Financial Stability…
Globalization, advances in information technology and deregulation of the financial sector in emerging market economies have brought the issue of financial stability to the forefront of public policy. Several episodes of financial fragility that have occurred in the latter half of the 1990s across the globe, which entailed enormous costs for the financial system of several countries, have further underlined the need for a safe and sound financial sector. Traditionally, it is believed that monetary stability leads to financial stability. While there are complementarities between these two objectives in the long run, the relationship can be very different in the short-run. In this regard, a stable macroeconomic environment can often downplay the risks posed to the financial system. Accordingly, episodes of financial instability often follow periods of protracted macroeconomic booms.
Financial stability refers to the smooth functioning of financial markets and institutions without experiencing any serious disruption. The relevant legal, institutional and policy frameworks are varied and policy instruments at the disposal of the authorities are wide ranging. In a way, the financial stability objective is shared with a set of public policy bodies and professional bodies. However, the primary responsibility for overall financial sector efficiency and stability generally rests with the monetary authority ñ the central bank. The reasons for such a responsibility are the major functions that a modern central bank Perform, besides maintaining monetary stability, viz., and issuer of currency and lender of the last resort. Some central banks are also responsible for the oversight of the financial infrastructure, Particularly the payment systems, and crisis management. Historically, central banks have been concerned with both price stability and financial stability. However, in view of the recent episodes of turmoil and the realization that financial stability and macroeconomic stability are mutually reinforcing in the process of economic development, central banks have begun to bestow a more focused attention to the objective of maintaining financial stability. This is in recognition of the weakness in the financial system that triggered recent episodes of economic crises. As a result, central banks have included financial stability as one of their core functions, although differences persist at a more fundamental level on the degree of activism that central banks should adopt in pursuing this objective.
The basic factors affecting financial stability are the rapid pace of technological innovation across the globe, increasing diversity of financial instruments and the emergence of a large number of financial conglomerates, cutting across not only various financial sectors, but also across countries. The role of financial intermediaries is also getting redefined with their ability to effectively compete by appropriate transformation of risk. Further, the source of financial disturbances has become more unpredictable mainly due to integration of financial markets across national boundaries, thereby exacerbating the possibility of contagion. The progressive dismantling of capital controls since the 1990s has led to substantial cross-border capital flows and volatile exchange rates. Sharp movements in exchange rates can have an adverse impact, particularly in emerging market economies, and can be a potential source of instability.
Globalization entails several challenges for financial stability. First, although globalization has led to productivity gains for the world economy, it has also been a source of some episodes of financial instability. These crises indicated that rapid movements of capital could be detrimental to economies with weak institutional frameworks. Second, the institutional backdrop has become more complex over the past twenty years as the hedge fund industry, which is relatively opaque in operation, has significantly grown in size. Such a large industry carries the risk of herd behavior and with high concentration of assets; this could clearly pose a threat to financial stability. Third, risk bearers are of two categories: (i) institutional, in the form of insurers or re-insurers; and (ii) the household sector. The re-insurers are a bit opaque with regard to the composition of their balance sheets and their risk exposures, while there are some concerns about the leverage that exists on household’s balance sheets.
Going by the experience of Latin American countries, the trigger points of financial instability were: (i) a boom in credit to the private sector; (ii) wholesale liberalization in the absence of an appropriate and effective prudential regulatory framework; (iii) direct effects of fiscal pressures on the domestic banking system; (iv) contagion and spillovers where a crisis in one country impacts other countries; (v) terms of trade shocks and movements in real exchange rates ; and (vi) political instability, unrest, and in some cases, civil conflict. In this regard, deficiencies in key economic and social infrastructure are some of the factors that increased financial vulnerability in these countries. These include: (a) inappropriate and ineffective prudential regulation and supervision; (b) inefficacy of bank intervention and resolution; (c) policy-induced distortions such as administered interest rates and weak government finances; (e) inadequate accounting practices, property rights and corporate governance; and (f) lack of institutional framework and adequate provisions, especially in the legal system.
The importance of financial stability emanates from four major trends in the financial systems, which have become evident in recent years. These are: (i) an imbalance of growth between the financial sector and the real economy; (ii) a change in the mode of financial operations due to financial deepening (credit/debit cards, etc.); (iii) emergence of a globally integrated financial system; and (iv) an evolution of sophisticated financial instruments and attendant risks. Consequently, the sources of crises have multiplied, necessitating the coordination of a number of authorities; both within and outside the country Central banks pursue a multifaceted approach for ensuring financial stability. This includes: (i) payments system oversight; clearly pose a threat to financial stability. Third, risk bearers are of two categories: (i) institutional, in the form of insurers or re-insurers; and (ii) the household sector. The re-insurers are a bit opaque with regard to the composition of their balance sheets and their risk exposures, while there are some concerns about the leverage that exists on household’s balance sheets.
