Duvvuri Subbarao: Financial crises and the impact of the latest one on
India
Welcome remarks by Dr Duvvuri Subbarao, Governor of the Reserve Bank of India, at the
Fourteenth C D Deshmukh Memorial Lecture, Mumbai, 15 February 2010.
* * *
1. On behalf of Reserve Bank of India, I have great pleasure in welcoming Lord Turner,
Chairman of the Financial Services Authority of the UK, who will shortly be delivering the
C.D. Deshmukh Memorial Lecture. I also want to specially acknowledge the family members
of late Sir C.D. Deshmukh - Smt. and Shri Atul Deshmukh, Shri Ashish Deshmukh and Smt.
and Shri Chitnis - who are here with us today. Thank you very much to all of you for rejoining
the RBI family today. And, of course, a hearty welcome to all our invitees.
2. Sir Chintaman D. Deshmukh has a special place in the history of the Reserve Bank of
India. He was the first Indian Governor of the Reserve Bank, and served here from August
1943 to June 1949. He presided over the transformation of the Reserve Bank from a private
shareholders' bank to a nationalised institution and was the intellectual force behind the
enactment of a comprehensive legislation for the regulation of banking companies.
Shri Deshmukh participated actively in the establishment of the Bretton Woods institutions in
1945 and played a critical role in managing the nascent economy as we confronted the
challenges of war financing following the Second World War. After leaving the Reserve Bank,
Shri Deshmukh went on to become the Finance Minister of India, a career graph repeated by
our current Prime Minister, Dr. Manmohan Singh nearly forty years later. Shri Deshmukh
brought to the office of the Finance Minister a passion for newly independent India's
development and a humane and inclusive vision for nation building.
3. The Reserve Bank instituted the C.D. Deshmukh Memorial Lecture in 1984 to honour
the memory of this illustrious Governor of the Bank and a great citizen of India. This year's
lecture, to be delivered by Lord Turner, is of special significance as it forms part of our
Platinum Jubilee celebrations.
4. Lord Turner, who has been Chairman of FSA since September 2008, is a familiar, and
also a famous, name in financial circles. He has had a multi-faceted career background
straddling business, public policy and academia. He became a cross-bench member of the
House of Lords in 2005, and has been the Chairman of the Climate Change Committee since
January 2008. He is a Visiting Professor at the London School of Economics and the Cass
Business School of the City University. Prior to that, he held prominent positions, such as the
Chairman of the Pensions Commission and the Low Pay Commission. Outside of the
Government, Lord Turner was associated with the Standard Chartered Bank, Merrill Lynch
Europe, Confederation of British Industry, and McKinsey and Company. Lord Turner's 2001
book - "Just Capital - The Liberal Economy" has been acclaimed for its insights and lateral
thinking.
5. There is a deluge of analysis and writing on what caused the crisis and on how to
prevent a recurrence. It is not possible for anyone to keep track of all that. But if you want
one source from which you can get the diagnosis and prescription for regulatory reforms
following the crisis, I suggest you read the Turner Review conducted under the intellectual
leadership of Lord Turner. Spread over four chapters, the Review describes what went
wrong, and the extent to which the crisis challenges past intellectual assumptions about the
self-correcting nature of financial markets. The Review sets out the actions required to create
an effective banking system, better able to serve the needs of the businesses and
households and less likely to be susceptible to financial instability.
6. I want to spend a couple of minutes giving Lord Turner a brief synopsis of the crisis and
the aftermath in India.
7. The crisis that erupted with the collapse of Lehman Brothers in September 2008
spread rapidly thereafter - sector by sector and economy by economy. Almost every country
in the world has been impacted, although to a different extent. India was no exception.
8. Largely driven by the then intellectually fashionable decoupling theory, there was
dismay in India that we were hit by the crisis. This dismay arose from two factors. First, there
was surprise that we were hit by a crisis with origins in the banking system even as our
banks, and indeed our entire financial system, had minimal exposure to tainted assets.
Second, there was also concern that we were hit by global recession even though our export
sector, at 15% of GDP, was relatively small.
9. The answer to both these points is that India was hit by the crisis because we are more
globally integrated than we tend to acknowledge. We were impacted through all channels -
the financial channel, the real sector channel and the confidence channel. The impact of
crisis on India was, however, relatively muted. India's financial sector remained safe and
sound, and our financial markets continued to function normally highlighting the stability
enhancing features of our policy and regulatory framework.
10. Just to highlight a few features of our approach to safeguarding financial stability. On
financial globalization, our stance has been gradualist. We view capital account liberalisation
as a process and not an event. The extent of opening is contingent upon progress in other
sectors. Our policy framework encourages equity flows, especially direct investment flows.
But debt flows are subject to restrictions, and these are reviewed and fine-tuned periodically.
The exchange rate is largely market-determined and we intervene in the foreign exchange
market in times of excessive volatility. Our approach to financial sector regulation has been
informed by the fact that our system is dominated by commercial banks. Thus, as early as
mid-1990s, the Reserve Bank instituted the prudential framework governing banks,
especially commercial banks, as a part of the overall structural reforms. As of April 2009, all
our commercial banks are Basel II compliant.
