) shadow banking system – greater consistency in regulation 18. another important regulatory challenge is ensuring “ greater consistency in regulation of similar instruments and institutions performing similar activity ” to prevent or contain regulatory arbitrage. in the case of systemically important non - deposit taking nbfcs ( nbfcs - nd - si ), a gradually calibrated regulatory framework in the form of capital requirements, exposure norms, liquidity management, asset liability management and reporting requirements has been extended, which has limited the space for regulatory arbitrage as also their capacity to leverage. given the increasing significance of the sector, the supervisory regime for the systemically important nbfcs will need to be strengthened further for a more robust assessment of the underlying risks. a working group under the former deputy governor, ms. usha thorat on nbfcs has, inter alia, examined the issues related to the regulatory gaps and arbitrage opportunities that exist in the system, and has given recommendations for addressing these issues as well as for enhanced disclosure requirements and improved supervisory practices, etc. ( iv ) other issues 19. the indian banking system has a modest leverage which provides comfort. the rbi has also been enhancing and fine - tuning its supervisory processes on an ongoing basis and based on the evolving financial scenario. a revised framework for monitoring of financial conglomerates has been rolled out since 2009. the financial stability and development council ( fsdc ) has also been activated under the aegis of the government of india for system level monitoring of build - up of risks and instability, specifically, risks emanating from the systemically important financial institutions ( sifis ) including the financial conglomerates. this is also expected to enhance coordination among the financial regulators. however, enterprise wise risk management processes need to be implemented / strengthened in the financial conglomerates and sifis. bis central bankers ’ speeches ( v ) structural changes ( a ) financial innovation 20. the crisis has also raised the issue of financial stability vis - a - vis financial innovation – in other words, the question of the “ social optimality ” of financial innovations. one of the main reasons why india escaped the adverse impact of the crisis was a calibrated approach to financial innovation. however, we as regulators and supervisors need to guard against stifling financial innovation while at the same time remain cautious about the objective and purpose behind the new and complex financial products that are proposed or introduced by the industry. this is particularly relevant for a country like india as

the one hand, recent thinking has stressed how monetary policy can contribute to sowing the seeds of future financial instability. low interest rates, for example, can contribute to the build - up of on this, see the discussion in robert shiller ( 2000 ), irrational exuberance, princeton university press. this has been convincingly argued by christina romer ( 1990 ), “ the great crash and the onset of the great depression ”, quarterly journal of economics, 105 ( august ), 597 – 624 as quoted in john lewis gaddis ( 2005 ), the cold war : a new history, penguin press. financial imbalances via the so - called “ risktaking ” channel. 7 simply put, very low interest rates may create incentives for banks to take on more risks. recent research has provided empirical evidence compatible with such a notion. it has been documented, 8 for example, how market based measures of bank ’ s risks as perceived by financial market participants tend to react positively to changes in interest rates, so that a lower interest rate leads investor to perceive banks as less risky. by the same token, several papers 9 have shown that credit standards are correlated with the level of interest rates : lower interest rates, in particular, imply lower credit standards including to customers who are perceived as representing a higher credit risk. on the theoretical side, research done at the banque de france 10 has shown that, when the regulatory environment is not transparent, a decrease in the level of real interest rate increases banks ’ risk - taking behavior, in parts because it may facilitate the under - pricing of risks typical when asset prices rise. another risk, spotted by raguram rajan 11, is that low interest rates lead banks into a “ search for yield ” strategy, in order to maintain a desired – or even institutionally mandated – rate of return. a time - honored principle of finance is that, ceteris paribus, the only way to increase the expected rate of return is to take more risk, and the result of such search for yield is therefore that banks will increase their risk exposure. an alternative channel through which excessively low rates may have contributed to the building up of financial imbalances during the period leading up to the crisis originates from central banks ’ ultimate focus on goods ’, rather than asset prices ’ inflation. during a period characterized by large, benign supply shocks originating from the integration of large developing countries into the global economy, the resulting disinflationary