rakesh mohan : emerging contours of financial regulation – challenges and dynamics paper by dr rakesh mohan, deputy governor of the reserve bank of india, for the financial stability review of bank of france, 10 june 2009. the assistance of anand sinha, prashant saran, p r ravi mohan, t gopinath, and muneesh kapur in preparation of the paper is gratefully acknowledged. the paper has also benefited from the report of the working group i of the g - 20 on “ enhancing sound regulation and strengthening transparency ”. * * * the world is currently in the midst of the most severe financial and economic crisis since the great depression. although the crisis originated in the sub - prime mortgage market in the united states, it then spread to europe and later to the rest of the world. the speed of the contagion that spread across the world is perhaps unprecedented. what started off as a relatively limited crisis in the us housing mortgage sector turned successively into a widespread banking crisis in the united states and europe, the breakdown of both domestic and international financial markets, and then later into a full blown global economic crisis. almost all governments and central banks of the world have been busy over the last 9 - 18 months in an effort to contain the effects of the crisis through both fiscal and monetary policy measures, respectively. just as the global nature of the crisis is unprecedented, so is the global nature of the response, as exemplified by the coordinated action being committed to by the g - 20. along with the coordinated fiscal and monetary policy actions, a comprehensive reexamination of the financial regulatory and supervisory framework is also underway around the world. against this backdrop, this paper attempts to analyse the emerging contours of regulation of financial institutions with an emphasis on the emerging challenges and dynamics. the paper is organised as follows : section i provides a broad overview of the global developments which contributed to the current global financial crisis. section ii presents the ongoing discussion and debate at the international level in the light of the shortcomings of the extant regulatory framework. section iii analyses proposals for reforming the regulatory framework, while section iv discusses the difficulties in implementing the regulatory proposals. i. evolution of crisis : what went wrong? what are some of the identifiable sources of market failures that led to the current financial turbulence? the current ongoing financial crisis is attributed to a variety of factors such as the developments in the sub - prime mortgage sector, excessive leverage, lax financial regulation and supervision, and

objective to anchor inflationary expectations. since inflation objective has to be pursued by the reserve bank, to avoid any conflict of interest, the primary statistics on inflation should be generated by another statistical agency. deseasonalised trend inflation 18. apart from the headline inflation, for policy purposes, central banks look at various secondary ( derived ) measures of inflation to gauge the underlying inflationary pressures. one such indicator of inflationary momentum is annualized month - over - month seasonally adjusted inflation. however, the use of such indicator for emerging market economies like india has its limitations because it could be quite volatile ( chart 4 ). chart 4 annualised m - o - m wpi ( seasonally adjusted ) inflation core inflation 19. another way to analyse inflation data is by looking at “ core inflation, ” which is generally a chosen measure of inflation that excludes the more volatile categories like food and energy prices. the main argument here is that the central bank should effectively be responding to the movements in permanent component of the price level rather than temporary deviations. 20. there are many variants of core inflation which try to remove the volatility of price changes by statistical means. these include truncation of commodities based on standard deviation of price changes, trimmed mean, median and other filter based smoothing techniques. various measures of wpi - based core inflation for the years 2008 – 09 and 2009 – 10 are presented in table 2. it can be seen that the core measures show significant month to month variations, though the volatility has been lower compared to the headline measure. since core inflation is derived from the headline, it reflects the weaknesses in the primary measure of inflation. a prerequisite of a good inflation measure is that it is broader in coverage and the base period is updated frequently reflecting structural changes in the economy. 21. in indian context, the derivation of core inflation by exclusion of food and energy from cpi / wpi discards a substantial portion of the commodity basket. so the price movement of the remaining commodities may not be representative of the underlying inflationary trend. although these prices have substantial effects on the overall index, they often are quickly reversed. but the reversal of volatile prices sometimes is not short - lived. therefore, determining when to use a core inflation measure versus an overall inflation measure remains a complex issue. table 2 various wpi - based core inflation measures4 ( per cent ) 1. 5 sd method : this method excludes all those commodities in which percentage price change