking about financial instability. Disturbances in financial markets or at
individual financial institutions need not constitute financial instability if they do not impair overall
economic functioning. Illustratively, a closure of a small financial institution, or for that matter,
movement in asset prices within certain limits or even minor corrections in financial markets need not
necessarily hamper stability. On the contrary, fluctuations in asset and other prices in financial markets
may actually be good for overall financial stability as adjustment mechanisms. Such market
adjustments also help to keep authorities alert and sensitive to incipient developments and can enable
them to identify and monitor newer risks. What are important from the macroeconomic standpoint are
issues related to contagion and systemic risk, which can lead to economy-wide upheavals and would,
therefore, need to be monitored on an on-going basis.
The point of making these observations is that unlike price stability, which can be easily quantified,
financial stability cannot be easily summarised into a single measure. As a consequence, monitoring
financial stability needs to encompass not only financial institutions and markets, but also the state of
financial infrastructure: a stable financial system depends as much on the health of financial
institutions as it does on the complex inter-linkages between those institutions and the interplay
between the financial system, the financial markets and the associated financial infrastructure. The
integrity of the payment system is at the core of the financial system, and confidence in the use of
money as a unit of account is essential to maintenance of financial stability. While central bankers
have always been concerned with addressing these aforesaid aspects, the issue therefore remains:
why is there an overt concern with financial stability in modern-day financial systems?
Historical background
To understand the current outbreak of concerns, let us review a little bit of history. It would be useful to
start of with salient developments in the world economy since the early 1900s in order to understand
the relevance of financial stability in modern day financial systems.
Until World War I, the international experience had broadly been of long run price and monetary
stability. A great degree of turbulence followed after the conclusion of World War I: the German
hyperinflation, the Great Depression, World War II itself, the Korean war, and later the Vietnam war. It is not
surprising that in the presence of such economic and political dislocation, price and financial stability
also suffered during this period. The financing of wars led to fiscal expansionism usually financed by
money creation. Thus a period of relatively high inflation ensued in the 1960s and 1970s, culminating
in double digit inflation in the US and Western Europe in the late 1970s, spiked by severe oil shocks of
the 1970s. Thus, after this long tumultuous period of fluctuating inflation during the 1960s and 1970s,
aggressive disinflationary policies of the early 1980s brought international inflation down to tolerable
levels.
Prior to World War I, the gold standard was, in some sense, the anchor of monetary, price and
financial stability. Central Banks' commitment to ensuring the convertibility of their currency into gold at
fixed prices did much to engender confidence in the system. There was also a significant degree of
cooperation among the central banks and governments of major economies, which helped to lubricate
the system in its functions in times of financial imbalances (Eichengreen, 1992). The gold standard,
however, came under severe strain after World War I in the wake of the breakdown in cooperation
between countries. The consequence was the depression, competitive devaluations, beggar thy
neighbour policies, decline in world trade and high unemployment, at different times in different
countries during the inter war period. Overall, there was a great degree of instability during this period.
The quest for a new international economic order that would restore economic and financial stability in
the world gave rise to the Bretton Woods institutions and the Bretton Woods Currency System. It was
not until 1958 that most European currencies became convertible and many currency adjustments
took place after the end of World War II. The anchor now was essentially the US dollar as the reserve
currency and the commitment to its convertibility to gold. The International Monetary Fund was to act
as the lender of last resort in case of balance of payment crises. But even this fixed exchange rate
system lasted only till 1971. The over-financing of exports, the economic pick up in hitherto war torn
countries led to the glut of the dollar; and the American inflation of the 1960s; all contributed to the
cessation of dollar convertibility to gold. The fixed exchange rate system got abandoned after the
Smithsonian agreement. The floating exchange rates that then followed meant that the world was left
without an easily understood, credible monetary anchor. Hence the increasing quest for
methodologies promoting financial stability.
