somewhat increased volatility, the standard deviation (percentage
change) of rupee-dollar exchange rate increased marginally from 0.27 during 2006-07
to 0.38 during 2007-08. 7.50 During 2008-09, the rupee continued the
depreciating trend till July 2008, reflecting FII outflows, bearish stock market
conditions, higher demand for dollars in the backdrop of rise in crude oil prices
and elevated inflation. Notwithstanding easing of international crude oil prices
from the peak of about US $ 147 per barrel in early July 2008 to around US $ 65
per barrel by third week of October 2008 and moderation in domestic WPI inflation
from a peak of 12.9 per cent on August 2, 2008 to 11.1 per cent by October 11,
2008, the rupee continued to depreciate. The exchange rate of the rupee fell from
Rs.39.99 per dollar at end-March 2008 to Rs.49.95 dollar on October 24, 2008.
7.51 As per the BIS Triennial Survey on the global foreign exchange and derivatives
market activity (2007), the foreign exchange market in India with a total daily
turnover of US $ 34 billion during 2006-07 was the 16th largest market in the
world. The daily average turnover in the OTC derivatives segment of the foreign
exchange market was US $ 24 billion, which was 17th largest among all countries.
Foreign exchange market exhibited a significant growth during the financial year
2007-08 as reflected in the turnover in both the inter-bank and merchant segments
highlighting enhanced liquidity and growing importance of foreign exchange as
an asset class. The high turnover was contributed by large cross-border trade
and capital flows. The average daily inter-bank turnover increased to US $ 34.0
billion during 2007-08 from US $ 18.7 billion during 2006-07 and the average daily
merchant turnover increased to US $ 13.9 billion from US $ 7.0 billion over the
same period. The total turnover in the foreign exchange market registered a growth
of 86.0 per cent during 2007-08. During 2007-08, the inter-bank to merchant turnover
ratio was in the range of 1.8-2.8 (Chart VII.10). 
Government Securities Market 7.52 In order
to facilitate efficient price discovery, the Reserve Bank initiated a series of
measures from the early 1990s to develop the Government securities market. Consequently,
the Government securities market witnessed significant transformation in various
dimensions, viz., market-based price discovery, widening of investor
base, introduction of new instruments, establishment of primary dealers, and electronic
trading and settlement infrastructure. This, in turn, has enabled the Reserve
Bank to perform its functions in tandem with the evolving economic and financial
conditions. 7.53 The Government securities markets
reasonably remained stable during 2007-08 and April-October 2008 (Chart
VII.11). The movements in the yields tracked the monetary policy measures.
The other factors which influenced the modulations in the yield include the significant
increase in issuances of MSS securities between July 2007 and October 2007 to
sterilise the liquidity on account of intervention, increased demand for SLR securities
on the back of large deposit growth and demand from the insurance sector. Incidentally,
the Government securities market exhibits liquidity only in a few benchmark securities.
The Government securities market remains predominantly a domestic market. Although
the FIIs were allowed to increase exposure to Government securities market from
US $ 2.6 billion to US $ 3.2 billion in January 2008 and further to US $ 5 billion
in May 2008, the response has been moderate so far. To some extent, the system
of allocating the limits amongst the FIIs acts as a dampener. On the other hand,
unlike in case of equity market which has seen significant sell off by FIIs in
recent months, FII exposure to Government securities market has remained relatively
unaffected.

7.54 During 2008-09 so far (up to September 1, 2008), the 10-year yield moved
in the range of 7.79-9.51 per cent. The yields in the Government securities market
started the current financial year with a hardening bias in response to increase
in the inflation.The 10-year yield rose to 8.69 per cent by end-June 2008 and
further to 9.32 per cent by end-July 2008. The G-Sec yields eased during August
2008 and September 2008 tracking the consistent fall in global crude prices and
SLR related buying arising from increase in net demand and time liabilities. The
10-year yields declined from 8.45 per cent by end-September 2008 to 7.45 per cent
by end-October 2008 reacting also to the monetary policy action of reducing the
repo rate from 9.00 per cent to 7.50 per cent and the cash reserve ratio from
9.00 per cent to 5.50 per cent (Chart VII.12). The 10-year
yields continued to decline during the month of November 2008 on expectations
of further easing of inflation and policy rates and stood at 7.11 per cent by
November 25, 2008. Over the years, the turnover in the Government securities market
and yield have generally witnessed an inverse relationship. 7.55 The
spread between one and 10-year yields widened marginally to 45 basis points at
end-March 2008 from 42 basis points at end-March 2007. At the longer end, the
spread between 10 and 30-year yields increased to 47 basis points at end-March
2008 from 37 basis points at end-March 2007. The spread further increased to 61
basis points at end-October 2008. The yield spread of 5-year AAA-rated bonds over
5-year Government securities widened to 390 basis points at end-October 2008 from
156 basis points at end-March 2008 (Table VII.4). 
Capital Markets 7.56
From a financial stability perspective, it is necessary to have an efficient and
diversified financial system wherein both the capital market and financial institutions
play an important role in facilitating raising of resources and allocation of
capital, with the ultimate objective of raising the productivity and growth of
the economy. Furthermore, the existence of a well-functioning capital market apart
from contributing to the financial deepening of the economy also imposes discipline
on firms to perform (Beck et al.,2000; Bandiera et al., 2000).
