Global Economic Slowdown-Financial Services

7/28/2019 Global Economic Slowdown-Financial Services

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April 2009

Global economic slowdownand its impact on the fnancial

services industry in India


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The global slowdown was anoutcome o two events - absence o

a sound regulatory ramework &mismatch between fnancialinnovation and the ability o theregulators to monitor them -

immediate aim should be to fxthe fnancial system and tomaintain the aggregate demand ata high enough level to stimulatethe real sector


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Contents

Executive summary 4

1. Global fnancial markets: A perspective 6

2. Indian fnancial services industry 9

3. Impact o the recession on the fnancial sector o the Indian economy 14

4. Future outlook 18

5. Conclusion 20

Contacts 23


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Executive summary

The global economy is reeling with the impact o the

ongoing recession which started with the sub-prime

crisis in the United States and ound its way to other

developed and emerging economies o the world.

This recession has its roots in the initial collapse o

the nancial sector. However, in a world that is more

integrated within each country as well as across nations,

the events in the nancial sector have eventually trickled

down to the real sector o the economies as well.

Finance and nancial markets play a dominant role

in growth and development o modern economies

hence, any recovery rom the current recession must

be couched in an overall recovery o the health and

perormance o the nancial sector.

In the absence o mature nancial markets in their own

economies, several emerging economies (including

India) have heavily depended on credit and other

nancial services rom the western nancial markets.

Thereore, any orm o ailure in these markets has a

direct eect on the markets in emerging economies.

The concerns relating to the US slowdown and its

intensity have mounted in view o the potential spill over

on to the global economy. With tightening in lending

standards, deterioration in asset quality and deceleration

in consumer loan demand, events in the nancial

markets are beginning to have a persisting impact

on the real economy as well, with direct slowdown

in employment and growth in several economies

across the world. Terms-o-trade losses due to soaring

commodity prices have not only reduced the capacity

o a re-balancing o the world economy but have also

adversely impacted several countries. Although the

Emerging Market Economies (EMEs) are exhibiting

resilience until now, the eventual depth and width o the

impact on these economies have kept many economists

guessing.

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This report ocuses on the impact o the global

slowdown on the banking and nancial services

sector in India. The impact o the slowdown on the

banking and nancial services sector in India has so ar

been moderate. Ironically, the slow pace o nancial

reorms in India, an overly cautious approach towards

permitting oreign investments in the Indian business

sectors, numerous bureaucratic hurdles and regulatory

constraints have turned out to be a blessing in disguise

in India. The Indian nancial system has very little

exposure to oreign assets and their derivative products

and it is this very eature that is likely to prove an

antidote to the nancial sector ills that have plagued

many other emerging economies.

The revival o the world economy will take a long time.

During this time, India is likely to be aected due to the

low investments by oreign companies into India, heavy

selling by the FIIs (Foreign Institutional Investors) in their

holdings in numerous Indian companies, and depressed

global demand or the various services that have added

to Indias GDP growth. However, the overall impact

on the Indian economy will be lesser as compared to

other emerging economies. Indias cautious approach

towards integrating with the world economy has

paid o and it is very likely that speed o integration

and de-regularization o the nancial sector will be

even slower in the atermath o the recession. More

regulations are expected to come into orce to prevent

India rom experiencing a situation that characterized

the economies o the ASEAN countries during the

1997-98 crisis as well as the current recession.

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1. Global fnancial markets:A perspective

While the current recession was triggered by the rising

deault rates on sub-prime mortgages in the US, the

source o the problem was signicant mispricing o

risks in the US nancial system. Easy monetary policy in

major nancial centres, globalisation o liquidity fows,

wide-spread use o highly complex structured debt

instruments and the inadequacy o banking supervision

in coping with nancial innovations contributed to

the severity o the current crisis. The persistent under

pricing o risks was suspected by several central banks

or quite some time, but it was elt by many that these

risks were widely dispersed through nancial innovation

and that they would not pose any serious problems

to the banking system. When the sub-prime crisis did

occur, however, it triggered a wide contagion aecting

many o the large global nancial institutions. Banks, in

particular, appear to have ceased to trust each others

creditworthiness leading to diculties in the money

markets in the US, Europe and the UK resulting in drying

up o liquidity. In an attempt to meet their liquidity

support obligations to the SIVs or to und the assetso the SIVs that were taken on to their balance sheets,

several banks leveraged excessively without recognizing

the corresponding risks and / or underpriced them thus

warranting large capital inusion. Uncertainty about the

possible losses yet to be disclosed by several o them

has not yet ceased.

These developments brought orward several new

realities that pose severe challenges to macroeconomic

management, in particular to monetary and regulatory

policies globally. First, concerns relating to the US

slowdown and its intensity have mounted in light o thespill over o these troubles on to the global economy.

Second, threats to the global economy are emanating

rom advanced economies in sharp contrast to earlier

crises which stemmed rom the emerging world. Third,

there are indications that protectionist tendencies

have increased around the world in anticipation o the

growing possibilities o slower growth in advanced

economies. Fourth, linkages between nancial sector

developments and the real sector have become more

apparent and worrisome than beore, with growing

evidence o the eects o the nancial turmoil on

the real sector. With tightening in lending standards,

deterioration in asset quality and deceleration in

consumer loan demand, events in the nancial markets

are beginning to have a persisting impact on the real

economy. Fith, new global economic imbalances are

emerging on account o large movements in commodity

prices, especially oil. Sixth, Emerging Market Economies

(EMEs) are exhibiting resilience until now in the ace

o the global nancial turmoil refecting relatively

stronger macroeconomic ramework and sustainable

macroeconomic balances. However, until how long and

to what extent such resilience will persist is uncertain.

