Y V Reddy: Monetary and regulatory policies - how to get the balance
with markets right
Remarks by Dr Y V Reddy, Governor of the Reserve Bank of India, as a panelist at the
Annual General Meeting Panel of the Bank for International Settlements, Basel,
29 June 2008.
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Chairman Jean-Pierre Roth, Governor Meirelles, distinguished economist Bill White, fellow
governors and friends.
It was a treat to listen to Edward Lord George's wonderful and erudite lecture on the
"Approach to Macroeconomic Management - How it has evolved" and Sir Andrew Crockett's
comments, as Chairman, on Lord George's Per Jacobsson Lecture and also on Lord George
- "Steady Eddie" as he is warmly described. The Reserve Bank of India considers both of
them as our special and lasting friends.
I am also thankful for the opportunity provided to me to share my thoughts on monetary and
regulatory policies. At the outset I would like to underscore that the critical word in the title is
"balance". So we have to recognize the links and interactions between the two, which may at
times be reinforcing and at times be conflicting.
In this balance, "time-dimension" is important. We know whether the balance is right or
wrong only ex-post. For example, when there is all round prosperity, everyone wants
everything to be left to the markets; when things go wrong and there is pain, monetary and
regulatory policies are invoked to save the situation. I will add that, in the balance to be
maintained, public opinion is also important for the legitimacy and the effectiveness of
monetary policy. Public opinion goes beyond financial markets and institutions, but it is useful
to remember that it includes government and media also.
Country-context is important because institutional factors of governance, state of the
marketdevelopment, and values are relevant in the context of "balance". Hence, we cannot be
judgmental about "balance" across countries, but we should assess the balance only in a
country-specific context.
I will present India's experience in recent years as to how we are viewing "balance", after
recognizing all the above factors.
First, on monetary policies, we monitor the monetary and credit aggregates. We use both
liquidity and interest rate instruments. A dynamic balance is evident from the spread between
the repo and reverse repo rates, which is enlarged during times of uncertainties. It has
moved from 150 basis points to 100 basis points when times were good and has now moved
to 250 basis points, reflecting greater uncertainties. We believe that market participants
should be willing to share some costs of uncertainties. Pre-emptive actions have been taken
since 2004 to withdraw monetary accommodation, which were reinforced with measures
aimed at moderating early signs of over-heating. Further, a differentiated approach between
the permanent component and temporary component with regard to oil prices has been
articulated in the policies. We did not treat oil prices entirely as a shock and focus on what is
described as core inflation. While undertaking a nuanced approach to managing aggregate
demand recognising the elements of shock and consequent impact on inflation expectations,
the underlying demand conditions warranted several interest rate and liquidity measures in
recent weeks.
Second, while monetary policy influences aggregates, reality in the financial sector is often
dis-aggregated. So we have used regulatory policies to supplement the monetary measures.
These relate mainly to risk weights, and provisioning requirements with regard to exposure to
NBFCs, capital markets, real estate, consumer credit etc; sectoral caps; and more recently
modulation of the exposure limits to oil companies.
Third, we do not take a view on asset prices, either in the real estate or the capital markets.
Though we do not take a view, we wanted to protect the banking system form possible risks.
In this regard, the nature of the markets is also important, for example, the housing markets
in India are less than liquid. We also modified the overly conservative accounting norms that
were earlier applicable to the Held to Maturity category, in India.
Fourth, A supervisory review process (SRP) was initiated with select banks having significant
exposure to sensitive sectors, including reliance on call money market, in order to ensure
that effective risk mitigants and sound internal control systems are in place. In the first round,
a framework was developed for monitoring the systemically important individual banks. The
second round of SRP was directed to analyse banks' exposure to sensitive sectors and
identify outliers. Based on the analyses of these outlier banks, guidelines were issued to all
banks indicating the need for better risk management systems in banks at operating levels.
In brief, in India the focus is on regulatory comfort rather than on regulatory compliance. In a
choice between emphasis of regulations on saving capital and protecting depositors'
interests or reinforcing financial system stability, the latter have always prevailed.
Fifth, we regularly interact with the industry associations namely the Indian Bankers'
Association, the Foreign exchange Dealers Association of India, the Primary Dealers
Association of India and the Fixed Income and Money Market Dealers Association of India.
Incidentally, the last two were promoted by the Reserve Bank of India. We have three-stage
participation in the process issue of important regulations. This normally involves preliminary
discussions with the representative bodies and select market participants; preparation of a
Technical Report by working groups that often include the regulators and the market
participants and academia; and placing the Report in public domain for a feedback. On the
basis of the Report and the initial feedback, draft guidelines are usually formulated and again
placed in public domain for a feedback. These guidelines are finalized on the basis of the
further feedback.
Sixth, our regulations and our policies are focused on the common person. This is, for
example, reflected in our approach to transparency by the industry, the ombudsman
mechanism, the setting up of a Banking Codes and Standards Board of India, guidelines on
recovery agents etc. This focus on the common person enhances the legitimacy of the RBI in
the public eye vis-à-vis market intermediaries. Though RBI issues micro regulations at times,
this is necessary to strike a better balance between financial institutions and public interest at
a micro level with reference to the common person.
Seventh, moral suasion and public articulation of concerns has helped in achieving a desired
re-balancing of suspected excesses in risk-taking among banks. Some of the areas where
moral suasion has been used are the need for banks to monitor unhedged foreign currency
exposures of their corporate clients, adoption of appropriate incentive mechanisms by banks
for encouraging disclosures of derivative exposures by their corporate clients, banks' reliance
on non-deposit resources to finance assets, their excessive reliance on wholesale deposits
and uncomfortable loan-to-value (LTV) ratios in respect of housing loans etc.
Eighth, the RBI has also focused on liquidity mechanisms and systems. Asset liability
management is left to the banks, but regulatory limits on short term buckets are prescribed.
Further, in order to reduce the extent of concentration of bank's liabilities the Reserve Bank
had issued guidelines to banks in March 2007 placing prudential limits on the extent of their
Inter-Bank Liability (IBL) as a proportion of their networth (200%). Those banks which had a
higher capital adequacy ratio of 125% of the regulatory minimum were allowed a higher limit
of 300% of networth. In addition, prudential limits have also been placed on the extent to
which banks may access the inter-bank call money market both as a lender and as a
borrower.
Ninth, whenever out-of-the-ordinary situations arise, exceptional or flexible arrangements are
needed. Timely flexibility, while reacting to the underlying balance is essential. This helps in
avoiding more serious problems relating to the balance over the medium-to-longer term. For
example, recently oil imports had to be financed through off-market processes. Delayed
adjustments to such sudden and unexpected cross-border exogenous developments at such
times may impose a stress on liquidity. Hence, addressing frictional issues of liquidity as
distinct from underlying issues of levels of liquidity is required to look at the balance
dynamics.
Thank you.