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Click here to return to main page of Annual Policy Statement 2008-09

Part II. Annual Statement on Developmental and Regulatory Policies for the Year 2008-09

105. The Annual Statement of April 2007 and subsequently the Mid-Term Review of October 2007 set the stance of developmental and regulatory policies for the year 2007-08 in terms of emphasis on credit quality, orderly conditions in financial markets, greater credit penetration and financial inclusion. In the Third Quarter Review of January 2008, heightened vigilance in the context of potential spillovers from the global financial turbulence was accorded priority, along with preparedness for swift responses to ensure financial stability. During 2007-08, development of the financial market infrastructure, liberalisation of foreign exchange transactions, strengthening risk management in banks and supervisory processes in response to financial innovations engaged the Reserve Bank, alongside the refinement of credit delivery mechanisms with specific focus on agriculture, micro, small and medium enterprises and financial inclusion.

106. The setting of developmental and regulatory policies for 2008-09 will continue to focus on developing a sound, efficient and vibrant financial system that ensures the efficient provision of financial services to the widest sections of society. In the context of recent financial developments internationally, the securing and maintenance of financial stability will continue to receive priority from a policy perspective. Credible communication, adequate and timely availability of information and a broad-based, participative and consultative approach in the conduct of its developmental and regulatory policies with involvement of all stakeholders would shape the Reserve Bank's responses to the emerging challenges.

107. Recent financial developments have brought to the fore several issues that carry implications for the health of the financial sector. First, there is close scrutiny of the business strategies of banks and financial institutions which are based on the model of 'originate and distribute'. Second, issues relating to securitisation are being debated in the context of incentive structures that provide for economising on capital requirements and enhancement of off-balance sheet exposures relative to considerations of financial soundness. Third, recent events have also underscored the need for enhanced market transparency relating to disclosures of off-balance sheet exposures, particularly with regard to liquidity commitments to conduits, valuations regarding structured credit products and the like. Fourth, the apparent inadequacy of financial institutions' capital cushions has been exposed. In this context, the role of sovereign wealth funds as providers of capital is being carefully assessed by supervisory authorities across the world. Fifth, the sharp repricing of risk that began in the middle of 2007 has raised issues relating to the marking to market of portfolios of financial institutions and attendant issues relating to capital provision. Sixth, there are concerns that existing risk pricing and management tools and techniques employed in banks and financial institutions are inadequate in relation to the evolving risks. Seventh, there is a progressive blurring of the boundaries between liquidity and solvency stress in situations of generalised uncertainty and loss of confidence among financial entities. Eighth, the role of structured investment vehicles (SIVs), the potential liquidity demands that could crystallise on balance sheets and the degree of leverage embedded in the global financial system has been largely underestimated with implications for the soundness and efficiency of the financial sector. Ninth, the functioning of the credit rating agencies and excessive reliance of institutional investors on the ratings are under scrutiny.

108. Against this backdrop, several measures have been suggested for mitigating the impact and improving the global financial system. According to the Institute of International Finance (IIF), banks should commit themselves to follow best practices in a number of areas where the financial crisis has revealed weaknesses. ‘Best practice’ should not imply legal obligations but high standards for entities to develop their own tailor-made solutions. The proposals made by the Financial Stability Forum (FSF) [a forum of select senior representatives of national financial authorities _ including central banks, supervisory authorities and treasury departments _ international financial institutions, international regulatory and supervisory groupings and committees of central bank experts] and ratified in early April 2008 by the G-7 to be implemented over the next 100 days are comprehensive and cover full and prompt disclosure of risk exposures, write downs and fair value estimates for complex and illiquid instruments; urgent action by setters of accounting standards and other relevant standard setters to improve accounting and disclosure standards for off-balance sheet or entities and to enhance guidance on fair value accounting, particularly on valuing financial instruments in periods of stress; strengthening of risk management practices, supported by supervisors' oversight, including rigorous stress testing; and strengthening of capital positions as needed. In addition, proposals made by the FSF for implementation by end-2008 include: strengthening prudential oversight of capital, liquidity, and risk management under Basel II, especially for complex structured credit instruments and off-balance sheet vehicles; enhancing transparency and valuation for off-balance sheet entities, securitisation exposures, and liquidity commitments under the Basel Committee's guidance; enhancing due diligence in the use of ratings; adherence by credit rating agencies to the revised code of conduct of the International Organisation of Securities Commissions (IOSCO); strengthening the authorities' responsiveness to risk through cooperation and exchange of information so as to act swiftly to investigate and penalise fraud, market abuse, and manipulation; implementing robust arrangements for dealing with stress in the financial system such as liquidity support from the central banks; and, strengthening arrangements for dealing with weak and failing banks, domestically and cross border. It may be noted that the International Monetary and Financial Committee (IMFC) has welcomed the above policy recommendation of FSF [The IMFC is a Committee of select Board of Governors of the IMF of which the Finance Minister, Shri P. Chidambaram is a member].

109. In the light of the current macroeconomic environment and global developments as discussed in Part I of the Statement, the Annual Statement on Developmental and Regulatory Policies focuses on certain key areas: new financial instruments, carrying forward development of various segments of financial markets and strengthening financial market infrastructure; developing a safe, secure and integrated real time payment and settlement system; further liberalisation of foreign exchange transactions; cross-border supervision, risk-based supervision and bank-led financial conglomerates; strengthening the supervisory framework as appropriate to evolving requirements; enhancing public confidence and consolidation in urban cooperative banks (UCBs) and regional rural banks (RRBs); improved credit delivery mechanisms and conducive credit culture, customer service and financial inclusion.

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