The other major feature of global financial markets has been the trends in capital flows. A major surge
in capital flows started around the 1870s and continued till World War I. This era, which coincided with
the operation of the gold standard, has been regarded until recently as the golden era of capital
mobility. Open trade and open labour markets also characterized this period. In retrospect, there was
an effective system shut down after World War I, almost until the 1970s. During the inter war period,
the world economic system got characterized by increasing trade restrictions, high tariffs, curbs on
capital flows, fixed exchange rates and other rigidities. Post World War II it has taken a long time to
open up international trade through the Successive GATT Rounds and now through the WTO.
The period after 1973 has been characterized by floating exchange rates and gradually increasing
international capital flows, along with increasing volumes of international trade. The geographical
demarcation of national borders gradually became less of a constraint for both trade and capital flows.
By the 1990s, open trade and open capital accounts led to a phenomenal growth cross border flows,
including to developing countries and the emerging economies in Eastern Europe.
All this entailed a phenomenal expansion of financial activity. This was partly in response to the
demographically-driven increase in the amount of investible wealth, but also reflected the increased
need for markets and institutions to channel funds between an increasingly active and diverse range
of borrowers and lenders.
At the same time, domestic financial liberalization led to the removal of constraints on the activities of
financial institutions of different kinds within a given national market in many countries. The
liberalization of cross-border capital movements and rights of market access meant that a broader
range of domestic and foreign institutions were able to provide banking and other financial services in
a given market. The range of services on offer also expanded; and an increasing number of both
markets and institutions became active across national boundaries. While this entailed lower costs of
products and services for consumers, this also entailed the possibility of contagion with ramifications
extending well beyond national borders particularly in the context of inadequate development of
financial markets in some countries.
On the flip side, however, this transformation of the financial marketplace extended and tightened
linkages across markets and institutions, increasing the uniformity of the information sets available to
economic agents and encouraging greater similarity in the assessment of information, driven to a large
extent by advances in information technology and communications networking. This, in effect, meant
that weaknesses in the financial system could engender serious and far more disruptive economic
consequences than was previously the case, and could increasingly engender contagion effects
extending well beyond national boundaries. The Mexican crisis of 1994-95, the East Asian crises of
1997-98 and the more recent crises in Argentina and Turkey are ample testimony to this fact. At the
national level, the banking crises in Nordic countries in the 1980s and 1990s, the problems in the
Philippines and Korean banking systems in the 1990s (and the near panic at the time of the LTCM
affair), and the financial bubble in Japan whose costs are felt even at present, deserve mention.
During the 1980s and 1990s, nearly one hundred national banking systems collapsed, many more
than in any comparable previous period. The range of movements in exchange rates and the extent of
deviations in market exchange rates from real exchange rates - the magnitude of undershooting and
overshooting - were larger than in any previous period. There were also massive asset price bubbles
in some countries: Japan, Sweden, Thailand, South East Asian Countries like, Malaysia and finally in
the United States.
All this meant that the sources of crises, which were earlier traced primarily to weaknesses in banking
systems, became manifold, and could emanate from any segment of the financial sector with
possibilities of spillovers to other sectors and countries. More importantly, as the Asian crises amply
demonstrated, such crises could even affect economies with sound real sector fundamentals. The
deficiencies in the international financial architecture meant that the IMF was no longer large enough
to take care of the crises. The earlier concerns on banking stability therefore become much larger in
scope and content, to assume the term 'financial stability'.
These developments have had several consequences for the institutional and systemic structure.
Among the most important of these from the point of view of systemic significance has been
disintermediation. Credit-worthy firms are relying increasingly on capital markets, rather than bank
loans, to finance investment projects. This has led to the deepening of capital markets of various
kinds, as well as to a more important role for the institutions that deal in traded securities.
A second important structural change is the emergence of markets for risks of different kinds, in which
exposures to specific market or credit risk can be bought and sold separately from financial assets.
This has provided economic agents the leeway to reduce or increase their exposure to specific
categories of risk.
