Duvvuri Subbarao: Lessons from the global financial crisis with special
reference to emerging market economies and India
Statement by Dr Duvvuri Subbarao, Governor of the Reserve Bank of India and Leader of
the Indian delegation at the International Monetary and Financial Committee Meeting, at the
International Monetary Fund, Washington DC, 11 October 2008.
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1. Since the collapse of the leading US investment banks in August-September 2008, there
has been a breakdown of trust in inter-bank and inter-institutional lending. Given that this
kind of extreme risk perception will be reversed only slowly, the full resolution of the crisis will
inevitably take time.
2. Additionally, there is the problem of contagion - across markets, across institutions and
across countries. Each day, there is news of the crisis spreading to a newer part of the world
or to a newer institution. What we are going through is an unprecedented crisis; and we will
be failing the world if we do not draw lessons from the crisis to prevent its recurrence. It is on
these lessons that I want to focus.
3. First, financial supervision has drawn widespread critique. The stereotype perception is
that risk management and supervisory practices lagged behind financial innovations and
emerging new business models. The present crisis underscores the need for regulation
staying ahead of the curve, and for continually upgrading the skills and instruments for
financial regulation and supervision. However, there is need for a note of caution here. There
is a distinct risk that in trying to stay ahead of innovation, regulation may get so stringent that
it stifles innovation. This is a risk we must guard against.
4. The second lesson relates to the inter-agency coordination. The origins of the current
crisis can be traced to both the build up of macro-global imbalances as well as the mispricing
of risks in the financial system, which in turn, was encouraged by prolonged easy monetary
policy and excess liquidity. We endorse the IMF view that the respective roles of central
banks, regulators, supervisors, and fiscal authorities regarding financial stability needs to be
revisited. Central banks should play a central role in maintaining financial stability and should
have the necessary informational base to do so effectively. This implies close co-operation
among all the agencies entrusted with the task of maintaining financial stability.
5. The third lesson is that the will have implications for the
large scale bail-out packages
regulatory architecture of the financial system and for the fisc of countries. Besides, the
rescue packages offered by one country could have ramifications for other countries, even
when they are far from the epicentre of the crisis. A relevant issue in this context is the
efficacy and coverage of deposit insurance. What should deposit insurance cover? How are
small deposits to be defined? Apart from small deposits, should we, in a crisis situation like
this, consider extending guarantees to the money markets and mutual funds?
6. Fourth, the unfolding crisis has revealed the weaknesses of structured products and
derivatives in the credit markets. This throws up questions about the appropriateness of
various structured product like credit derivatives and their financial stability implications. Are
exchange traded derivatives superior to over the counter (OTC) derivatives? Do we need to
focus on prescribing and instituting appropriate clearing and settlement practices even for
OTC products? In what way can we eliminate the shortcomings of the "originate-to-distribute"
model?
7. Finally, the near meltdown of the US financial sector is seen by some as evidence that
markets and competition do not work. This is clearly the wrong lesson to draw. The right
lesson to draw is that markets and institutions do succumb occasionally to excesses, which
is why regulators have to be vigilant, constantly finding the right balance between attenuating
risk-taking and inhibiting growth.
8. Let me now make a brief comment on India.
9. India, with its strong internal drivers for growth, may escape the worst consequences of
the global financial crisis. Indian banks have very limited exposure to the US mortgage
market, directly or through derivatives, and to the failed and stressed financial institutions.
The equity and the forex markets provide the channels through which the global crisis can
spread to the Indian system. The other three segments of the financial markets - money,
debt and credit markets - could be impacted indirectly. Risk aversion, deleveraging and
frozen money markets have not only raised the cost of funds for Indian corporates but also
its availability in the international markets. This will mean additional demand for domestic
bank credit in the near term. Reduced investor interest in emerging economies could impact
capital flows significantly. The impending recession will also impact on Indian exports.
10. To sum up, even EMEs which do not have direct or significant exposure to stressed
financial instruments and troubled financial institutions are experiencing the indirect impact of
the financial crisis, and this impact is by no means insignificant or trivial. Indeed, it could
intensify in the months ahead.
11. It is heartening that there is coordination among developed countries in the management
of the crisis. That is welcome and necessary, but not sufficient. In as much as emerging and
developing economies are likely to be increasingly impacted by the crisis, going forward two
things are necessary. First, in managing the crisis, the implications of that management for
emerging and developing economies should be explicitly factored in. Second, emerging and
developing economies should be taken into confidence and consulted whenever the policies
and actions of the developed countries have implications for them.