The central banks in major countries have had to take

recourse, in appropriate mix, to three instruments to

avoid serious spill-over o these issues in money or credit

markets into the wider economy:

(i) Adjustment o interest rates or borrowing and

lending

(ii) Money market operations designed to inject special

liquidity in order to avoid a break-down in payment

systems among banks; and


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(iii) To put in mechanisms or nancial transactions

among the largest o the nancial intermediaries

which automatically impact the second and

third rung intermediaries. Central banks in major

industrialised economies, by and large, responded

with injection o liquidity or a longer period than

is usually done; they also resorted to dilution in the

quality o collateral required or liquidity support.

Most o these operations have not been conducted

at the penal rates expected in such situations. This is

an unprecedented package which, some observers

believe, is indicative o the seriousness o the

underlying problems. In addition, there were some

specic-institution oriented operations, namely, in

the United States, Germany and the United Kingdom

There are also calls or undamental rethink on

macroeconomic, monetary and nancial sector policies

to meet the new challenges and realities, which,

represent a structural shit in the international nancial

architecture demanding potentially enhanced degreeo coordination among monetary authorities and

regulators. A review o the policies relating to nancial

regulation, in a way, needs to address both the acute

policy dilemmas in the short run and a undamental

re-think on broader rameworks o nancial and

economic policies over the medium-term.

Market ailures1

There have been numerous systemic ailures in the

perormance and conduct o the large nancial sector

institutions that have been a key reason or the current

crisis.

First, the prolonged benign macroeconomic conditions

gave rise to complacency among many market

participants and led to an erosion o sound practices,

resulting in adoption o poor credit risk appraisal

standards.

Second, some o the standard risk management

tools and models used by market participants were

not equipped to estimate the potential impact o

adverse events or structured credit products and high

uncertainty around model estimates that largely missed

the underlying combination o risks. Further, these

risk models, generally tended to induce the market

participants to adopt a unidirectional approach.

Third, many investors, including institutional ones, with

the capacity to undertake their own credit analysis, did

not undertake sucient in-house examination o the

risks in the assets underlying structured investments.

Fourth, the role o Credit Rating Agencies (CRAs) in the

recent market developments has attracted attention.

Fith, the distortions in incentive structures can be

seen rom various perspectives namely incentives or

originators, arrangers, distributors and managers in

the originate-to-distribute model; the compensationschemes in nancial institutions not distinguishing

between realised and unrealised prots; encouraging

nancial structures tailored to obtaining high ratings etc.

Sixth, weaknesses in public disclosures by nancial

institutions on the type and magnitude o risks

associated with their on-and o-balance sheet

exposures are noticeable.

Seventh, large commercial banks and investment banks

have assumed increasingly similar risk proles, use

similar models to assess and are subject to the same riskmanagement challenges under the given circumstances.

Eighth, there is a new dimension to bank liquidity, with

the shiting emphasis to a market based wholesale

or purchased liabilities. This makes banks increasingly

dependent on the market or raising liquidity, while

markets may have a tendency to shy away rom

providing liquidity when they are most needed.


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Regulatory shortcomings1

While the oregoing brings out the ailures o the

markets and o the market participants, some o the

regulatory shortcomings identied are as ollows:

First, the regulators recognised some o the underlying

vulnerabilities in the nancial sector but ailed to

take eective action, partly because they may have

overestimated the strength and resilience o the

nancial system or they assumed that the risks were

well distributed among entities outside the banking

system. Many analysts and policymakers had raised

concerns about excessive risk taking, loose underwriting

standards, and asset overvaluations, all o which have

in the absence o timely eective actions laid the seeds

or crises.

Second, the limitations in regulatory arrangements,

including the capital adequacy ramework, contributed

to the growth o unregulated exposures, excessive risk-

taking and weak liquidity risk management.

Third, weaknesses in the application o accounting

standards and the shortcomings associated with the

valuation and nancial reporting o structured products

played a signicant role in the current turbulence

through pro-cyclical valuations and lack o ull disclosure

o banks true risk prole through the cycle.

Fourth, the crisis revealed the need to adapt some o the

tools and practices o central banks to manage system

liquidity in the light o banks cross-border operations.

The recent experiences have highlighted the d ierencesin emergency liquidity rameworks o central banks,

on aspects such as range o collateral, range o eligible

counterparties; and the dierences in central bank

practices.

Fith, supervisors did not adequately address

deterioration in risk management standards in the

regulated entities, which did not ully reckon the risks

associated with new nancial instruments, and there

were shortcomings in consolidated supervision.

Sixth, deciencies in crisis management and bank

resolution rameworks, including deposit insurance,

have been observed, especially where central banks do

not have a central supervisory role.

Seventh, the complex inter-relationship between

regulation, the inappropriate accounting practices, and

regulators excessive dependence on external ratings

may have exacerbated the market turbulence.


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2. Indian fnancial servicesindustry2

Financial stability in India has been achieved through

perseverance o prudential policies which prevent

institutions rom excessive risk taking, and nancial

markets rom becoming extremely volatile and

turbulent. As a result, while there are orderly conditions

in nancial markets, the nancial institutions, especially

banks, refect strength and resilience. While supervision

is exercised by a quasi-independent Board carved out

o the Reserve Bank o India (RBI) Board, the interace

between regulation and supervision is close in respect

o banks and nancial institutions, and on market

regulation, a close coordination with other regulators

exists.

In contrast to the global scenario, India has by-and-large

been spared o global nancial contagion or a variety o

reasons. The credit derivatives market is in an embryonic

stage in India; the originate-to-distribute model in India

is not comparable to the ones prevailing in advanced

markets; there are restrictions on investments by Indian

investors in such products issued abroad; and regulatoryguidelines on securitisation do not permit immediate

prot recognition.