Equity and debt markets can also diffuse stress on the banking sector by diversifying
credit risk across the economy. In response to a series of reforms introduced
since the early 1990s, the capital market has become safe, modern and transparent.
7.57 The resources raised by the corporates through public issues in the
capital market rose sharply to touch a record high of Rs.83,707 crore, an increase
of 158.5 per cent over that in 2006-07. Most of the issues were equity issues,
which accounted for 98.4 per cent of total resource mobilisation through public
issues during 2007-08 as compared with 97.4 per cent in the previous year (Chart
VII.13). The resource mobilisation through public issues, however, declined
sharply to Rs.12,502.64 crore during April-October 2008 from Rs.32,116.78 crore
during the corresponding period of the previous year. During April-October 2008,
there were no public issues by scheduled commercial banks as against three issues
(by scheduled commercial banks) of Rs.11,379 crore during the corresponding period
of the previous year.
Table
VII.4: Yield Spreads | (Basis
points) | Year/Month | 10
Year- | 10
Year- | 20
Year- | 30
Year- | 5
Year |
| reverse | 1
Year | 10
Year | 10
Year | AAA
Bond- |
| repo
rate |
|
|
| 5
Year G-sec | 1 | 2 | 3 | 4 | 5 | 6 |
2006-07 | 189 | 77 | 32 | 43 | 106 |
2007-08 | 192 | 37 | 30 | 38 | 151 |
Jan 2007 | 176 | 36 | 32 | 35 | 130 |
Feb 2007 | 198 | 37 | 16 | 21 | 137 |
Mar 2007 | 197 | 42 | 26 | 37 | 177 |
Apr 2007 | 217 | 27 | 19 | 33 | 166 |
May 2007 | 212 | 41 | 25 | 36 | 190 |
Jun 2007 | 220 | 65 | 23 | 31 | 190 |
Jul 2007 | 190 | 77 | 30 | 47 | 152 |
Aug 2007 | 194 | 51 | 31 | 39 | 184 |
Sep 2007 | 193 | 52 | 40 | 49 | 163 |
Oct 2007 | 189 | 21 | 37 | 43 | 128 |
Nov 2007 | 196 | 20 | 31 | 39 | 132 |
Dec 2007 | 182 | 19 | 25 | 31 | 127 |
Jan 2008 | 157 | 11 | 24 | 28 | 144 |
Feb 2008 | 160 | 11 | 32 | 36 | 163 |
Mar 2008 | 193 | 45 | 38 | 47 | 156 |
Apr 2008 | 201 | 27 | 38 | 42 | 144 |
May 2008 | 217 | 29 | 24 | 29 | 144 |
Jun 2008 | 269 | -49 | 58 | 50 | 158 |
Jul 2008 | 332 | -4 | 50 | 53 | 124 |
Aug 2008 | 278 | -34 | 93 | 98 | 196 |
Sep 2008 | 263 | 11 | 67 | 74 | 224 |
Oct 2008 | 145 | 17 | 53 | 61 | 390 |

7.58 In recent years, large resources have been raised by way of debt from the
private placement market. During 2007-08, resources raised from the private placement
market increased sharply by 45.7 per cent to Rs.2,12,568 crore. However, during
the first half of the current financial year (April-September 2008), mobilisation
of resources through private placements declined by 15.7 per cent to Rs.79,594
crore. 7.59 During the financial year 2007-08, the domestic stock markets
continued to surge from the beginning of the year till January 8, 2008 on the
back of robust macroeconomic fundamentals, healthy corporate earnings, strong
FII inflows, rise in global metal prices, cut in US Fed rate and easing of domestic
annual inflation rate. The upward trend, although punctuated by mild corrections
during mid-August 2007, mid-October 2007 and mid-December 2007 on account of worries
over sub-prime losses and credit crunch in US and Europe, concerns over slowdown
in US economy, it recovered again to attain new highs. The BSE Sensex closed at
an all-time high of 20873.33 on January 8, 2008, recording gains of 59.7 per cent
over end-March 2007. 7.60 Beginning, January 9, 2008, the domestic stock
markets have witnessed a generally downtrend due to heightened concerns over recession
in the US economy. Downward revision of GDP growth rate by CSO, hike in short-term
capital gains tax in the Union Budget 2008-09, rise in domestic annual inflation
rate, rise in global crude oil prices to record high levels, heavy net sales by
FIIs and liquidity squeeze from the secondary market in the wake of biggest IPO
by Reliance Power were other factors which dampened the market sentiment. As a
result of these developments, the BSE Sensex at 15644.44 at end-March 2008, declined
by 25.1 per cent from its all-time high level of 20873.33 on January 8, 2008.
S&P CNX Nifty closed at 4734.50 at end-March 2008, recording gains of 23.9
per cent over end-March 2007. The coefficient of variation, a measure of volatility,
of the BSE Sensex rose to 13.7 per cent during 2007-08, from 11.1 per cent during
2006-07. 7.61 The performance of domestic stock markets in 2008-09 (up
to December 8, 2008) has witnessed two distinct phases. The markets witnessed
an upward trend till May 21, 2008 on account of strong Q4 2007-08 results by some
IT and telecom companies, permission for short selling and securities lending
and borrowing by both institutional and retail investors with effect from April
21, 2008, increase in global metal prices and other sector and stock specific
news. On May 21, 2008, the BSE Sensex registered gains of 10.2 per cent over end-March
2008. A downward trend followed thereafter, mainly due to downswing in major international
equity markets due to concerns over recession in the US. The BSE Sensex on December
8, 2008 at 9162.62, was 41.4 per cent lower than end-March 2008, while S&P
CNX Nifty at 2784.00 was 41.2 per cent lower than end-March 2008 (Chart
VII.14). 