Risks from Global Financial Imbalances
Large and growing global financial imbalances have generally been perceived as constituting a significant threat to global financial system stability. The most fundamental imbalance in the world economy relates to the saving propensities among the major countries. On the one extreme, the United States has a very low savings rate, which is about 10 per cent of GDP in 2005, on the other extreme stands China with a very high savings rate reaching about 50 per cent of its GDP. Hence, with such diversity among national savings rates, the current accounts of the various countries reveal a high degree of imbalance. Large surplus savings in many Asian countries has facilitated the financing of the US current account deficit of around 6.5-7.0 per cent. In this regard, the significant capital inflows needed to finance US current account deficits have emanated from such surplus economies, especially China and Japan, and, more recently, by several oil-exporting countries, which have benefited from revenue windfalls due to a surge in international oil prices. India, like many other emerging market economies, could be adversely affected by the sudden unwinding of global financial imbalances. However, the impact could be different on different sectors such as the government, the corporate sector and the banking system First, the Government of India does not raise resources from the international capital markets to finance its fiscal deficit. The Government could, however, be affected indirectly through the spillover impact of external developments on domestic interest rates. To the extent there is a rise in domestic interest rates, there could be an increase in the cost of borrowings undertaken by the Government. However, since most of the outstanding debt is at fixed rates and not on floating rates, the rise in the borrowing cost of the Government will be incremental and, therefore, will not have a significant impact on the interest burden.
Non-Banking Financial Companies
The Reserve Bank continued its efforts to strengthen the non-banking financial companies. The periodicity of returns on important financial parameters of NBFCs not accepting/holding public deposits and having an asset size of Rs.500 crore or above was changed in September 2005 from quarterly to monthly to facilitate a macro level assessment of large non-deposit taking companies at more frequent intervals. The threshold asset size of such companies was also reduced from ëRs.500 crore and above to Rs.100 crore and above to widen the coverage.
Financial Markets
A stable financial system requires sound financial institutions, well-functioning financial markets and robust financial infrastructure. Operations and performance of commercial banks, co-operative banks and non-banking financial institutions during 2005-06 have been detailed in Chapter 3, 4 and 5, respectively. This and the following section analyze the developments in the financial markets and the payment and settlement systems in India during 2005-06 from the point of view of financial stability. Financial markets play an important role in allocating resources in an efficient manner. They also facilitate the price discovery process in financial instruments and are the conduit of transmitting policy signals to the real economy. Financial markets offer a mechanism of diversifying risk within the financial system. Volatile movements in financial markets have serious implications for macroeconomic performance. Hence, stability in the financial markets is an important pre-requisite for the stability of the financial system.
Payment and Settlement Systems
The smooth functioning of the payment and settlement system is a pre-requisite for financial stability. Any assessment of financial stability, therefore, needs to be examined from the perspective of the functioning of the payment and settlement systems. In this context, large-value payments, which involve systemic risk, are particularly important as they link various financial institutions through intra-locking of claims. Any glut arising out of transaction failure in one leg of the financial system could trigger off a chain of successive failures, which could pose a serious systemic risk to the stability of the financial system has been the endeavor of the Reserve Bank to reduce the risks associated with payment and settlement systems. The Reserve Bank, therefore, has taken several measures from time to time to develop the payment and settlement system along sound lines. The initiatives taken during 2005-06 relate to: (i) enhancing usage of
the real time gross settlement system (RTGS) system; (ii) providing incentives and guidelines for reducing transaction costs associated with payment system dependent on technology: (iii) improving legal infrastructure for the payment system; (iv) introducing nationwide payment system for retail payment; (v) improving international remittance services; and (vi) facilitating newer channels of payment and settlement.