Investment portolio

In the year 2000 the Reserve Bank o India (RBI)

conducted a stress test o the banks investment

portolio in an increasing interest rate scenario, when

the general trend then was decreasing interest rates. At

that time, banks in India were maintaining a surrogate

capital charge or market risk, which was at a variance

rom the Basel norms. On the basis o the ndings,

in order to equip the banking system to be betterpositioned to meet the adverse impact o interest

rate risk, banks were advised in January 2002 to build

up an Investment Fluctuation Reserve (IFR) within a

period o ve years. The prudential target or the IFR

was 5% o their investments in Held or Trading (HFT)

and Available or Sale (AFS) categories. Banks were

encouraged to build up a higher percentage o IFR up

Note: Originate-to-distribute model is a model o lending, where the originator o a loan sells it to various third parties. This method o lend ing was very popular in the mortgage-

loans market until a disruption in this market began in the middle o 2007. It is basically an agency problem in which agents (the originator o the loans) do not have the incentives

to act ully in the interest o the principal (the ultimate holder o the loan). Originators had every incentive to maintain origination volume, because that would allow them to earn

substantial ees, but they had weak incentives to maintain loan quality. When loans went bad during the subprime crisis, originators lost money, mainly because o the warranties

they provided on loans; however, those warranties oten expired as quickly as ninety days ater origination. Furthermore, unlike traditional players in mortgage markets, originators

oten saw little value in their charters, because they oten had little capital tied up in their rm. When hit with a wave o early payment deaults and the associated warranty claims,they simply went out o business. While the lending boom lasted, however, originators earned large prots. Many securitizers o mortgage-backed securities and resecuritizers,

such as CDO managers, also, in retrospect, appear to have been motivated more by issuance and arrangement ees and less by concern or the longer-run perormance o these

securities. These agency problems combined to lower underwriting standards, so that borrowers with weaker nancial histories had access to larger loans. When the housing

market cooled and house prices no longer rose at a rapid pace, these subprime borrowers ound themselves unable to either repay their loans or renance out o them.

India has historically ollowed a cautious policy o nancial de-regulation and supervision as described in the ollowing subsections.

to 10% o their AFS and HFT investments. This counter-

cyclical prudential requirement enabled banks to absorb

some o the adverse impact when interest rates began

moving in the opposite direction in late 2004. Banks

have been maintaining capital charge or market risk as

envisaged under the Basel norms since end-March 2006.

The regulatory guidelines in India require banks to

classiy their investments in three categories, similar to

the international standards. The investments included

in the Held to Maturity (HTM) category was capped at

25% o the total investments and banks are allowed

to carry the investments in the HTM category at cost.

With the change in the direction o the movement o

interest rates in 2004, the cap on the HTM category

was reviewed in the light o the statutory prescriptions

(reerred to as Statutory Liquidity Ratio (SLR) in India)

requiring banks to mandatorily invest up to 25% o their

Demand and Time Liabilities (DTL) in eligible government

securities. In view o the statutory pre-emption and

the long duration o the government securities, bankswere permitted to exceed the limit o 25% o total

investments under Held to Maturity (HTM) category

provided the excess comprised only o the SLR securities,

and the total SLR securities held in the HTM category

was not more than 25% o their DTL. Such shiting was

allowed at acquisition cost or book value or market

value on the date o transer, whichever is the least, and

the depreciation, i any, on such transer was required to

be ully provided or. The above transition is consistent

with international standards that do not place any cap

on HTM category, and was considered advisable taking

into account the statutory nature o the SLR whileensuring prudence and transparency in valuation on

transer to HTM category. While the earlier prescription

or this category was relatively more conservative, the

changes in September 2004 recognised the dynamic

interace with the interest rate cycles and were counter-

cyclical.


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Capital adequacy risk weights

In view o the increase in growth o advances to the

real estate sector, banks were advised to put in place

a proper risk management system to contain the risks

involved. In June 2005, the RBI advised banks to have

a board mandated policy in respect o their real estate

exposure covering exposure limits, collaterals to be

considered, margins to be kept, sanctioning authority /

level and sector to be nanced. In view o the rapid

increase in loans to the real estate sector raising

concerns about asset quality and the potential systemic

risks posed by such exposure, the risk weight on banks

exposure to commercial real estate was increased rom

100% to 125% in July 2005 and urther to 150% in

April 2006. The risk weights on housing loans extended

by banks to individuals against mortgage o housing

properties and investments in Mortgage Backed

Securities (MBS) o Housing Finance Companies (HFCs),

recognised and supervised by National Housing Bank

(NHB) were increased rom 50% to 75% in December

2004. However, on a review, banks were advisedto reduce the risk weight in respect o exposures

arising out o housing loans up to Rs.30 lakh (USD

75,000 approx) to individuals against the mortgage o

residential housing properties rom 75% to 50%, in view

o the lower perception o risks in these exposures.

Provisions against standard assets

The prudential norms relating to income recognition,

asset classication and provisioning, introduced during

1992-93 are being continuously monitored and rened

to bring them on par with international best practices.

In keeping with this, several measures were initiated in2005-06. The provisions or standard assets were revised

progressively in November 2005, May 2006 and January

2007, in stages in view o the continued high credit

growth in the real estate sector, personal loans, credit

card receivables, and loans and advances qualiying as

capital market exposure and a higher deault rate with

regard to personal loans and credit card receivables,

which emerged as a matter o concern. The standard

assets in the ollowing categories o loans and advances

attract a 2% provisioning requirement (i) personal

loans (including credit card receivables); (ii) loans and

advances qualiying as capital market exposure; (iii)

real estate loans (excluding residential housing loans),

and (iv) loans and advances to systemically important

non-deposit accepting non-banking nance companies

(NBFC-ND-SI). In order to ensure continued and

adequate availability o credit to the highly productive

sectors o the economy, the provisioning requirement

or all other loans and advances, classied as standard

assets was kept unchanged, viz., (i) direct advances to

the agricultural and SME sectors at 0.25%; and (ii) all

other loans and advances at 0.4%.

Exposure to inter-bank liability

In order to reduce the extent o concentration o banks

liabilities the RBI had issued guidelines to banks in March

2007 placing prudential limits on the extent o their

Inter-Bank Liability (IBL) as a proportion o their net

worth (200%). Those banks which had a higher capital

adequacy ratio o 125% o the regulatory minimum

were allowed a higher limit o 300% o net worth. In

addition, prudential limits have also been placed on the

extent to which banks may access the inter-bank call

money market both as a lender and as a borrower.