7.62 The volatility in the stock markets, as measured by the coefficient of variation
in the BSE Sensex and Nifty, increased beginning January 2008, reflecting episodes
of erratic movements (Chart VII.15). To contain volatility,
emphasis has been laid on risk management practices at the stock exchange level
and strengthening of the market design in recent times.

Payment
and Settlement System 7.63 The payment and settlement systems,
by providing a fast, efficient and secure basis for financial transactions, form
the bedrock of the financial system. Current payment systems operate based on
the technological development. The efficiency and velocity of the payment systems,
based on the technological developments of the last 20 years, may diffuse a crisis
arising in one country to the rest of the world, given the interconnection of
the systems and the fact that their regulation and legislation have not advanced
as fast as technological innovations (Box VII.3). Payment systems
assume special significance, given the uncertain consequences that a disequilibrium
in the payment systems could have on the implementation of monetary policy and
the repurcussions the propagation of a systemic crisis has for financial stability.
With a view to preventing systemic crises that could arise due to the failure
of one or more payment system participants, the Committee for Payment and Settlement
System (CPSS) at the BIS formulated the Core Principles for systemically important
payment systems. Moreover, remarkable advances on the creation of the Core Principles
for Securities Settlement Systems have been achieved. The principles are intended
to be accurate and precise, and at the same time universal, capable of being followed
and applied depending on the development, resources and necessities of each country.
7.64 A sound legal base for the payments system constitutes one of the core
principles for systemically important payment systems. The notification of the
Payment and Settlement Systems Act, 2007 along with its regulations, viz.,
Board for Regulation and Supervision of Payment and Settlement Systems Regulations,
2008 and Payment and Settlement Systems Regulations, 2008 on the same date (August
12, 2008), was a leap forward towards providing a well founded legal basis for
payment systems in India. Accordingly, the Reserve Bank has been vested with the
powers to regulate and oversee the payment and settlement systems in the country,
including those operated by entities not regulated by the Reserve Bank. The Bank
has framed the minimum standards for magnetic ink character recognition (MICR)
and non-MICR clearing houses. Similarly minimum standards for operations of ECS
and NEFT have also been prepared and circulated to clearing houses for adoption. Box
VII.3: Inter-dependencies of the Payment and Settlement Systems The
network of domestic and cross-border systems that comprise the global payment
and settlement infrastructure has evolved significantly in recent years. These
systems, like the financial markets and economies they support, are increasingly
connected through a wide array of complex inter-relationships. Through these relationships,
the smooth functioning of a single system often becomes contingent on the performance
of one or more other systems. It is because of the implications that disturbances
in payment systems may create for financial and economic stability that central
banks have, as a priority task, the purpose of facing the challenges stated by
the interdependence of payment systems. This increasing inter-dependence
is driven by several interrelated factors, including technological innovations,
globalisation and financial sector consolidation. In addition, a number of initiatives
by the financial industry and by public authorities to reduce the costs and risks
of settlement have purposely promoted greater integration among the numerous components
of the global payment and settlement infrastructure. For instance, the 1989 G-30
recommendations for T+3 securities settlement, central bank policies encouraging
the development and reliance on systems with intra-day finality, and the CPSS
focus on reducing foreign exchange settlement risk have provided incentives for
more straight through processing (STP) and tighter relationships among individual
systems. While these explicit initiatives explain one aspect of tightening
inter-dependencies, institutions' profit-seeking and cost management incentives
also foster interdependencies. Inter-dependencies have important implications
for the safety and efficiency of the global payment and settlement infrastructure.
Some forms of inter-dependencies have facilitated significant improvements in
the safety and efficiency of payment and settlement processes. On the positive
side, interdependencies improve the safety of the global payment and settlement
infrastructure by facilitating delivery versus payment (DvP)
and payment versus payment (PvP) processes, thereby eliminating
a key source of principal credit risk. In addition, inter-dependencies can reduce
credit and liquidity risk by facilitating the use of central bank money as a settlement
medium. Inter-dependencies can also help reduce operational risk through better
integration of the different steps across systems. At the same time, inter-dependencies
increase the potential for a given disruption to spread quickly to many different
systems. This potential was noted in the G-10 report on Financial sector consolidation
(the Ferguson Report, 2000), which suggested that inter-dependencies might accentuate
the role of payment and settlement systems in the transmission of disruptions
across the financial system. In some circumstances, disruptions may amplify as
they spread across systems. In other situations, inter-dependencies may help dampen
the effect of disruptions, in particular by allowing liquidity to flow more rapidly
across different elements of the global payment and settlement infrastructure.
Moreover, the actual path that a disruption would follow could be influenced by
many other factors, including the reactions of systems and institutions. In addition,
risks have become increasingly concentrated in a limited number of critical systems,
institutions and service providers. In some cases, such as that of CLS, this trade-off
has been anticipated and accepted, especially in the light of reduction of principal
credit risk. While some risk management practices and standards consider
inter-dependencies to an extent, there is still a considerable room for improvement.