11. The Reserve Bank has been proactive in adopting a counter-cyclical approach to
financial regulations. Notably, in the years before the crisis, we increased the risk weights
and provisioning norms on a selective basis. The intent was to limit the exposure of the
banking system to sensitive sectors of the economy posting high credit growth and thereby
prevent mispricing of risk. Again, in another counter cyclical measure, as part of crisis
management, we reversed the earlier tightening and normalized the risk weights and
provisioning norms to facilitate credit flow to these sectors.
12. India's banking system has remained remarkably well capitalized with capital to risk
weighted asset ratio (CRAR) much above the minimum prescribed under Basel II. The asset
quality post-crisis also remained sound though there has been a slight deterioration in recent
months. In recognition of the fact that banks should build up provisioning and capital buffers
in good times which can be used for absorbing losses in a downturn, recently, banks have
been advised to ensure that the provisioning coverage ratio, i.e., the ratio of provisioning to
gross NPA, is not less than 70 per cent. In view of the heightened concerns with regard to
financial stability during the recent years, the Reserve Bank is retooling itself to safeguard
financial stability. We have also set up a Financial Stability Unit which will make regular and
systematic assessment of the stability of the Indian financial system.
the crises: Assessing the costs and
13. Lord Turner will be speaking to us today on "After
Benefits of Financial Liberalization", a topic of great obvious relevance.
14. A study of financial crises shows that almost every crisis is preceded by, if I may use
what is by now a cliché, "irrational exuberance" of the financial sector with the growth of the
financial sector outstripping the growth of the real sector engendering a belief, bordering on
hubris, that real value can be created by sheer financial engineering. Take this crisis for
example.
15. In the world that existed before the crisis - a benign global environment of easy
liquidity, stable growth and low inflation - profits kept coming, and everyone got lulled into a
false sense of security in the firm belief that profits will keep rolling in forever. Herb Stein, an
economist, pointed out the truism that, "if something cannot go on for ever, it will eventually
stop." But no one paid attention. The magic of the financial sector gave it such a larger than
life profile that we began to believe that for every real life problem, no matter how complex,
there is a financial sector solution. Now, of course, we know better - for every real life
problem, no matter how complex, there is a financial sector solution, which is wrong.
16. Take the case of the United States. Over the last 50 years, the share of value added
from manufacturing in GDP shrank by more than half from 25 per cent to 11 per cent while
the share of financial sector more than doubled from 3.6 per cent to 7.5 per cent. The job
share of the manufacturing sector declined by more than half from 29 per cent to 11 per cent
while the job share of the financial sector increased by over a third from 3.5 per cent to
4.6 per cent. The same trend is reflected in profits too. Over the last 50 years, the share of
manufacturing sector profits in total profits declined by more than half from 49 per cent to
21 per cent while the share of profits of the financial sector increased by more than half from
17 per cent to 27 per cent. Clearly, the excessive risk-taking behaviour of the financial sector
raised the value-added of the sector beyond a sustainable level making the melt down, in
retrospect, inevitable.
17. Forgotten in the euphoria of financial alchemy is the basic tenet that the financial sector
has no standing of its own; it derives its strength and resilience from the real economy. It is
the real sector that should drive the financial sector, not the other way round.
18. Financial crises are not uncommon. Then how come we don't learn? I can do no better
This Time is Different: Eight
than quote Reinhart and Rogoff. In their recent seminal book -
centuries of Financial Folly, they say, [I quote]:
"Finance professionals and, all too often, government leaders explain that we are
doing things better than before, we are smarter, and we have learned from past
mistakes. Each time, society convinces itself that the current boom, unlike the
many booms that preceded catastrophic collapses in the past, is built on sound
fundamentals, structural reforms, technological innovation, and good policy".
[unquote]
19. Having said that, we must remember that not all financial liberalization is bad; the world
has benefitted from financial innovation and liberalization. True, the damage inflicted by the
crisis has been colossal, but the world enjoyed the benefits of the Great Moderation - over
15 years of unprecedented growth, price stability and low unemployment.
20. It is important therefore to take a balanced view. Who better then than a person with
the scholarship and stature of Lord Turner to approach that balanced view.
21. Lord Turner incidentally is the second Chairman of FSA to deliver the C.D. Deshmukh
Memorial Lecture. Mr. Howard Davies, the then Chairman of FSA, had delivered the tenth
C.D. Deshmukh Memorial Lecture in February 2000 on the subject of "International Financial
Regulation: The Quiet Revolution". In his concluding statement, Mr. Davies had said, "I wish
you a volatile, but not too volatile, future". In many ways, Mr. Davies prediction has come
true. We had our share of volatility, and I believe it has been good for us, giving us as it did,
an opportunity for us to work on Schumpeterian "creative destruction".
22. Lord Turner has two important responsibilities. Apart from being the Chairman of FSA,
he is also the Chairman of the Committee on Climate Change (CCC). I believe that is a fair
balance. As Chairman of FSA, his job is to save capitalism from well, the onslaught of
capitalists. As Chairman of CCC, his job is to save the planet from the onslaught of
capitalism. In short, Lord Turner handles recessions with one hand and emissions with the
other.
23. Lord Turner, once again, I want to say, we are delighted that you have accepted our
invitation. I now have great pleasure in inviting you to deliver the 14th C. D. Deshmukh
lecture.