Financial regulation o systemically important

NBFCs and banks relationship with them

The RBI has been strengthening the regulatory and

supervisory ramework or Non-Banking Finance

Companies (NBFCs) since 1997 with the objective o

making the NBFC sector vibrant and healthy. The ocus

was initially on deposit-taking NBFCs. These eorts were

pursued urther during 2006-07, when a major thrust

was on strengthening the regulatory ramework with

regard to systemically important non-banking nancial

companies so as to reduce the regulatory gaps. At that

time, the regulatory ocus was also widened to includesystemically important non-deposit taking NBFCs and

prudential norms were specied or these entities. The

application o dierent levels o regulations to the

activities o banks and NBFCs, and even among dierent

categories o NBFCs, had given rise to some issues

relating to uneven coverage o regulations. Based on the

recommendations o an Internal Group and taking into

consideration the eedback received thereon, a revised

ramework to address the issues pertaining to the overall

regulation o systemically important NBFCs and the

relationship between banks and NBFCs was put in place

in December 2006.


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Securitisation guidelines

The RBI has issued guidelines on securitisation o

standard assets in February 2006. The guidelines are

applicable to banks and nancial institutions, including

Non-Banking Financial Companies (NBFCs). These

guidelines provide or a conservative treatment o

securitisation exposures or capital adequacy purposes,

especially in regard to the credit enhancement and

liquidity acilities. The regulatory ramework encourages

greater participation by third parties with a view

to ensure better governance in the structuring o

Special Purpose Vehicles (SPVs), the products, and

the provision o support acilities. A unique eature

o these guidelines, which may be at a variance with

the accounting standards, is that any prots on sale

o assets to the SPV are not allowed to be recognised

immediately on sale but over the lie o the pass through

certicates issued by the SPV. We believe that these

guidelines, as a package, have ensured an appropriate

incentive mechanism or securitisation transactions.

Banks investment in non-SLR Securities

RBI had emphasised that banks should observe

prudence in order to contain the risk arising out o their

non-SLR (i.e., non government) investment portolio,

in particular through the private placement route.

Detailed prudential guidelines on the subject were

issued in June 2001, which were reviewed and revised

in November 2003. These guidelines, inter alia, address

aspects o coverage, regulatory requirements, listing and

rating requirements, xing o prudential limits, internal

assessments, role o boards, disclosures, and trading

and settlement in debt securities. Banks were specicallyadvised that they should not be solely guided by the

ratings assigned to these securities by the external rating

agencies but that they should do a detailed appraisal as

in the case o direct lending.

Marking-to-market

The Indian accounting standards are generally aligned to

the International Financial Reporting Standards, though

there are some dierences. In India, we are yet to ully

adopt the marking-to-market requirements as available

in the international standards. The Indian standards are

relatively conservative and do not permit recognition o

unrealised gains in the prot and loss account or equity,

though unrealised losses are required to be accounted.

Banks are required to mark-to-market the investments

in the Held or Trading (HFT) and Available or Sale (AFS)

categories at periodical intervals, on a portolio basis,

and provide or the net losses and ignore the net gains.

This has proved to be a stabi lising actor, inasmuch as it

has not induced an imbalance in the incentive structures

and has also proved to be less pro-cyclical.


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Moral suasion and supervisory review

Moral suasion and public articulation o concerns has

helped in achieving a desired re-balancing o suspected

excesses in risk taking among banks. Some o the areas

where moral suasion has been used are the need or

banks to monitor unhedged oreign currency exposures

o their corporate clients, adoption o appropriate

incentive mechanisms by banks or encouraging

disclosures o derivative exposures by their corporate

clients, banks reliance on non-deposit resources to

nance assets, their excessive reliance on wholesale

deposits and uncomortable Loan-to-Value (LTV) ratios in

respect o housing loans etc.

A Supervisory Review Process (SRP) was initiated with

select banks having signicant exposure to sensitive

sectors, including reliance on call money market,

in order to ensure that eective risk mitigants and

sound internal control systems are in place. In the rst

round, a ramework was developed or monitoring the

systemically important individual banks. The secondround o SRP was directed to analyse banks exposure

to sensitive sectors and identiy outliers. Based on

the analyses o these outlier banks, guidelines were

issued to all banks indicating the need or better risk

management systems in banks at operating levels.

In brie, in India the ocus is on regulatory comort,

going beyond regulatory compliance. In a choice

between emphasis o regulations on saving capital and

protecting depositors interests or reinorcing nancial

system stability, the latter have always prevailed.

Financial sector liberalisation and development

It is necessary to clariy that while the measures

mentioned above were aimed at ostering nancial

stability, several other initiatives have been taken

to liberalise the macro-policy environment in which

banks operate through a re-orientation o regulatory

prescriptions by replacing micro regulations with

macro-prudential regulations. These changes have been

instrumental in providing an enabling environment or

universal banking, improved corporate governance in

private sector banks, and enabling consolidation o

banks in the private sector. Some o these measures

include:

Areductioninpre-emptionthroughreserve

requirements

Shifttomarketdeterminedpricingforgovernment

securities

Disbandingofsomeoftheadministeredinterestrates

Auction-basedrepos-reversereposforshort-term

liquidity management Facilitationofimprovedpaymentsandsettlement

mechanism

SettingupoftheClearingCorporationofIndia

Limited (CCIL) to act as central counter party or

acilitating payments and settlement system relating

to xed income securities, money market instruments

and oreign exchange transactions

SettingupofINFINETasthecommunication

backbone or the nancial sector

IntroductionofNegotiatedDealingSystem(NDS)for

screen-based trading in government securities

The prudential target or the IFR was 5% otheir investments in Held or Trading (HFT)and Available or Sale (AFS) categories


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IntroductionofRealTimeGrossSettlement(RTGS)

system

Debtrecoverytribunals,assetreconstruction

companies, settlement advisory committees,

corporate debt restructuring mechanism, etc. or

quicker recovery / restructuring o stressed assets

PromulgationofSecuritisationandReconstruction

o Financial Assets and Enorcement o Securities

Interest (SARFAESI) Act, 2002 and its subsequent

amendment to ensure creditor rights; setting up o

Credit Inormation Bureau o India Limited (CIBIL)

or inormation sharing on deaulters as also other

borrowers

These growth oriented initiatives have appropriately

complemented the stability oriented initiatives.

