by constructing a “ seamless credit provision system ”, in which customers can choose any type of credit in the spectrum from borrowing from banks to raising funds in capital markets. such a seamless system for credit provision can be developed within the context of a diversified division of labor. if and when a diversified division of labor is achieved, the discussion on the ideal number of financial institutions is likely to lose its meaning. currently, we hear comments about the rather complex situation of japan ’ s financial system. for example, some have voiced criticism that the provision of financial services is not sufficient, while others say that japan ’ s financial system is over - banked. as the division of labor becomes diversified, however, the complex situation should gradually be resolved. 2. improvement of integrated risk management and prompt and appropriate actions to changes in the environment the second challenge is how to make the integrated risk management framework more sophisticated as well as take prompt and appropriate actions to respond to changes in the environment. many financial institutions need to take on various risks over the short term and long term to smoothly satisfy their customers ’ needs. the more capital a financial institution holds, the more risks it can manage. what is required of financial institutions is to take on risks using a finite amount of capital, thereby satisfying customer needs and maximizing their profits. thus, financial institutions need an entity - wide framework in which they can handle various types of risks stemming from routine businesses and carefully judge the balance between risks and financial strength as well as sector - by - sector profitability. this framework is called the “ integrated risk management system ”. under this system, we measure the magnitude of various risks such as market risks and credit risks, and integrate the results using value - at - risk and other benchmarking methods. then, we calculate the magnitude of entity - wide risks and appropriately allocate risk capital to various business areas. it is inevitable that the risk profiles taken on by financial institutions will change as the financial needs of firms and households become more diversified and complex. consequently, we should continuously upgrade the framework of risk management by adopting the most recent theories of finance and utilizing new financial engineering techniques. having said this, let me emphasize that the most significant factor for the effective functioning of the risk management framework lies in human judgment, particularly that of the top management. in fact, operating environments sometimes move in a direction different from that initially expected due to factors such as a change in the economic situation, the volatile movement of market prices, and

in trying to finance such a large cad, we are exposing the economy to the risk of sudden stop and exit of capital flows. this will be the case to the extent capital flows in in pursuit of short - term profits. should the risk of capital exit materialize, the exchange rate will become volatile causing knock - on macroeconomic disruptions. monetary easing in the context of a large cad 53. while the external sector vulnerability is a cause for concern on a number of counts as i indicated above, it also poses a special challenge for calibrating the monetary policy stance. 54. in our quarterly policy review at the end of january this year, the reserve bank cut the benchmark repo rate by 25 bps in response to the growth - inflation dynamics that i outlined earlier. several analysts and commentators have questioned the wisdom and logic of monetary easing at a time when the cad is rising. there are two elements to this argument : ( i ) an interest rate cut raises aggregate demand, and hence demand for imports, and will aggravate an already elevated cad ; and ( ii ) an interest rate cut will narrow the interest differential between india and the advanced economies which are the source of capital, and could potentially lead to capital exit. 55. let me respond to both these strands of criticism : 56. the risk of the cad widening further because of the stimulus offered by the rate cut is much less than apprehended for a host of reasons. first, when growth is sluggish as is the case now, the rate cut is unlikely to translate into import demand. second, the rate cut was a response to softening inflation. lower inflation will improve the competitiveness of our exports. third, the rate cut was effected during a phase of easing commodity prices – particularly of oil – which will reduce the pressure on the cad. finally, empirical evidence bis central bankers ’ speeches shows that in emerging economies such as india, import demand is less a function of lower interest rate than of increased income. in other words, the marginal propensity to import by borrowing money is small. 57. on the other criticism about the impact of capital flows required to finance the cad, it must be noted that interest rate differential is only one of the several push and pull factors that influence capital flows. moreover, debt and equity flows have traditionally responded differently to a rate cut. while debt flows may be more sensitive to a narrowing of the interest rate differential, equity flows may actually increase because they see