The Board for Regulation and Supervision of Payment and Settlement Systems (BPSS), set up in March 2005, as a committee of the Central Board of the Reserve Bank, is the apex body for giving policy direction in the area of payment and settlement systems. The BPSS gave important policy directions/decisions including: (i) setting target for usage of the RTGS system; (ii) publishing a list of frequently asked questions (FAQ) on payment systems; (iii) publishing the charges levied by banks for electronic payment systems; (iv) setting up of an umbrella organization for all retail payment systems in the country; (v) finalizing the Payment and Settlement Systems Bill; and (vi) preparing the Electronic Funds Transfer Regulations under the Reserve Bank of India Act. With introduction of RTGS, whereby a final settlement of individual inter-bank fund transfers is effected on a gross real time basis during the processing day, a major source of systemic risk in the financial system has been reduced substantially. RTGS transactions, both in terms of volume and value, have increased sharply in a short span of its operation. The use of Electronic Clearing Service (ECS), both debit and credit, has been on the increase. The reach of ECS has increased, which is now available at 65 centers. In November 2005, banks were advised to develop appropriate delivery channels of electronic payment services using the payment systems developed by the Reserve Bank such as RTGS, ECS, Electronic Fund Transfer (EFT), and National Electronic Fund Transfer (NEFT) with no further delay. In order to start a robust state-of-the-art nationwide ECS covering more branches and locations with centralized data submission system, banks (including co-operative banks) were advised to furnish certain information indicating their level of preparedness for the project as on June 27, 2006. To take the effort further, all banks were directed on July 4, 2006 to initiate steps for incorporating an appropriate mandate management routine for handling ECS (Debit) transactions.
Risks to Financial Stability
The Annual Policy Statement of the Reserve Bank in April 2006 warned of three key risks from global developments for India and other emerging market economies. These are: (a) potential escalation and volatility in international crude oil prices; (b) hardening of international interest rates along with uncertainty about the future course of monetary policy; and (c) disorderly unwinding of the global imbalances. In addition, the turnaround in the credit cycle brought about by rising international interest rates in advanced economies could also pose a risk to financial stability. If any of the above risks materialize, global financial market conditions could react in a way that could increase the risks to financial stability. In particular, concerns have been raised about the potential for liquidity to emerge in credit markets in emerging market economies such as India. The volatility in international financial markets would also spill over to the domestic financial markets. This section examines the main sources of risks that could affect financial stability in India in the near future. It needs to be noted that drawing attention to sources of risk for financial stability differs from seeking to identify the most Probable outcome.
- By Mazhar pasha
ATW, INDIA.
Note: Financial Stability opinion/article is prepared taking RBI policies, Payment Systems & Settlement methods, Oil prices, and other international financial factors.
Financial Stability…
Translated into English by: mazhar pasha
Financial Stability…
Globalization, advances in information technology and deregulation of the financial sector in emerging market economies have brought the issue of financial stability to the forefront of public policy. Several episodes of financial fragility that have occurred in the latter half of the 1990s across the globe, which entailed enormous costs for the financial system of several countries, have further underlined the need for a safe and sound financial sector. Traditionally, it is believed that monetary stability leads to financial stability. While there are complementarities between these two objectives in the long run, the relationship can be very different in the short-run. In this regard, a stable macroeconomic environment can often downplay the risks posed to the financial system. Accordingly, episodes of financial instability often follow periods of protracted macroeconomic booms.
Financial stability refers to the smooth functioning of financial markets and institutions without experiencing any serious disruption. The relevant legal, institutional and policy frameworks are varied and policy instruments at the disposal of the authorities are wide ranging. In a way, the financial stability objective is shared with a set of public policy bodies and professional bodies. However, the primary responsibility for overall financial sector efficiency and stability generally rests with the monetary authority ñ the central bank. The reasons for such a responsibility are the major functions that a modern central bank Perform, besides maintaining monetary stability, viz., and issuer of currency and lender of the last resort. Some central banks are also responsible for the oversight of the financial infrastructure, Particularly the payment systems, and crisis management. Historically, central banks have been concerned with both price stability and financial stability. However, in view of the recent episodes of turmoil and the realization that financial stability and macroeconomic stability are mutually reinforcing in the process of economic development, central banks have begun to bestow a more focused attention to the objective of maintaining financial stability. This is in recognition of the weakness in the financial system that triggered recent episodes of economic crises. As a result, central banks have included financial stability as one of their core functions, although differences persist at a more fundamental level on the degree of activism that central banks should adopt in pursuing this objective.
The basic factors affecting financial stability are the rapid pace of technological innovation across the globe, increasing diversity of financial instruments and the emergence of a large number of financial conglomerates, cutting across not only various financial sectors, but also across countries. The role of financial intermediaries is also getting redefined with their ability to effectively compete by appropriate transformation of risk. Further, the source of financial disturbances has become more unpredictable mainly due to integration of financial markets across national boundaries, thereby exacerbating the possibility of contagion. The progressive dismantling of capital controls since the 1990s has led to substantial cross-border capital flows and volatile exchange rates. Sharp movements in exchange rates can have an adverse impact, particularly in emerging market economies, and can be a potential source of instability.