A third key trend has been changes in the business profile of financial institutions. In many countries,
services traditionally associated with "banking" are now offered by institutions not legally characterized
as banks, while banks are increasingly engaged in para-banking activities.
These fundamental changes - deregulation, liberalization and disintermediation - have, not
surprisingly, made financial systems far more interconnected, with possible ramifications for contagion
in the event of an exigency in any country. As a consequence, central banks, which were traditionally
focused on monetary and banking stability, have increasingly come to focus on financial stability as a
key concern in the conduct of monetary policy.
How are central banks responding to this development?
Avoiding crises becomes ultimately a national responsibility. The impact of instability in times of crisis
typically tends to be borne by domestic taxpayers rather than the global private entities. The burden of
such an asymmetric adjustment means that there is a need to institute domestic mechanisms that
could focus on the aspect of financial stability on an on-going basis. As institutions traditionally
mandated with the task of price stability, central banks became the natural choice for Governments to
be entrusted with oversight of financial stability.
Given that financial stability has become a paramount focus of central banks, the key question
therefore arises is: how are central banks responding to the challenge? Interestingly, new legislations
explicitly provide mandates for financial stability; illustratively, Hungary passed such legislation in
2001, the Netherlands in 1993, Spain in 1994 and the UK in 1997.
So, the question is why have the central banks become interested in financial stability? Central banks
are clearly responsible for issue of currency, maintaining its value as a means of exchange and unit of
account. They are also responsible for maintaining the efficiency and integrity of payment systems.
Ultimately, they are the lenders of last resort. Notwithstanding the complexity involved, evidence
suggests that involvement in financial stability can be broadly categorised into five types of activities.
Being a key fulcrum of the policy apparatus responsible for financial stability, central banks might be
involved in several of these tasks.
oversight of the financial
First, infrastructure: This involves the operation as well as oversight of the
payments and settlement systems and securities clearing system. It might also involve oversight of
financial disclosures, market conduct and the like. It is important to note that all at the markets need
the payment system, including the capital market.
Second, regulation and supervision of financial entities: This involves the formulation of prudential
guidelines (capital adequacy and reserve requirements, provisioning norms, risk management
standards), the monitoring of compliance with those rules (on-site inspection and off-site surveillance)
and the imposition of sanctions in case of non-compliance.
safety net
Third, provisions: This involves decisions to restructure troubled banks as well as 'honest
brokering'. It also involves the operation of financial safety net in the form of deposit insurance.
Fourth, Liquidity: The response to a crisis may necessitate judicious use of the emergency liquidity
assistance facilities in order to avoid disruptions from disorderly failures and to contain contagious
strain. Only central banks can inject liquidity.
Fifth, market surveillance: central banks are often involved in the regulation and surveillance of
markets. The three markets that are primarily the focus of surveillance by central banks are the
money, bond and foreign exchange markets.
macro financial
In addition, central banks are typically concerned with stability. This encompasses
monitoring the behaviour of all important players in the financial sector, the health of non-financial
sector balance sheets as well as assessment of systemic vulnerabilities. This analysis is accompanied
by communication policy on financial stability issues, either through dedicated financial stability reports
or disclosure of information on financial stability as part of regular reports (Annex 1). The basic motive
behind such reports is to communicate to the markets and the public at large and thereby express the
commitment of the central bank for achieving its objectives. This is accompanied by a process of
structured communication among the various bodies involved in the pursuit of financial stability.
In their quest for financial stability, central banks worldwide have exhibited a variety of responses. On
the one hand, several central banks have been given an explicit mandate to promote financial stability
(Annex 2). Another broad category of response has been the constitution of independent departments
to oversee financial stability. Illustratively, at the Reserve Bank of New Zealand, the supervisory and
financial market departments were merged into a Financial Stability Department. At the ECB, the area
concerned with financial stability matters (Prudential Supervision Division) was upgraded to a
Directorate (Financial Stability and Supervision), which reports to a member of the Executive Board,
and plays a coordination role for euro area/ EU financial stability monitoring. Finally, the Bank of
England has also constituted a dedicated Financial Stability Department for oversight of financial
stability matters, headed by a Deputy Governor. The transfer of supervisory responsibilities outside the
central bank in several countries has also led central banks to focus their attention on systemic issues
as reflected in a reorientation of organisational arrangements.