Additional exercises to test the compatibility of different entities' business
continuity plans, for instance, could improve the degree of co-ordination among
inter-dependent stakeholders, helping to prevent and manage potential disruptions.
Moreover, the increasing inter-dependence of the global payment and settlement
infrastructure is a dynamic phenomenon, and generally poses risks to be managed
rather than eliminated. To maintain their effectiveness, risk management policies
need to keep pace with the changing sources of risk arising from inter-dependencies.
Strengthening systems to prevent and contain systemic risks has been a long-standing
focus of the CPSS and its member central banks. As a result, many elements of
the CPSS Core Principles for systemically important payment systems (Core Principles),
CPSS/IOSCO recommendations for securities settlement systems (RSSS), and CPSS/
IOSCO recommendations for central counterparties (RCCP) address some of the challenges
posed by interdependencies, including the potential for disruptions to spread
across systems. The RSSS and RCCP standards, for example, contain explicit recommendations
on links between two central securities depositories (CSDs) and two central counterparties
(CCPs), respectively. Moreover, all three sets of standards address the management
of settlement risk, including settlement asset risk, and the related potential
for disruptions to affect other systems. To address the problem of the potential
for a disruption to spread quickly to many systems, the system operators, financial
institutions, and service providers are required to take several actions in order
to adapt their existing risk management practices to the more complex, integrated
environment resulting from tighter inter-dependencies. Towards that end, the importance
of broad risk management perspectives, risk management controls commensurate with
the role played in the global payment and settlement infrastructure, and greater
coordination among inter-dependent stakeholders cannot be overlooked. Central
banks and other authorities also need to review, and where necessary, adjust their
policies in the light of the challenges posed by inter-dependencies.
References: BIS. 2005. Central Bank Oversight of Payment
and Settlement Systems. CPSS Paper No.68. May. BIS. 2008. The Interdependencies
of Payment and Settlement Systems. CPSS Paper No.84. June. BIS. 2001. Core
Principles for Systemically Important Payment Systems. CPSS Paper No.43. January.
7.65 The Reserve Bank continued to exercise its oversight over payment and settlement
systems with a view to ensuring its security, efficiency and soundness. Significant
measures were taken by the Board for Regulation and Supervision of Payment and
Settlement Systems (BPSS) towards risk mitigation, improving customer service,
as well as modernising, and increasing technological intensity of the system.
Some of the important measures initiated included, inter alia, preparation
of a framework for payments through mobile phones; extension of jurisdiction of
the MICR clearing houses; computerisation of non-MICR clearing houses; expanding
national electronic funds transfer (NEFT) system to make all real time gross settlement
RTGS branches NEFT enabled; upgrading the NEFT system into a 24x7 type remittance
system; making mandatory use of electronic mode of payment for large value transactions
(initially Rs.1 crore and above, later Rs.10 lakh and above) between the Reserve
Bank regulated entities and markets. The Report on Oversight of Payment Systems
in India released on November 28, 2007 laid down the major international initiatives
towards oversight of the payment and settlement systems, and status of implementation
in the Indian case. 7.66 The major highlight of the Reserve Bank's initiatives
in the area of information technology (IT) during 2007-08 was setting up of new
data centres, and consolidation of systems for centralised data processing, business
continuity and disaster recovery. In order to delineate the broad approaches being
followed by the Reserve Bank so as to enable banks to plan their IT initiatives
suitably, the latest version of the Financial Sector Technology (FST) Vision document
for the period 2008-10 was also released. 7.67 The Reserve Bank continued
to play a major role in developing the payment and settlement systems in India.
This was reflected in an increase in the use of various electronic and paper based
transactions. Various indicators of the payment system point towards a sharp increase
in both volumes and values put through systemically important payment system (SIPS)
and retail payment system, especially through the electronic clearing instruments,
viz., RTGS, forex and Government securities clearing and retail electronic
fund transfer and card based payments within retail payment system. The systemically
important payment systems (SIPS) transactions and the settlement of financial
market clearing constituted 85.1 per cent of total transactions during 2007-08.
7.68 The ratio of annual turnover through various channels of the payment
and settlement systems to GDP increased to 12.7 in 2007-08 from 8.6 in 2005-06,
reflecting the robust increase in the value of annual turnover by 41.8 per cent
during 2007-08 over and above the increase of 37.5 per cent in the previous year.
The turnover of the various retail payment systems, including cheque clearing,
electronic clearing services and card payments, increased by 23.4 per cent during
2007-08 from 11.6 per cent in 2006-07 mainly on account of sharp growth in retail
electronic funds transfer. Cheques continued to be the predominant mode of retail
payment, though the share of retail electronic mode of payment increased during
2007-08. MICR cheque clearing constituted 83.7 per cent and 86.1 per cent of the
volume and value, respectively, of the paper based clearing during 2007-08. More
than 800 clearing houses have been computerised where the settlement is done electronically,
while the instruments still continue to be sorted manually. 7.69 The
electronic funds transfer increased by more than five times during 2007-08 over
the previous year, reflecting a significant increase across all modes of retail
electronic funds transfer systems, viz., electronic clearing services
(ECS), EFT and NEFT systems (Table VII.5). The sharp growth
in value of retail transactions vis-a-vis their volume reflected, inter
alia, the use of electronic mode, as mandated by the stock exchanges, for
refunding the oversubscription amount of IPOs floated by companies. Accordingly,
the share of retail electronic funds transfer, which remained fairly low in the
retail payment system (2.6 per cent during 2006-07), increased sharply to 10.9
per cent during 2007-08.