Globalization entails several challenges for financial stability. First, although globalization has led to productivity gains for the world economy, it has also been a source of some episodes of financial instability. These crises indicated that rapid movements of capital could be detrimental to economies with weak institutional frameworks. Second, the institutional backdrop has become more complex over the past twenty years as the hedge fund industry, which is relatively opaque in operation, has significantly grown in size. Such a large industry carries the risk of herd behavior and with high concentration of assets; this could clearly pose a threat to financial stability. Third, risk bearers are of two categories: (i) institutional, in the form of insurers or re-insurers; and (ii) the household sector. The re-insurers are a bit opaque with regard to the composition of their balance sheets and their risk exposures, while there are some concerns about the leverage that exists on household’s balance sheets.
Going by the experience of Latin American countries, the trigger points of financial instability were: (i) a boom in credit to the private sector; (ii) wholesale liberalization in the absence of an appropriate and effective prudential regulatory framework; (iii) direct effects of fiscal pressures on the domestic banking system; (iv) contagion and spillovers where a crisis in one country impacts other countries; (v) terms of trade shocks and movements in real exchange rates ; and (vi) political instability, unrest, and in some cases, civil conflict. In this regard, deficiencies in key economic and social infrastructure are some of the factors that increased financial vulnerability in these countries. These include: (a) inappropriate and ineffective prudential regulation and supervision; (b) inefficacy of bank intervention and resolution; (c) policy-induced distortions such as administered interest rates and weak government finances; (e) inadequate accounting practices, property rights and corporate governance; and (f) lack of institutional framework and adequate provisions, especially in the legal system.
The importance of financial stability emanates from four major trends in the financial systems, which have become evident in recent years. These are: (i) an imbalance of growth between the financial sector and the real economy; (ii) a change in the mode of financial operations due to financial deepening (credit/debit cards, etc.); (iii) emergence of a globally integrated financial system; and (iv) an evolution of sophisticated financial instruments and attendant risks. Consequently, the sources of crises have multiplied, necessitating the coordination of a number of authorities; both within and outside the country Central banks pursue a multifaceted approach for ensuring financial stability. This includes: (i) payments system oversight; clearly pose a threat to financial stability. Third, risk bearers are of two categories: (i) institutional, in the form of insurers or re-insurers; and (ii) the household sector. The re-insurers are a bit opaque with regard to the composition of their balance sheets and their risk exposures, while there are some concerns about the leverage that exists on household’s balance sheets.
Risks from Global Financial Imbalances
Large and growing global financial imbalances have generally been perceived as constituting a significant threat to global financial system stability. The most fundamental imbalance in the world economy relates to the saving propensities among the major countries. On the one extreme, the United States has a very low savings rate, which is about 10 per cent of GDP in 2005, on the other extreme stands China with a very high savings rate reaching about 50 per cent of its GDP. Hence, with such diversity among national savings rates, the current accounts of the various countries reveal a high degree of imbalance. Large surplus savings in many Asian countries has facilitated the financing of the US current account deficit of around 6.5-7.0 per cent. In this regard, the significant capital inflows needed to finance US current account deficits have emanated from such surplus economies, especially China and Japan, and, more recently, by several oil-exporting countries, which have benefited from revenue windfalls due to a surge in international oil prices. India, like many other emerging market economies, could be adversely affected by the sudden unwinding of global financial imbalances. However, the impact could be different on different sectors such as the government, the corporate sector and the banking system First, the Government of India does not raise resources from the international capital markets to finance its fiscal deficit. The Government could, however, be affected indirectly through the spillover impact of external developments on domestic interest rates. To the extent there is a rise in domestic interest rates, there could be an increase in the cost of borrowings undertaken by the Government. However, since most of the outstanding debt is at fixed rates and not on floating rates, the rise in the borrowing cost of the Government will be incremental and, therefore, will not have a significant impact on the interest burden.
Non-Banking Financial Companies
The Reserve Bank continued its efforts to strengthen the non-banking financial companies. The periodicity of returns on important financial parameters of NBFCs not accepting/holding public deposits and having an asset size of Rs.500 crore or above was changed in September 2005 from quarterly to monthly to facilitate a macro level assessment of large non-deposit taking companies at more frequent intervals. The threshold asset size of such companies was also reduced from ëRs.500 crore and above to Rs.100 crore and above to widen the coverage.