The crux of these observations is that financial stability has been a prime locus of change in central
banks and increasingly, central banks are taking a pro-active stance to address the threats posed by
Financial Stability
financial instability. For instance, the Forum, for instance, was created in the
aftermath of the Asian financial crisis, comprising members as major countries, international financial
institutions such as BIS and IMF and the international standard setters such as International
Organisation of Securities Commissions (IOSCO) and International Association of Insurance
Supervisors (IAIS).
Having traced the broad contours of the growing importance of financial stability worldwide and the
role played by central banks in the process, let me turn to how the Reserve Bank has been responding
to the challenge.
Indian experience on financial stability - an overview
Till the onset of reforms in the early 1990s, India was a relatively closed economy, being largely
insulated from the vicissitudes of global markets. It was not, of course, totally insulated from
exogenous shocks. The severe drought of 1965 to 1967, the oil shocks of 1973, 1979 and 1989, and
wars all had significant effects including the emergence of external payments crises. However, the
financial system was effectively controlled, particularly in the 1970s and 1980s and the risk of financial
contagion was therefore not high.
The gradual opening up of the economy since the 1990s raised several important challenges for
central bankers. The opening of the external sector meant that developments in India came to be
increasingly influenced by developments abroad. It is interesting to look at some numbers. Contrary to
various perceptions, the Indian economy is now substantively open. As the Finance Minister observed
in a lecture at Yale University, whereas India's GDP in 2004-05 was roughly US $700 billion, the gross
flows on the current account and the capital account, put together, came to US $500 billion. This is
despite the fact that trade tariffs are still higher than in most other countries in the world, and that
capital account controls still exist. The large capital inflows, despite the cautious approach to
liberalization, meant that such flows can engender volatility in exchange rate movements. The speed
of capital flows, both inward and outward, is much higher than current account flows and can therefore
destabilize the exchange rate, and operation of financial and capital markets, possibly in response to
external events unconnected with the domestic economy (Jalan, 2003). Consequently we have to be
concerned with exchange rate instability, as distinguished from mere fluctuation, for its potential to
affect other markets, both goods and capital markets. Exchange rate instability arising from external
events can give rise to domestic instability in the operation of the stock market, government securities
markets, and the money markets, along with their attendant effects. For emerging economies such as
India, it therefore becomes necessary to institute special defenses for ensuring financial stability.
Furthermore, with the interest rate emerging as a key channel of monetary policy signals, the efficacy
of monetary transmission is predicated on the health of the financial sector. The gradual liberalization
of the financial sector has also witnessed the emergence of conglomerates, with attendant systemic
implications.
More broadly however, the period since the 1990s has been testimony to several shocks impinging on
the economy. Illustratively, nuclear sanctions and the border tensions in the late 1990s, the monsoon
vagaries in the recent past, most recently in 2003, the crises in East Asia in 1997 and 1998, the
upheaval in domestic stock markets in May 2004 coupled with the recurrent oil price fluctuations, has
meant that the economy has been susceptible to intermittent shocks. And unlike the shocks of earlier
decades, the economy has been able to withstand these disruptions with limited impact on the
financial sector. The role of central banks in such a milieu is not hard to foresee. The response of the
Reserve Bank in May, 2004 is a case in point. Judged thus, the role of Reserve Bank in its task of
monitoring financial stability can hardly be over-emphasized.
Financial stability has, therefore, emerged as a key consideration in the conduct of monetary policy. In
this process, the Reserve Bank has adopted a two-track approach in the pursuit of financial stability.