Table
VII.5: Paper-based versus Electronic Transactions |
(Volume
in thousand and Value in Rs. crore) | Year | Volume | Value |
| Paper | Electronic | Total | Share
of | Paper | Electronic | Total | Share
of |
| -based |
|
| Electronic | -based |
|
| Electronic |
|
|
|
| (%) |
|
|
| (%) |
1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 |
2002-03 | 1,013,900 | 173,000 | 1,186,900 | 14.6 | 1,34,24,313 | 37,536 | 1,34,61,849 | 0.3 |
2003-04 | 1,022,800 | 167,551 | 1,190,351 | 14.1 | 1,15,95,960 | 49,67,813 | 1,65,63,773 | 30.0 |
2004-05 | 1,166,848 | 230,044 | 1,396,892 | 16.5 | 1,04,58,895 | 1,18,86,255 | 2,23,45,150 | 53.2 |
2005-06 | 1,286,758 | 287,489 | 1,574,247 | 18.3 | 1,13,29,134 | 2,24,39,286 | 3,37,68,420 | 66.5 |
2006-07 | 1,367,280 | 383,445 | 1,754,007 | 21.9 | 1,20,42,426 | 3,50,50,234 | 4,71,06,333 | 74.4 |
2007-08 | 1,460,564 | 541,150 | 2,001,714 | 27.0 | 1,33,96,066 | 2,83,60,321 | 4,17,56,387 | 67.9 |
7.70 To encourage the use of electronic mode of payments, the
Reserve Bank waived the processing charges for all electronic payment systems
operated by it for another year, i.e., till March 2009. The availability
ofECS at 70 centres as against 67 centres in the previous year and the proposed
National ECS (NECS) as announced in the Mid-Term review of the Annual Policy for
2007-08 would facilitate prompt services to the customers. The ECS as also NEFT
are being preferred for making refunds of subscription to IPOs. The EFT, which
was operationalised in 1995, is now permitted only for Government payments. All
other electronic retail funds transfer are encouraged through NEFT, which is a
much more secure payment system. These developments have contributed to the speed,
efficiency and safety of the payment system. 7.71 The use of cards for
making retail payments is also one of the preferred modes. The convenience and
the acceptability of this mode of payment are reflected in the increased volume
of transactions through cards - both debit as well as credit. Credit card transaction
volumes increased by 34.6 per cent in 2007-08 and 8.6 per cent in 2006-07, while
the increase in value was 40.2 per cent and 22.1 per cent, respectively, during
the same period. Debit card transaction volumes increased by 46.7 per cent in
2007-08 and 31.7 per cent in 2006-07, while the increase in value was 53.2 per
cent and 38.6 per cent, respectively, during the same period (Chart
VII.16). Banks had issued a total of 26.7 million credit cards and 122.0 million
debit cards, and the number of merchant establishments reached 428,479 at end-October
2008. The average value of transaction at point of sale (POS) using debit card
and credit card was Rs.161 and Rs.2,415, respectively. With the increased usage
of cards and to mitigate risk the Reserve Bank issued guidelines for credit card
operations (refer Chapter II, paras 2.179-2.180). 
7.72 The use of automated teller machines (ATMs) has also increased in view of
the customer convenience. The number of ATMs increased to 36,314 at end-June 2008
from 28,704 at end-June 2007. The Reserve Bank examined the various issues through
the Approach Paper on 'ATMs of Banks: Fair Pricing and Enhanced Access,' and issued
regulatory guidelines on customer charges for use of ATMs for cash withdrawal
and balance enquiry (refer Chapter II, para 2.197). 7.73 The RTGS system,
which was operationalised in March 2004 for facilitating faster settlement of
high value transactions, has stabilised with increased branch network and wider
geographical coverage. The RTGS connectivity was extended to 47,608 branches at
end-June 2008 facilitating sharp increase in volumes settled through this system.
The volume and value of transactions through the RTGS system, both in the inter-bank
and customer segment, increased sharply, particularly during the last quarter
of 2007-08. The integration of the RTGS system with the Reserve Banks' internal
accounting system (IAS) has enabled straight through processing (STP). Also, with
the integration of the RTGS-IAS and the securities settlement system (SSS), automatic
intra-day liquidity (IDL) is available. The clearing and settlement operations
at NCC, Mumbai and CCIL operated systems are settled in the RTGS as multilateral
net settlement batch (MNSB) mode. These measures have contributed to financial
stability. 7.74 The Clearing Corporation of India Limited (CCIL) set
up by banks and financial institutions at the initiative of the Reserve Bank clears
and settles inter-bank trades in Government securities and foreign exchange as
well as a money market product, viz., the CBLO. The settlement of all
secondary market outright sales and repo transactions in Government securities
is carried out through CCIL. All OTC trades in this segment, which are reported
on the Reserve Bank's NDS platform, and trades which are contracted on the online
anonymous, trading platform NDS-OM, are accepted by CCIL for settlement. These
trades are settled on a delivery versus payment (DvP) III basis, i.e.,
the funds leg as well as the securities leg is settled on a net basis. CCIL also
provides guaranteed settlement facility for all US dollar - Indian rupee, inter-bank
cash, spot and forward transactions by becoming the central counter party to every
trade accepted for settlement, through the process of novation11. The rupee legs
of the transactions are settled through the member's current accounts with the
Reserve Bank and the US $ leg through CCIL's account with the settlement bank
at New York. CCIL also provides continuous linked settlement (CLS) services for
banks in India by availing of third party services of a settlement bank. Currently,
13 banks are availing this facility to settle cross currency trades. The total
volume and value transacted through the two systems - Government Securities Clearing
and Forex Clearing has witnessed a significant increase (Table
VII.6). These systems have significantly promoted safety and efficiency in
the settlement of inter-bank payments. 7.75 The centralised funds management
system (CFMS) enables banks holding current account with the Reserve Bank to view
their balances at all the Reserve Bank offices [through centralised funds enquiry
system (CFES)] and transfer funds between the Reserve Bank offices [through centralised
funds transfer system (CFTS)]. This facility is now available at all the Reserve
Bank centres. At present, 71 member banks are making use of this facility extensively.