Financial Markets
A stable financial system requires sound financial institutions, well-functioning financial markets and robust financial infrastructure. Operations and performance of commercial banks, co-operative banks and non-banking financial institutions during 2005-06 have been detailed in Chapter 3, 4 and 5, respectively. This and the following section analyze the developments in the financial markets and the payment and settlement systems in India during 2005-06 from the point of view of financial stability. Financial markets play an important role in allocating resources in an efficient manner. They also facilitate the price discovery process in financial instruments and are the conduit of transmitting policy signals to the real economy. Financial markets offer a mechanism of diversifying risk within the financial system. Volatile movements in financial markets have serious implications for macroeconomic performance. Hence, stability in the financial markets is an important pre-requisite for the stability of the financial system.
Payment and Settlement Systems
The smooth functioning of the payment and settlement system is a pre-requisite for financial stability. Any assessment of financial stability, therefore, needs to be examined from the perspective of the functioning of the payment and settlement systems. In this context, large-value payments, which involve systemic risk, are particularly important as they link various financial institutions through intra-locking of claims. Any glut arising out of transaction failure in one leg of the financial system could trigger off a chain of successive failures, which could pose a serious systemic risk to the stability of the financial system has been the endeavor of the Reserve Bank to reduce the risks associated with payment and settlement systems. The Reserve Bank, therefore, has taken several measures from time to time to develop the payment and settlement system along sound lines. The initiatives taken during 2005-06 relate to: (i) enhancing usage of
the real time gross settlement system (RTGS) system; (ii) providing incentives and guidelines for reducing transaction costs associated with payment system dependent on technology: (iii) improving legal infrastructure for the payment system; (iv) introducing nationwide payment system for retail payment; (v) improving international remittance services; and (vi) facilitating newer channels of payment and settlement.
The Board for Regulation and Supervision of Payment and Settlement Systems (BPSS), set up in March 2005, as a committee of the Central Board of the Reserve Bank, is the apex body for giving policy direction in the area of payment and settlement systems. The BPSS gave important policy directions/decisions including: (i) setting target for usage of the RTGS system; (ii) publishing a list of frequently asked questions (FAQ) on payment systems; (iii) publishing the charges levied by banks for electronic payment systems; (iv) setting up of an umbrella organization for all retail payment systems in the country; (v) finalizing the Payment and Settlement Systems Bill; and (vi) preparing the Electronic Funds Transfer Regulations under the Reserve Bank of India Act. With introduction of RTGS, whereby a final settlement of individual inter-bank fund transfers is effected on a gross real time basis during the processing day, a major source of systemic risk in the financial system has been reduced substantially. RTGS transactions, both in terms of volume and value, have increased sharply in a short span of its operation. The use of Electronic Clearing Service (ECS), both debit and credit, has been on the increase. The reach of ECS has increased, which is now available at 65 centers. In November 2005, banks were advised to develop appropriate delivery channels of electronic payment services using the payment systems developed by the Reserve Bank such as RTGS, ECS, Electronic Fund Transfer (EFT), and National Electronic Fund Transfer (NEFT) with no further delay. In order to start a robust state-of-the-art nationwide ECS covering more branches and locations with centralized data submission system, banks (including co-operative banks) were advised to furnish certain information indicating their level of preparedness for the project as on June 27, 2006. To take the effort further, all banks were directed on July 4, 2006 to initiate steps for incorporating an appropriate mandate management routine for handling ECS (Debit) transactions.
Risks to Financial Stability
The Annual Policy Statement of the Reserve Bank in April 2006 warned of three key risks from global developments for India and other emerging market economies. These are: (a) potential escalation and volatility in international crude oil prices; (b) hardening of international interest rates along with uncertainty about the future course of monetary policy; and (c) disorderly unwinding of the global imbalances. In addition, the turnaround in the credit cycle brought about by rising international interest rates in advanced economies could also pose a risk to financial stability. If any of the above risks materialize, global financial market conditions could react in a way that could increase the risks to financial stability. In particular, concerns have been raised about the potential for liquidity to emerge in credit markets in emerging market economies such as India. The volatility in international financial markets would also spill over to the domestic financial markets. This section examines the main sources of risks that could affect financial stability in India in the near future. It needs to be noted that drawing attention to sources of risk for financial stability differs from seeking to identify the most Probable outcome.
- By Mazhar pasha
ATW, INDIA.
Note: Financial Stability opinion/article is prepared taking RBI policies, Payment Systems & Settlement methods, Oil prices, and other international financial factors.
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