First, by ensuring monetary stability through lowering of inflation, it has lowered inflationary
expectations, thereby fostering financial stability. Second, the Reserve Bank has adopted a
multipronged strategy, with suitable country-specific adaptations, to promote stability of financial
institutions, financial markets and the financial infrastructure. The stable economic regime combined
with the macro financial oversight of the financial system has imparted confidence to market players to
conduct their business in an orderly manner.
In general, it is possible to discern two broad sets of instruments by which the Reserve Bank has been
addressing the financial stability concerns: preventive instruments, comprising micro and macro
prudential measure and reactive instruments, comprising liquidity support measures and public
intervention tools aimed at safeguarding depositors' interests.
With regard to institutions, the Reserve Bank founded the Board of Financial Supervision in 1994 to
upgrade its practice of financial supervision. A set of prudential norms for the commercial banking
sector had been instituted as early as 1994 with regard to capital adequacy, income recognition and
asset classification (IRAC), provisioning, exposure norms and more recently, in respect of their
investment portfolio. The approach adopted here was one of gradual convergence with international
best practices, while internalizing it to suit country-specific requirements. In tandem with the gradual
opening up of the economy, the regulatory and supervisory framework was spruced up comprising of a
three-pronged strategy of regular on-site inspections, technology-driven off-site surveillance and
extensive use of external auditors. As a result of improvements in the regulatory and supervisory
Core Principles
framework, the degree of compliance with the Basel has gradually improved. The
supervisory framework has been further upgraded with the institution of a framework of Risk-based
Supervision (RBS) for intensified monitoring of vulnerabilities. A scheme of Prompt Corrective Action
(PCA) was effected in December 2002 to undertake mandatory and discretionary intervention against
troubled banks based on well-defined financial/prudential parameters. In view of the growing
emergence of financial conglomerates and the possibility of systemic risks arising therefrom, a system
of consolidated accounting has been instituted. A half-yearly review based on financial soundness
indicators is being undertaken to assess the health of individual institutions and macro-prudential
indicators associated with financial system soundness. The findings arising thereof are disseminated
to the public through its various Reports. In fact, in 2003 that the Reserve Bank published a chapter
titled 'Financial Stability' in its Report on Currency and Finance in that year, highlighting its challenges
and problems in the pursuit of stability. Subsequently, with effect from 2004, the annual statutory
Report of Trend and Progress of Banking in India has began to publish a dedicated chapter on
financial stability. This is in addition to the Monetary and Credit Policy Review where the Governor
highlights the threats and challenges to the financial environment before announcing policy measures.
Given the multi-faceted nature of financial stability, no one body might be in a position to monitor it in
its entirety. Keeping this in view, the Ministry of Finance has constituted a High-Level Coordination
Committee on Financial and Capital Markets with the Governor, RBI, Chairman, Securities and
Exchange Board of India (SEBI) and Chairman, Insurance Regulatory and Development Authority
(IRDA) along with the Finance Secretary, Government of India as members to address policy gaps
and overlaps.
An important aspect of the financial stability process has been the growing emphasis on the role of
market discipline. As part of the process, the Reserve Bank has laid strong emphasis on the levels of
transparency and standards of disclosure in banks' balance sheets. These disclosures, presently
supplemented as 'Notes on Accounts' not only encompasses prudential ratio pertaining to capital
adequacy (tier-I and tier-II separately) ratio, non-performing loans, exposure to sensitive sectors
(capital market, real estate and commodities), but also financial ratios such as interest and
noninterest income as percentage of working funds, return on average assets and net profit per employee.
These disclosures have been gradually expanded over time and presently include maturity pattern of
assets and liabilities (both Rupee and FC), movements in non-performing loans, issuer composition of
non-SLR investment, assets subject to corporate debt restructuring as well as details of assets sold to
Securitisation / Reconstruction company.