Development orientation

In the context o the rapidly evolving nancial

landscape, the RBI has also been suitably reorienting its

regulatory and supervisory ramework to meet the needso the common man by simultaneously ocusing on

nancial inclusion and extension o banking services to

the unbanked areas o the economy. The RBI has taken

several measures in recent years aimed at providing

customer service at reasonable cost. These measures

include enhancing customer protection and disclosures,

code o ethics and grievance redressal, among others.

The RBIs broad approach to nancial inclusion aims at

connecting people with the banking system and not

just credit dispensation; giving people access to the

payments system; and portraying nancial inclusion as a

viable business model and opportunity.

Monetary policy

As a part o the conduct o monetary policy, the RBI

monitors, inter alia, monetary and credit aggregates.

It uses both liquidity and interest rate instruments to

achieve the monitory policy objectives. Pre-emptive

actions have been taken since 2004 to withdraw

monetary accommodation which was reinorced

with measures aimed at moderating early signs o

over-heating. Further, appreciation o the possible

permanent and temporary components with regard

to oil prices has been articulated in the policies.

While undertaking a nuanced approach to managing

aggregate demand recognising the elements o shock

and consequent impact on infation expectations,

the underlying demand conditions warranted several

interest rate and liquidity measures in recent weeks.

While monetary policy infuences aggregates, reality is

oten dis-aggregated. Hence, the RBI uses prudential

regulatory policies to complement the monetary

policy measures and objectives. It is pertinent that thelender o last resort unction is not separate either

rom monetary and liquidity management or rom

nancial regulation. Thus both monetary policy and

prudential regulations are used as complementary

tools to achieve the central bank objectives and they

both support and reinorce each other.


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3. Impact o the recession on the fn

Contrary to the decoupling theory, whereby several

emerging economies were claimed to be decoupled

rom the developed economies, most emerging

economies have been hit by the crisis. The decoupling

theory held that even i advanced economies went

into a downturn, emerging economies will remain

unscathed because o their substantial oreign exchange

reserves, improved policy ramework, robust corporate

balance sheets and relatively healthy banking sector.

Given the evidence o the last ew months capital

fow reversals, sharp widening o spreads on sovereign

and corporate debt and abrupt currency depreciations

the decoupling theory stands totally invalidated

reinorcing the notion that in a globalized world

no country can be an island with growth prospects

o emerging economies being undermined by the

cascading nancial crisis with, o course, considerable

variation across countries.

How has India been hit by the crisis?

The contagion o the crisis has spread to India throughall the channels the nancial channel, the real channel,

and importantly, the condence channel.

Let us rst look at the nancial channel. Indias nancial

markets equity markets, money markets, orex markets

and credit markets had all come under pressure rom a

number o directions. Indian equity market will continue

to track global developments in 2009. First, the Indian

stock markets, both BSE as well as NSE, ell dramatically

over 2008 Indias main index sensex plunged nearly

50% during the year rom a high o 19,080 in January

2008 to 8,674 in January 2009. The NSE also ell by asimilar percentage. Foreign institutional investors pulled

out close to Rs 50,000 crore (Rs 500 billion) rom the

domestic stock market in 2008-09, almost equalling

the infow in the previous scal. As per the latest

inormation on the Securities and Exchange Board o

India website, FIIs net outfows have been Rs 47,706

crore (Rs 477.06 billion) till March 30 in the nancial

year 2008-09 as against huge infows o Rs 53,000

crore (Rs 530 billion) in the previous scal. However,

it is believed that FIIs may resume investments in

Indian equities later in FY 2009-10, as the country still

remains an attractive investment destination with sound

undamentals.

As a consequence o the global liquidity squeeze,

Indian banks and corporates ound their overseas

nancing drying up, orcing corporates to shit their

credit demand to the domestic banking sector. Also, in

their rantic search or substitute nancing, corporates

withdrew their investments rom domestic money

market mutual unds putting redemption pressure on

the mutual unds and down the line on Non-Banking

Financial Companies (NBFCs) where the MFs hadinvested a signicant portion o their unds. This

substitution o overseas nancing by domestic nancing

brought both money markets and credit markets under

pressure. In the oreign exchange market, although

there has been some fight o oreign capital rom the

Indian capital markets, the current level o reserves

is reasonably healthy. In act, the extent o inward

remittances during 2008 was a record $40 billion. The

orex market came under pressure because o reversal o

capital fows as part o the global deleveraging process.

Simultaneously, corporates were converting the unds

raised locally into oreign currency to meet their externalobligations. Both these actors put downward pressure

on the rupee. Third, the Reserve Banks intervention in

the orex market to manage the volatility in the rupee

urther added to liquidity tightening.

14


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15

ancial sector o the Indian economy

On the real channel, the transmission o the global

cues to the domestic economy has been quite straight

orward through the slump in demand or exports.

The United States, European Union and the Middle East,

which account or three quarters o Indias goods and

services trade are in a synchronized down turn. Service

export growth is also likely to slow in the near term

as the recession deepens and nancial services rms

traditionally large users o outsourcing services are

restructured. Remittances rom migrant workers too are

likely to slow as the Middle East adjusts to lower crude

prices and advanced economies go into a recession.

Beyond the nancial and real channels o transmission

as above, the crisis also spread through the condence

channel. In sharp contrast to global nancial markets,

which went into a seizure on account o a crisis o

condence, Indian nancial markets continued to

unction in an orderly manner. Nevertheless, the

tightened global liquidity situation in the period

immediately ollowing the Lehman ailure inmid-September 2008, coming as it did on top o a

turn in the credit cycle, increased the risk aversion o

the nancial system and made banks cautious about

lending.

