ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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Issues in the Financial Sector: Defining and Achieving Financial Stability

Key issues of financial stability are touched upon over here. First, the difficulties of defining financial stability as an operational and workable proposition are addressed. Second, the enhanced scope and coverage of the Committee on Financial Sector Assessment in dealing with issues concerning it are explained. Third, India's overall approach to financial stability, which stood in good stead through several crises, is briefly discussed. Finally, a decisive approach in following up on the comprehensive set of the CFSA's recommendations is suggested.

Issues in the Financial Sector: Regulatory Architecture

One of the issues that the Committee on Financial Sector Assessment addressed on the infrastructure for the financial sector was regulation. This is of great relevance since one of the reasons for the global financial crisis was a failure of regulation. The committee studied and discussed regulatory issues in a number of areas and from a number of important perspectives: (i) principles versus rules based regulation; (ii) regulation of financial conglomerates; (iii) multiple versus single regulator; (iv) role of self-regulatory organisations; and (v) regulatory independence vis-à-vis the government. This edition of the monthly review discusses these five aspects of regulation. The second of a three-part series on issues relating to the CFSA's reports.

The Taxing Problem: Future of the Cash Reserve Ratio

There is an implicit tax in the application of the cash reserve ratio and when applied on a uniform basis between banks it is also regressive and discriminatory. The imposition of the CRR results in forgone income and it is estimated that a one percentage point increase in the ratio can reduce the multiplier effect on this income by 0.94 percentage points. This would translate in 2009 into forgone income equivalent to about 2.6% of total profits of the commercial banks. The problem is that non-payment of interest on CRR balances has magnified the tax impact of this instrument. The central bank could consider alternatives such as a slab system and concessional treatment of rural and cooperative institutions, so that the tax impact of CRR is made progressive and discriminates between institutions.

Liberalising Savings Bank Deposit Rates

While a considered view needs to be taken on deregulation of all interest rates on small savings, a reform that need not wait and that is simpler to implement is freeing of interest rates on savings bank deposits. While SBDs are operative in many countries, the way in which these accounts are worked in India makes them more akin to checking or chequable accounts abroad. Although meant to inculcate the savings habit, SBDs are now held by a variety of individuals, including high net worth individuals, and also by organisations in the government, financial and non-financial sectors. To be a true small savings account the cheque writing facility of these accounts has to be withdrawn. As in other countries, SBDs could offer minimum facilities such as withdrawal and ATM/debit card with modest interest payment. The SBDs may in principle be treated similar to "no frills" accounts and the interest rate on them freed.

Quenching the Inflation Fire

The current surge in inflation is not receiving the urgent attention that is needed from the government. Alongside a rise in wholesale price inflation, uncertainty and risk have increased. Consumer price inflation is also ruling at an unacceptably high level. The explanations that are offered are many, but it is clear that both supply and demand factors are at work behind the acceleration in inflation. Increase in inflation variability, which is indicative of uncertainty associated with the inflation rate, would place a higher premium on inflation risk, which would, in turn, be reflected in the next upturn in the interest rate cycle. One way of mitigating the inflation risk premium and generating interest in long maturities is to issue a series of inflation indexed bonds with an assured real return in the range of 2 to 3%.

Upwardly Sticky Bank Lending

The Reserve Bank of India's recent Report on Trend and Progress of Banking in India, 2008-09 places considerable emphasis on bank lending in the context of the country returning to a higher growth path. But credit growth has dropped unusually to a low of less than 10% for the period ending 30 October, which is about half of the RBI's projection for the current year and roughly about one-third of the growth rate witnessed a year ago. Banks seem to be reluctant to expand their credit portfolio. What of this phenomenon of upwardly sticky lending?

Are Market Operations Open?

The RBI's market operations in the post-reform period appear to have had a three-pronged objective: to maintain an appropriate interest rate regime, to manage the government borrowing programme, and to contain exchange rate volatility, while keeping an eye on its impact on competitiveness. Since early 2009, the market operations have led to a significant release of liquidity. It may be necessary for the RBI to make all the operations discretionary and indicate to the public in the interest of transparency the policy intentions of any major operation. While there could be an interest rate corridor for the money market, the repo and reverse repo operations, combined with open market operations in the securities and forex market, should perhaps target a pre-announced rate. The actual rate could be allowed to fluctuate depending upon the market conditions. As in the case of the forex market, the rate may be broadly market-determined, avoiding only extreme short-term volatility.

Wanted: A Turf War for Development of Financial Markets

The effectiveness of a regulatory architecture in the financial sector can be gauged by three parameters - (1) the framework and mechanisms in place for clearly defined regulatory jurisdictions of financial markets and institutions; (2) the clarity regarding the developmental role with regard to the promotion and nurturing of the financial institutions and markets in their respective areas of jurisdiction; and (3) the responsibility and accountability for financial stability. Testing the present arrangements in India against these three parameters shows some weaknesses and the need for improvement.

Whither Exchange Rate Policy?

This is an attempt at uncovering the nuances of India's exchange rate policy as spelt out by the Reserve Bank of India from time to time and discerning the current challenges, based on a brief review of developments in rates since January 2007.

Choice between Monetising and Monetary Easing

The market borrowing programme of the government has been hiked to unprecedented levels since September 2008 and it is budgeted to reach gigantic proportions in 2009-10. A preliminary analysis of securities market data and banking trends suggests that a successful completion of the 2009-10 programme of the central government will need considerable monetary easing over the current year, if not monetisation of the deficit, if the increase in yield rates is to be contained within moderate limits. This will crucially depend upon the management of interest rates and liquidity conditions by the RBI using both their monetary and debt management skills. At this critical juncture, any idea of immediate separation of debt management function from the monetary management should be kept under a tight lid.

Downward Sticky Lending Rates

The markets are quick to raise interest rates and curtail lending during the tightening phase of monetary policy, but their reactions are lukewarm in an easing phase. This asymmetric behaviour leads to the conclusion that monetary policy is effective only during the tightening phase. A review of the policy interventions between September 2004 and 2008 provides some support to this view, but the results seem to be mixed when we consider the responses from the rate and quantity channels of monetary transmission. The transmission of monetary policy through both the rate and quantity channels was weak during the easing phase; the rate channel has been stronger during the tightening phase. But the quantity channel may overshoot and contradict the macroeconomic objectives if the tightening phase is accompanied by capital inflows.

Priorities of the Central Bank

An approach to implementing public policies that allows some distance between policy outcomes and public aspirations has prevented the Reserve Bank of India from playing an effective role in the process of development. Experience suggests that when credit expansion is restrained due to reasons of inflation and stabilisation objectives, the worst to suffer are the vulnerable sections of society. But when policy distortions take place, social compulsions make the governments in power adopt unhealthy policy stances such as doubling of bank credit for agriculture within three years, loan waivers and granting of loans at subsidised rates of interest for agriculture and other small borrowers. This is interference in central bank autonomy, but such governmental actions arise as a reaction to the apathy shown by the monetary authorities and the banking system to the aspirations and developmental needs of the larger community.

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