7.76 It is thus evident that in the conduct of its oversight of the payment
and settlement system, the Reserve Bank's responses to the emerging challenges
were based on credible communication, adequate and timely availability of information
and a broad-based, participative and consultative approach in its developmental
and regulatory policies with involvement of all stakeholders. Any shortcoming
in this vital infrastructure could lead to broader financial and economic instability
as large-values are transacted by the SIPS and failures in the retail payments
segment could lead to the erosion of public confidence. In an event of financial
stress, market participants or central banks may wish to supply emergency liquidity
to certain participants in a payment and settlement system in an attempt to encourage
the orderly settlement of transactions in the interests of overall financial system.
Additionally, central bank's role in payment systems frequently calls for co-operation
and co-ordination of activities with other authorities such as banking supervisors
and securities regulators to ensure smooth discharge of legal or other responsibilities
essential for the payment system. Accordingly, the role of the central bank in
discharging its oversight function is to assess the risks involved and to seek
cooperation with relevant stakeholders to put in place risk mitigation measures,
and also ensure that the risks are not transmitted to other systems/participants.
Table
VII.6: Government Securities and Forex Clearing by CCIL |
(No.
of trades in 000's; value in Rs. crore) | Period | Government
Securities Settlement | Forex
Settlement |
| Outright | Repo |
|
|
| No.
of | Value | No.
of | Value | No.
of | Value |
| Trades |
| Trades |
| Trades |
|
1 | 2 | 3 | 4 | 5 | 6 | 7 |
2004-05 | 161 | 11,34,222 | 24 | 15,57,907 | 466 | 40,42,435 |
2005-06 | 125 | 8,64,751 | 25 | 16,94,509 | 490 | 52,39,674 |
2006-07 | 137 | 10,21,536 | 30 | 25,56,502 | 606 | 80,23,078 |
2007-08 | 189 | 16,53,851 | 27 | 39,48,751 | 757 | 127,26,832 |
3. Key Sources of Vulnerability to the Indian
Financial System 7.77 The multi-pronged approach followed for
strengthening and developing financial institutions, markets, payment systems
and infrastructure have had a positive impact on the Indian financial system.
The assessment of developments during 2007-08 and 2008-09 so far suggests that
financial institutions, especially scheduled commercial banks, are on a sound
footing. Domestic financial markets have been constantly developing, and functioning
normally, despite some indirect knock on effects of global developments. Financial
infrastructure now is much more robust than it was a few years ago. While the
financial system on the whole is quite robust, which augurs well for financial
stability, there is also a need to be aware of some downside risks in certain
areas that could have a bearing on the stability of the financial sector in the
near future. 7.78 In the backdrop of the financial market turmoil in
the developed economies, threats to financial stability remain at elevated levels
with possible feedback into the prospects for macroeconomic performance. Since
the collapse of the leading US investment banks in August-September 2008, there
has been a breakdown of trust in inter-bank and inter-institutional lending. Given
that this kind of extreme risk perception would be reversed only slowly, the full
resolution of the crisis would inevitably take time. While emerging markets had
initially remained fairly resilient to global financial market turmoil, they have
recently come under increasing pressure. Financing conditions have deteriorated
since beginning of 2008 and equity markets have declined sharply, albeit
from elevated levels. Capital outflows have intensified leading to tighter international
and, in some cases, domestic liquidity conditions. Borrowers and financial institutions
in emerging markets are likely to be confronted with a more trying macroeconomic
environment. The developments in these areas need to be watched carefully with
a view to putting in place corrective macroeconomic policy responses with the
ultimate objective of maintaining stability in different segments of the financial
system and to fortify the economy from the possible spillover effects.
Adverse International Developments 7.79 Developments
in the global financial system have heightened the uncertainty in the global economy.
The credit markets in the western world, especially in the US, have, in the recent
past, witnessed considerable turmoil and significant loss of market liquidity
leading to financial distress in a few institutions and considerable financial
damage to several others, prompting some of the major central banks to inject
liquidity into the markets. There was a collective failure to appreciate the extent
of leverage taken on by a wide range of institutions - banks, monoline insurers,
government-sponsored entities, hedge funds - and the associated risks of a disorderly
unwinding. Private sector risk management, disclosure, financial sector supervision,
and regulation all lagged behind the rapid innovation and shifts in business models,
leaving scope for excessive risk-taking, weak underwriting, maturity mismatches,
and asset price inflation. The transfer of risks off bank balance sheets was underestimated.