The purport o the above explanation is to show how,

despite not being part o the global nancial sector

problem, India has been aected by the crisis through

the pernicious eedback loops between external shocks

and domestic vulnerabilities by way o the nancial, real

and condence channels.

Why has India been hit by the crisis?

There is, at least in some quarters, surprise that India has

been aected by the crisis in global nancial markets.

This surprise stems rom two arguments:

The rst argument states that the Indian banking system

has had no direct exposure to the sub-prime mortgage

assets or to the ailed institutions. It has very limited

o-balance sheet activities or securitized assets. Hence,

the enigma is - how can India be caught up in a crisis

when it is not exposed to any o the maladies that are

at the core o the crisis?

The second reason or surprise is that Indias recent

growth has been driven predominantly by domestic

consumption and domestic investment. External

demand, as measured by merchandize exports, accounts

or less than 15% o our GDP. The question then is,

even i there is a global downturn, why should India be

aected when its dependence on external demand is so

limited?

The explanation lies in the story o Indias globalization.

First, Indias integration into the world economy over

the last decade has been remarkably rapid. Integration

into the world implies more than just exports. Going

by the common measure o globalization, Indias

two-way trade (merchandize exports plus imports), as

a proportion o GDP, grew rom 21.2% in 1997-98, the

year o the Asian crisis, to 34.7% in 2007-08.

Second, Indias nancial integration with the world

has been as deep as Indias trade globalization,

i not deeper. I we take an expanded measure

o globalization, that is the ratio o total external

transactions (gross current account fows plus gross

capital fows) to GDP, this ratio has more than doubledrom 46.8% in 1997-98 to 117.4% in 2007-08.

Importantly, the Indian corporate sectors access (and

dependence) to external unding has markedly increased

in the last ve years. In the ve year period 2003-08,

the share o investment in Indias GDP rose by 11%

points. Corporate savings nanced roughly hal o

this, but a signicant portion o the balance nancing

came rom external sources. While unds were available

domestically, they were expensive relative to oreign

unding. On the other hand, in a global market awash

with liquidity and on the promise o Indias growthpotential, oreign investors were willing to take risks and

provide unds at a lower cost. For example, last year

(2007 / 08) India received capital infows amounting

to over 9% o GDP as against a current account decit

in the balance o payments o just 1.5% o GDP. These

capital fows, in excess o the current account decit,

evidence the importance o external nancing and the

depth o Indias nancial integration.

Hence, the reason why India has been impacted by the

crisis, despite mitigating actors, is clearly Indias rapid

and growing integration into the global economy.


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16

How have we responded to the challenge?

The ailure o Lehman Brothers in mid-September was

ollowed in quick succession by several other large

nancial institutions coming under severe stress. This

made nancial markets around the world uncertain

and unsettled. This contagion spread to emerging

economies, including India. Both the government and

the Reserve Bank o India responded to the challenge

in close coordination and consultation. The main

plank o the government response was scal stimulus

while the Reserve Banks action comprised monetary

accommodation and counter cyclical regulatory

orbearance.

Monetarypolicyresponse

The Reserve Banks policy response was aimed at

containing the contagion rom the outside to keep

the domestic money and credit markets unctioning

normally and see that the liquidity stress did not

trigger solvency cascades. In particular, we targeted

three objectives: rst, to maintain a comortable rupeeliquidity position; second, to augment oreign exchange

liquidity; and third, to maintain a policy ramework

that would keep credit delivery on track so as to arrest

the moderation in growth. This marked a reversal o

Reserve Banks policy stance rom monetary tightening

in response to heightened infationary pressures o

the previous period to monetary easing in response

to easing infationary pressures and moderation in

growth in the current cycle. The measures to meet

the above objectives came in several policy packages

starting mid-September 2008, on occasion in response

to unanticipated global developments and at othertimes in anticipation o the impact o potential global

developments on the Indian markets.

Our policy packages included both conventional and

unconventional measures. On the conventional side,

the RBI reduced the policy interest rates aggressively

and rapidly, reduced the quantum o bank reserves

impounded by the central bank and expanded and

liberalized the renance acilities or export credit.

Measures aimed at managing orex liquidity included

an upward adjustment o the interest rate ceiling

on the oreign currency deposits by non-resident

Indians, substantially relaxing the External Commercial

Borrowings (ECB) regime or corporates, and allowing

non-banking nancial companies and housing nance

companies access to oreign borrowing.

The important unconventional measures taken by the

Reserve Bank o India are a rupee-dollar swap acility or

Indian banks to give them comort in managing their

short-term oreign unding requirements, an exclusive

renance window as also a special purpose vehicle

or supporting non-banking nancial companies, and

expanding the lendable resources available to apex

nance institutions or renancing credit extended to

small industries, housing and exports.

Governmentsfscalstimulus

Over the last ve years, both the central and state

governments in India have made a serious eort toreverse the scal excesses o the past. At the heart o

these eorts was the Fiscal Responsibility and Budget

Management (FRBM) Act which mandated a calibrated

road map to scal sustainability. However, recognizing

the depth and extraordinary impact o this crisis, the

central government invoked the emergency provisions

o the FRBM Act to seek relaxation rom the scal

targets and launched two scal stimulus packages

in December 2008 and January 2009. These scal

stimulus packages, together amounting to about 3% o

GDP, included additional public spending, particularly

capital expenditure, government guaranteed undsor inrastructure spending, cuts in indirect taxes,

expanded guarantee cover or credit to micro and

small enterprises, and additional support to exporters.

These stimulus packages came on top o an already

announced expanded saety-net or rural poor, a

arm loan waiver package and salary increases or

government sta, all o which too should stimulate

demand.


