, in particular tax regimes, and safeguards against misuse of liberalised current account regime to effect capital transfers. sound management will also avoid dollarisation of the domestic economy and internationalisation of domestic currency. fifth, operationally, management of capital account involves a distinction not only between residents and non residents or between inflows and outflows but also between individuals, corporates and financial intermediaries. the financial intermediaries are usually a greater source of volatility amongst these. if such financial intermediaries operating in the developing countries are owned or controlled by foreign entities / investors, there is perhaps greater tendency to volatility in the flows. it is noticed that such foreign owned / controlled intermediaries are often influenced by considerations other than domestic economy and have less appreciation of local conditions - apart from the issues relating to cross - border supervision of financial intermediaries by the host country supervisor. sixth, the prudential regulations over financial intermediaries, especially over banks, in respect of their forex exposures and forex transactions must be effective and a dynamic component of management of capital account as well as financial supervision. such prudential regulations should not be treated as capital controls. seventh, capital controls should be treated as only one of the components of management of capital account. as liberalisation advances, the control - regime would contract, and thus, it is the changing mix of controls that charecterises the process of liberalisation in management of capital account. eighth, capital controls may be price based, including tax - regimes, or administrative measures. depending on the legal framework and governance structures, the mix between the two would vary. as liberalisation advances, the administrative measures would get reduced and price - based increased, but the freedom to change the mix and reimpose controls should always be demonstrably available. such freedom to exercise the policy of controls adds comfort to the markets at times of grave uncertainity. finally, as mentioned by professor kenneth rogoff, a distinction needs to be made between de jure and de facto financial integration in general and hence, in the context of capital account in particular. in practice, there are difficulties in measuring the degree of financial integration. however, the institutional structures, both of public policy and markets, need to be evolved to meet the imperatives of liberalised capital account. in the final analysis, the basic issue in any policy context is whether capital controls lead to distortions in exchange rate or the liberal

bis study states, non - linear interaction emerges when losses from default on an instrument depend on movements in market risk factors, or conversely, when changes in the values of instruments due to movements of market risk factors depend on whether there is a default or rating migration. in these circumstances, the two types of risk are inextricably linked, and attempts to measure them separately and then combine them can lead to substantial biases. in fact, research shows cases in which the combined risk is actually higher than the sum of the components leading to “ compounding effects ” as opposed to diversification effects. a particularly clear example is foreign currency loans, which constitute a sizable part of lending in certain countries. consider a bank lending in foreign currency to domestic borrowers. these positions contain market risk ( exchange rate risk ) and credit risk ( default risk of borrowers ). now assess the two risks separately. when for example the domestic economy slows, ceteris paribus, the probability of domestic borrowers defaulting increases. when the domestic currency depreciates, ceteris paribus, the value of the loan in domestic currency increases as it is denominated in foreign currency. so, on the surface one could think that the two effects offset each other. but this reasoning would neglect the strong relationship between exchange rate changes and default risk in this type of contract. the ability of a domestic borrower to repay a loan in foreign currency depends in a non - linear way on fluctuations in the exchange rate ( unless the domestic borrower has other revenues in the foreign currency in which the loan is denominated ). a home currency depreciation has a particularly major effect on the repayment amount and therefore repayment probability of a foreign currency loan by an unhedged domestic borrower, which tends to be stronger than the valuation effect mentioned above. 18 ) similarly, floating or adjustable rate loans have coupons that change as interest rates change. therefore, if the coupons on the loans adjust frequently ( or in the limit continuously ), then the interest rate risk of the loan is passed on to borrowers, and therefore, assuming the loans do not default, they have no market risk for the bank. if credit risk is computed separately from market risk, then the credit risk of the loans is computed while holding interest rates constant. this treatment of credit risk can miss an important interaction between market and credit risk. for example, if probabilities of default are increasing in interest