As risks have materialised, this has placed enormous pressures back on the balance
sheets of banks. Notwithstanding unprecedented intervention by major central banks,
financial markets remain under considerable strain, now compounded by a more worrisome
macroeconomic environment, weakly capitalised institutions, and broad-based deleveraging.
7.80 The exact extent of losses and exposures is not known as yet and perceptions
of a pronounced increase in default risk continues to prevail as was evident in
high credit default swap (CDS) spreads. Money markets remain dislocated and, despite
central bank liquidity injections alleviating pressures, uncertainty about future
liquidity supply and counterparty risk persists. Global equity markets have fallen
considerably in 2008 with an increase in volatility, decline in investors' risk
tolerance, the worsening of the macroeconomic outlook and renewed credit related
concerns. Bond yields, which stabilised since mid-March, 2008 have started to
recover in developed economies and a flight to safety is leading up to a shortage
of paper. Longer term real yields have declined sharply on recession fears. In
the foreign exchange market, the US dollar and the pound sterling depreciated
in effective terms whereas the euro, the yen and the Swiss franc appreciated along
with several Asian currencies. Concerns about a more widespread slowdown, and
perceptions of overvaluation have been weighing on emerging market asset classes
in 2008 with spreads on sovereign debt widening. The outlook is highly unclear
and the prospects of resolution of the multiple disequilibria embedded in global
developments are fraught with uncertainty. 7.81 The financial market
crisis with US at its epicentre has started to spread across markets, and across
nations. The US slowdown is spreading via the trade and financial channels.
The significant slowdown in the projected global growth from 5.0 per cent in 2007
to 3.7 per cent in 2008, and to just over 2.0 per cent in 2009, is likely to have
implications for every economy (WEO Update, November 2008). In view of strong
international linkages among economies, macroeconomic prospects for the EMEs,
which till very recently remained relatively insulated, face the downside risks
from lagged effects of the downturn. As the notion of 'decoupling' of emerging
market countries from mature markets has turned out to be incorrect, emerging
market policymakers would have to cope with a global growth slowdown, and reversal
of capital flows (Box VII.4). As per the WEO update of November
2008, growth in emerging economies would decelerate from 8.0 per cent in 2007
to 6.6 per cent in 2008 and further to 5.1 per cent in 2009. There is a risk that
the confluence of circumstances emerging out of the financial turmoil could accelerate
a downturn in the credit cycle in some emerging market economies. 7.82
The banking sector in India does not have any direct exposure to the US sub-prime
market. Some banks in India, however, have indirect exposure through their overseas
branches and subsidiaries to the US sub-prime markets in the form of structured
products, such as collateralised debt obligations (CDOs) and other investments.
However, such exposure is not very significant, and banks have made adequate provisions
to meet mark-to-market losses on such investments. Besides, banks also maintain
high level of capital adequacy ratio. Thus, the risks in the banking sector appear
limited and manageable. 7.83 There is, however, apprehension that current
market conditions, may lead to recession in the US having significant impact on
other economies. In this context, it may be noted that India is largely a domestic
demand driven economy and exports constitute a relatively smaller portion of India's
GDP, as compared to many other economies. In recent years, India's export basket
has also become more diversified, although the US continues to be one of the major
trading partners. While strong regional sources of growth within EMEs may be a
mitigating factor, weakening of economic activity in the US would impact India's
economy through the trade channel. There are indications that the current crisis
has implications in terms of higher funding costs and difficulties in raising
external finance, particularly, for lower rated firms. Box
VII.4: Economic Integration and Decoupling of the Emerging Economies In
recent years with rapid increase in trade and financial linkages across countries,
emerging market economies have emerged as major players in the global economy.
Decoupling holds that emerging European and Asian economies have broadened and
deepened to the point that they no longer depend on the US for growth This has
generated a debate about possible changes in the generally observed patterns of
international business cycle co-movement. The major channels of coupling
include: (i) integration between economies and rise in internationally integrated
production; (ii) the international movement of workers leading to remittances;
(iii) growth in international linkages in financial services through increased
cross-listings of stocks and more cross-border ownership and control of exchanges,
banks, and securities settlement systems; (iv) spillover through commodity prices
and through financial variables such as short- and long-term interest rates and
equity prices. Empirical research shows convergence of business cycles
among a larger group of industrial economies and among emerging market economies
over time, but there has also been a simultaneous decoupling of business cycles
between these two sets of countries (Kose, Ortok and Prasad, 2008). The authors
cautioned that although the results suggested emerging markets as a group are
becoming an independent driver of global growth, their decoupling potential would
still depend on the duration and severity of a US downturn. However, their analysis
includes linkages through real macroeconomic aggregates but does not account for
financial ones. So long as the US slowdown was attributed to US specific developments
- primarily in housing and manufacturing, the spillover effects to other economies
was Considered modest. However, as the transmission began to involve asset price
spillovers or confidence channels, the impact became much larger. The influence
of the U.S. economy on other economies does not appear to have diminished. On
the contrary, indications are that the magnitude of spillovers has increased over
time, particularly in neighboring countries and regions, which is consistent with
the notion that greater trade and financial integration tends to magnify the cross-border
effects of disturbances (WEO, 2007).Stock prices in the emerging market economies
moved downward during acute periods of US financial stress over the past year.
