rakesh mohan : central banks and risk management – pursuing financial stability address by dr rakesh mohan, deputy governor of the reserve bank of india, at the 4th annual conference on cash, treasury and risk management in india, new delhi, 21 november 2006. * * * i have chosen to speak on " financial stability " for a number of reasons. although financial stability has always been of concern to central banks, it is a relatively new concept in terms of the widespread attention being given to it in recent years. i thought it would be useful to discuss why it has become so important to central banks. achieving this understanding would also help in explaining some of the behaviour of central banks. i will also try to explain why it is important for us. financial stability - what is it? what is financial stability? despite widespread usage of the term, there is no widespread agreement on a useful working definition of the term. some define financial stability in terms of what it is not – the absence of financial instability. others take a more macro - prudential view and specify financial stability in terms of limitation of risks of significant real output losses in the presence of episodes of system wide financial distress. in the absence of a widely accepted definition it is useful to discuss what we expect a financial system to do. the primary function of the financial system is to smoothly and efficiently facilitate inter - temporal allocation of resources from savers to the ultimate users. this process of intermediation of funds enables the utilisation of available resources to their most productive uses. such a process implies management of financial risk on an inter - temporal basis. in doing so however, the financial system is expected to absorb real economic surprises and shocks. if for some reason this is not done well, it could impair the efficient functioning of the financial system as a whole and engender financial instability. but we need to be careful in thinking about financial instability. disturbances in financial markets or at individual financial institutions need not constitute financial instability if they do not impair overall economic functioning. illustratively, a closure of a small financial institution, or for that matter, movement in asset prices within certain limits or even minor corrections in financial markets need not necessarily hamper stability. on the contrary, fluctuations in asset and other prices in financial markets may actually be good for overall financial stability as adjustment mechanisms. such market adjustments also help to keep authorities alert and sensitive to incipient developments and can enable them to identify and monitor newer risks. what are

of labour force survey data, the number of people employed increased by 0. 5 % on average for the year in the centre and north and by 0. 6 % in the south. the increase was accounted for mainly by the weakest groups, women and young people. given italy ’ s low participation rate, however, the number of job seekers has also increased. the unemployment rate in the centre and north declined marginally in the 12 months to october, from 7. 7 to 7. 6 %. in the south, unhappily, it increased further, from 22. 6 to 23. 2 % ; youth unemployment in the region rose to a new peak. the use of saving saving is the raw material of investment and growth. the large quantity generated is not all put to use domestically ; it is necessary to create the conditions for it to be turned into investment to the benefit of employment in italy. analysis of the balance between the formation and use of saving, in a period marked by high unemployment and sluggish investment, highlights the lack of domestic demand and, indirectly, the shortfall in competitiveness. a succession of current account surpluses in the six years from 1993 to 1998 enabled italy to bring its net external position into balance. a high level of foreign debt is inappropriate for an advanced industrial economy and the primary cause of continuous weakening of the exchange rate and inflation. – 6 – the achievement of a sound external position was a necessary condition for stabilising the exchange rate and consolidating the value of the currency. in the private sector, the flow of saving declined further in relation to disposable income in 1998 ; its use in the domestic economy to the benefit of growth and employment remained inadequate. the external current account surplus amounted to 45 trillion lire in 1998 ; in absolute terms it was in line with the figure for 1995 ; it was one third less than in 1996 and 1997. a substantial part of the surplus is regularly reinvested abroad, passing through italy ’ s financial accounts. the “ errors and omissions ” item of the balance of payments resulted in about half the current account surplus recorded in 1996 and 1997 not appearing in the national accounts. in 1998 revenues not officially brought into the country or not recorded in the financial accounts amounted to around 50 trillion lire ; they cancelled out the entire current account surplus. analysis of officially recorded cross - border capital movements also highlights a reduction in the surplus and the progressive emergence in 1998 of a deficit of