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17

Impact o monetary measures

Taken together, the measures put in place since

mid-September 2008 have ensured that the Indian

nancial markets continue to unction in an orderly

manner. The cumulative amount o primary liquidity

potentially available to the nancial system through

these measures is over US$ 75 bn or 7% o GDP. This

sizeable easing has ensured a comortable liquidityposition starting mid-November 2008 as evidenced by

a number o indicators including the weighted-average

call money rate, the overnight money market rate

and the yield on the 10-year benchmark government

security. Taking the signal rom the policy rate cut,

many o the big banks have reduced their benchmark

prime lending rates. Bank credit has expanded too,

aster than it did last year. However, Reserve Banks

rough calculations show that the overall fow o

resources to the commercial sector is less than what it

was last year. This is because, even though bank credit

has expanded, it has not ully oset the decline innon-bank fow o resources to the commercial sector.

Evaluating the response

In evaluating the response to the crisis, it is important

to remember that although the origins o the crisis are

common around the world, the crisis has impacted

dierent economies dierently. Importantly, in advanced

economies where it originated, the crisis spread rom

the nancial sector to the real sector. In emerging

economies, the transmission o external shocks todomestic vulnerabilities has typically been rom the real

sector to the nancial sector. Countries have accordingly

responded to the crisis depending on their specic

country circumstances. Thus, even as policy responses

across countries are broadly similar, their precise design,

quantum, sequencing and timing have varied. In

particular, while policy responses in advanced economies

have had to contend with both the unolding nancial

crisis and deepening recession, in India, our response

has been predominantly driven by the need to arrest

moderation in economic growth.

The important unconventional measurestaken by the Reserve Bank o India are arupee-dollar swap acility or Indian banks to

give them comort in managing their short-term oreign unding requirements


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18

4. Future outlook

The global economic outlook deteriorated sharply over

the last quarter. In a sign o the erocity o the down

turn, the IMF made a marked downward revision o

its estimate or global growth in 2009 in purchasing

power parity terms rom its orecast o 3.0% made

in October 2008 to 0.5% in January 2009. In market

exchange rate terms, the downturn is sharper global

GDP is projected to actually shrink by 0.6%. With all

the advanced economies the United States, Europe

and Japan having rmly gone into recession, the

contagion o the crisis rom the nancial sector to

the real sector has been unorgiving and total. Recent

evidence suggests that contractionary orces are strong:

demand has slumped, production is plunging, job losses

are rising and credit markets remain in seizure. Most

worryingly, world trade the main channel through

which the downturn will get transmitted on the way

orward is projected to contract by 2.8% in 2009.

Policy making around the world is in clearly uncharted

territory. Governments and central banks acrosscountries have responded to the crisis through big,

aggressive and unconventional measures. There is a

contentious debate on whether these measures are

adequate and appropriate, and when, i at all, they will

start to show results. There has also been a separate

debate on how abandoning the rule book driven by the

tyranny o the short-term, is compromising medium-

term sustainability. What is clearly beyond debate

though is that this Great Recession o 2008 / 09 is

going to be deeper and the recovery longer than earlier

thought.

Solutions and prescriptions3

The actors mentioned earlier clearly demonstrate a

need to enhance the resilience o the global system

and consider some o the prescriptions that have been

oered or the consideration o the policy makers. The

recent developments in the global nancial markets have

been closely ollowed by many. These include market

participants, central bankers, supervisors, multilateral

institutions, political leaders, analysts, academicians, and

also the layman. With so much attention being ocused

on the ongoing turbulence, by so many stakeholders,

we have a wide menu o solutions and prescriptions.

Broadly, these prescriptions are as ollows:

1. Improving risk management rameworks (including

governance arrangements) in banks and nancial

institution

2. Empowering the supervisors to play a more active role

in scrutinizing the risk management practices

3. Improving transparency by upgrading reporting

requirements, reviewing the norms or dealing with

o balance sheet items and delinking incentives rom

excessive risk taking behaviour

4. Improving the governance and rating methodologies

used by the credit rating agencies

5. Constantly reviewing and resolving the element o

pro-cyclicality in prudential regulations, accounting

rules, and the attitude o the authorities that tend to

apply these

6. Revisiting the relevant accounting standards and

scope or applying air value accounting to mitigate

pro-cyclicality7. Providing additional powers to the regulatory

authorities to intervene at the rst sign o weakness,

preerably much beore the institutions net worth

turns negative

8. Evaluating the deposit insurance schemes adopted

by the nancial institutions and making appropriate

modications, when needed, to provide greater

certainty and saeguards to the wealth o the

depositors

As ar as India is concerned, the outlook going orward

is mixed. There is evidence o economic activityslowing down. Real GDP growth has moderated in

the rst hal o 2008 / 09. The services sector too,

which has been our prime growth engine or the last

ve years, is slowing, mainly in construction, transport

and communication, trade, hotels and restaurants

sub-sectors. For the rst time in seven years, exports

have declined in absolute terms or three months in

a row during October-December 2008. Recent data

indicate that the demand or bank credit is slackening

despite comortable liquidity in the system. Higher input

costs and dampened demand have dented corporate


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19

margins while the uncertainty surrounding the crisis has

aected business condence. The index o industrial

production has shown negative growth or two recent

months and investment demand is decelerating. All

these actors suggest that growth moderation may be

steeper and more extended than earlier projected.

In addressing the all out o the crisis, India has several

advantages. Some o these are recent developments.

Most notably, headline infation, as measured by the

wholesale price index, has allen sharply, and recent

trends suggest a aster-than-expected reduction in

infation. Clearly, alling commodity prices have been

the key drivers behind the disinfation; however, some

contribution has also come rom slowing domestic

demand. The decline in infation should support

consumption demand and reduce input costs or

corporates. Furthermore, the decline in global crude

prices and naphtha prices will reduce the size o

subsidies to oil and ertilizer companies, opening up

scal space or inrastructure spending. From theexternal sector perspective, it is projected that imports

will shrink more than exports keeping the current

account decit modest.