You would also appreciate that the performance of the non-financial sector has an important bearing
on financial stability. Keeping this in view, the Reserve Bank has also been closely monitoring the
stability ratios of the non-financial sector. In the corporate sector for instance, the reduction in debt
liabilities following corporate restructuring and reduced interest expenses in an environment of low
interest rates has improved the financial stability indicators in manufacturing. Available indications are
that both consumption and investment demand are currently buoyant. Business surveys also point to
high levels of both business confidence and capacity utilisation. The improved investment sentiment
and business confidence, as reflected in the increasing number of firms incurring capital expenditure,
suggests the prospects for buoyant manufacturing growth in 2005-06.
You would all be aware that issues of governance in banks has assumed relevance worldwide in the
wake of accounting irregularities in the US and elsewhere. Problems in governance can derail even
the best efforts on the part of regulators to ensure financial stability. To address this aspect, the
Reserve Bank issued guidelines on ownership and governance based on well-defined principles, viz.,
a well-diversified ownership and control; important shareholders being 'fit and proper'; directors and
CEO being 'fit and proper' and observation of sound corporate governance principles.
An important hallmark of the pursuit of financial stability in India has been the adoption of a
consultative approach to policy formulation, taking on board the various stakeholders in the financial
system. Such an approach has had the merit of providing useful lead time to market participants to
adjust their behavior in conformity to the regulatory guidelines.
Evidence suggests that no two crises are exactly alike. As a result, in addition to preventative
instruments just discussed, the Reserve Bank had also resorted to reactive instruments.
One such instrument is emergency liquidity support. Thus, in very rate and unusual circumstances,
when a bank faces a sudden and unforeseen liquidity problem, the Reserve Bank has, on an earlier
occasion, at its discretion, extended liquidity support to the bank.
A second such instrument is the provision of safety net in the form of deposit insurance (DI). In India,
DI is mandatory and covers all banks (commercial / cooperative / RRBs / LABs). All deposits except
(a) deposits of foreign governments, (b) deposits of Central/State governments, (c) inter-bank deposits
and (d) deposits held abroad are covered by DICGC. The amount of coverage is presently Rs.1 lakh
(Rs.100,000), and is provided to deposits held in the same right and in the same capacity. Given the
present limit, as much as 95 per cent of deposit accounts and 66 per cent of assessable deposits are
fully protected. Given the level of per capita GDP at constant prices (Rs.15017 in 2004), this implies
that the coverage limit is roughly 6 times the per capita GDP (Annex 3). The premium is charged on a
flat rate basis, which is presently 8 paise per Rs.100 of assessable deposits for the year 2004-05 and
10 paise from 2005-06 (earlier it was 5 paise per Rs.100 of assessable deposits).
A third instrument is treatment of insolvent banks (winding down). The Reserve Bank, rather than
closing them down, has shown a preference for merging such banks with healthy banks. The rationale
behind such an approach has been dictated by two considerations. First, given the dominance of
commercial banks, their closure can raise systemic concerns. Second, given that a significant portion
of bank depositors in India are small, it is imperative to safeguard their interests, while dealing with
insolvent banks (Mohan, 2004).
The second broad element of strategy has been the development of financial markets. Ensuring
financial markets
orderly conditions in has been an important component of the Reserve Bank's
approach towards financial stability. The cornerstone of the process has been to widen, deepen and
integrate various segments of financial markets to enable the price discovery process, lower
transactions costs and enhance market liquidity. Accordingly, the operating procedures of monetary
policy have been continuously fine-tuned to attune it to the realities of market dynamics.
In the money market, the focus has been on developing a deep and liquid money market, supplanted
by a wide array of instruments to modulate monetary conditions with a relative emphasis on indirect
policy instruments to enable swift responses to changing market conditions. In the face of large capital
flows, a new facility in the form of Market Stabilisation Scheme (MSS) was instituted in April 2004. The
MSS essentially seeks to differentiate the liquidity absorption of a more enduring nature by way of
sterilisation from the day-to-day normal li