There are also several structural actors that have come

to Indias aid. First, notwithstanding the severity and

multiplicity o the adverse shocks, Indias nancial

markets have shown admirable resilience. This is in

large part because Indias banking system remains

sound, healthy, well capitalized and prudently regulated.

Second, our comortable reserve position provides

condence to overseas investors. Third, since a largemajority o Indians do not participate in equity and

asset markets, the negative impact o the wealth

loss eect that is plaguing the advanced economies

should be quite muted. Consequently, consumption

demand should hold up well. Fourth, because o Indias

mandated priority sector lending, institutional credit

or agriculture will be unaected by the credit squeeze.

The arm loan waiver package implemented by the

government should urther insulate the agriculture

sector rom the crisis. Finally, over the years, India

has built an extensive network o social saety-net

programmes, including the fagship rural employment

guarantee programme, which should protect the poor

and the returning migrant workers rom the extreme

impact o the global crisis.

RBIs policy stance

Going orward, the Reserve Banks policy stance will

continue to be to maintain comortable rupee and

orex liquidity positions. There are indications that

pressures on mutual unds have eased and that NBFCs

too are making the necessary adjustments to balance

their assets and liabilities. Despite the contraction in

export demand, we will be able to manage our balance

o payments. It is the Reserve Banks expectation that

commercial banks will take the signal rom the policy

rates reduction to adjust their deposit and lending rates

in order to keep credit fowing to productive sectors.

In particular, the special renance windows opened

by the Reserve Bank or the MSME (micro, small and

medium enterprises) sector, housing sector and export

sector should see credit fowing to these sectors. Also

the SPV set up or extending assistance to NBFCs shouldenable NBFC lending to pick up steam once again.

The governments scal stimulus should be able to

supplement these eorts rom both supply and demand

sides.

When the turnaround comes

Over the last ve years, India clocked an unprecedented

9% growth, driven largely by domestic consumption

and investment even as the share o net exports has

been rising. This was no accident or happenstance. True,

the benign global environment, easy liquidity and low

interest rates helped, but at the heart o Indias growthwere a growing entrepreneurial spirit, rise in productivity

and increasing savings. These undamental strengths

continue to be in place. Nevertheless, the global crisis

will dent Indias growth trajectory as investments

and exports slow. Clearly, there is a period o painul

adjustment ahead o us. However, once the global

economy begins to recover, Indias turn around will be

sharper and switer, backed by our strong undamentals

and the untapped growth potential. Meanwhile, the

challenge or the government and the RBI is to manage

the adjustment with as little pain as possible.


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20

Third, it is relevant to ask whether there is a beginning

o scalisation o the nancial sector in view o the

intensication o the links between the two? For

example, the recent episodes o participation o the

sovereign wealth unds in the re-capitalisation o banks

tantamount to scal support. Further, large doses o

liquidity support to nancial markets by regulators

against collateral may also involve quasi-scal costs,

under some circumstances.

5. Conclusion

The nance sector is currently undergoing a deep and

thorough restructuring. The crisis has hit the sector

unevenly, which may result in labour movement among

nancial sub-sectors. This will reinorce the impetus

towards structural changes similar to those experienced

until now. This restructuring o the nance sector

cannot take place without substantial consequences or

both employment and income o current employees in

this industry. In act, the sector is already experiencing

a permanent decline in overall activity ater years o

expansion, which is triggering signicant job losses.

Moreover, evidence shows stagnation and even

deceleration in income growth. The detailed account

given above o the developments in the global and the

Indian nancial sector would be incomplete without

devoting some attention to the broader issues. These

issues need to be reckoned and debated widely lest

the response to recent developments be construed as

internal to the nancial sector, warranting only such

sector-specic solutions.

First, should the benets o nancial liberalisation and

nancial globalisation be re-evaluated? It is possible

to argue that liberalisation o trade in goods has

contributed more to growth and price stability than

nancial sector initiatives. In particular, it may be

argued that the incentive rameworks or nancial

intermediaries appear to be disproportionate to

their conceivable contribution to the economy. The

arguments in avour o persevering with nancial

innovation and urging regulators to continue to give

priority to acilitate innovations should be viewed in this

context.

Second, should the regulators have placed greater

emphasis on savings o capital in banks rather than on

the interests o the depositors and on systemic stability?

The recent compulsions or shoring up o capital by

some o the global nancial institutions in advanced

economies seem to suggest this. What induced

the regulators to permit such excesses in leverage

and savings o capital? Does this also involve issues

pertaining to governance and accountability o the

regulators?


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21

Fourth, whether there is, what may be called,

nancialisation o the political economy? The

attractiveness o nancial intermediaries in terms o high

protability, signicant growth especially cross-border,

massive spread o investors, and the inadequate scope

or application o principles o rules o origin in the

nancial sector could have resulted in enhanced clout

or these intermediaries in the political economy.

Fith, whether there has been excessive nancialisation

o corporates, in the sense that large corporates take

signicant positions in the nancial markets through

their treasury operations? Increasingly, many o the

positions o the corporates in the nancial markets

may not be related to their underlying business. Do we

have an issue when such activities o corporates in the

nancial markets, unrelated to their underlying business,

are not regulated the way similar activities o nancial

market intermediaries are regulated?

To conclude, on the way orward, to exit the current

nancial turbulence and ortiy against uture similar

episodes, we may need to look beyond reorms within

the nancial sector and address broader related issues

that impinge on the balance between the sovereign, the

regulators, the nancial institutions and the markets4.


22/24

22

Endnote1 Excerpts taken rom a speech given by Y. V. Reddy on Global Financial Turbulence and Financial Sector

in India: A Practitioners Perspective

2 www.rbi.or.in

3 Excerpts taken rom a speech given by Y. V. Reddy on Global Financial Turbulence and Financial Sector


4 Excerpts taken rom a speech given by Y. V. Reddy on Global Financial Turbulence and Financial Sector



23/24

23

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Documents

Global Economic Slowdown-Financial Services