The IMF in a recent study confirms that global factors are as important in explaining
the movement in emerging markets equity prices as their domestic fundamentals.
Using various measures of correlation, it is also found that the scope for spillovers
to emerging equity markets has risen, suggesting a growing transmission channel
for equity price movements. This could, in turn, affect consumption and investment
in emerging markets, although such macrofinancial linkages are found to be small
and they tend to play out gradually (GFSR, 2008). In the context of effect
of financial crisis on developed countries, it is argued that financial innovations
like growth of non-bank intermediaries such as private equity firms and hedge
funds, deepening of resale markets for capital, and sophisticated products and
contracts, among others, might have made these economies less vulnerable to crises
by widening the access to liquidity and allowing assets to be traded more easily
during periods of stress (Gai et al., 2008). Though the developed economies
are able to tide over mild and less severe shocks, in case of extremely severe
shocks, a crisis is inevitable, regardless of the ex ante beliefs. In the crisis
situation, such financial innovations could impact more severely by way of relaxing
the financial constraints facing borrowers with the result that asset prices are
driven down to such an extent that all intermediaries and firms are forced to
liquidate all of their assets, intermediaries shut down, and the closure of firms
means that there are no investment opportunities in the more-productive sectors
of the economy. It is also argued that crises in emerging market economies are
more frequent but less severe than in developed countries [Caprio and Klingebiel
(1996), and Demirguc-Kunt and Detragiache (2005)]. References:
Bayoumi, Tamim and Andrew Swiston. 2007. "Foreign Entanglements: Estimating
the Source and Size of Spillovers Across Industrial Countries." IMF Working
Paper 07/182. Washington: International Monetary Fund. July. World Economic Outlook.
2007. "Decoupling the Train? Spillovers and Cycles in the Global Economy."
International Monetary Fund. April. Kose. M. Ayhan, Christopher Otrok,
and Eswar Prasad. 2008. "Global Business Cycles: Convergence or Decoupling?"
IZA Discussion Paper No. 3442. April. Gai, Prasanna, Sujit Kapadia, Stephen Millard
and Ander Perez. 2008. "Financial Innovation, Macroeconomic Stability and
Systemic Crises." Bank of England Working Paper No. 340. February.
Kohn, Donald L. 2008. "Global Economic Integration and Decoupling" at
the International Research Forum on Monetary Policy. Frankfurt. Germany. June
26. 7.84 The main impact of the global financial turmoil in India has emanated
from the significant change experienced in the capital account in 2008-09 so far,
relative to the previous year. Total net capital flows declined from US $17.3
billion in April-June 2007 to US $13.2 billion in April-June 2008. Capital flows
are expected to be lower in the current fiscal year 2008-09 as compared with the
previous year. While foreign direct investment (FDI) inflows have continued to
exhibit accelerated growth (US $ 19.3 billion during April-September 2008 as compared
with US $ 9.2 billion in the corresponding period of 2007), portfolio investments
by foreign institutional investors (FIIs) witnessed a net outflow of about US
$ 11.9 billion in April-October 2008 as compared with a net inflow of US $ 22.3
billion in the corresponding period of the previous year. 7.85 The slowdown/reversal
of capital flows could affect an economy through several ways such as (i) decline
in equity markets and the resultant difficulty in raising capital from the market;
(ii) sharp realignment of exchange rates; (iii) tightening of liquidity conditions
and rise in interest rates; and (iv) hard lending of credit cycle. Capital flows
have also become an important determinant of exchange rate movements on a day-to-day
basis. Such exchange rate movements have implications for the financial and real
sectors of the economy. With the existence of a merchandise trade deficit of 7.7
per cent of GDP in 2007-08, and a current account deficit of 1.5 per cent, and
change in perceptions with respect to capital flows, there has been significant
pressure on the Indian exchange rate in recent months. The exchange rate has depreciated
from Rs.39.99 per dollar as at end-March 2008 to Rs.49.11 as on December 10, 2008.
In real effective terms whereas the 6-currency real exchange rate appreciated
from an index of 104.9 (base 1993-94=100) in September 2006 to 115.0 in September
2007, it has now depreciated to a level of 100.1 as on December 10, 2008.
7.86 The net sales by FIIs have adversely affected the equity market in India.
This combined with some other factors resulted in a decline in the BSE Sensex
by 56.1 per cent (as on December 8, 2008), since January 8, 2008. According to
the IMF's Global Financial Stability Report of October 2008, correlation of equity
markets in EMEs with those in the advanced economies has risen, suggesting a growing
transmission channel for equity price movements. 7.87 In India, inflation
based on year-on-year variations in the wholesale price index (WPI) increased
to 7.7 per cent in 2007-08 compared with 5.9 per cent in 2006-07. Consistent with
the stance of monetary policy, the evolving liquidity situations and on the basis
of incoming information on domestic and global macroeconomic and financial developments,
it was decided to increase the CRR by 25 basis points each on May 10, 2008 and
May 24, 2008 to 8.25 per cent. Furthermore, the repo rate under the LAF was increased
from 7.75 per cent to 8.00 per cent on June 12, 2008 and further to 8.50 per cent
with effect from June 25, 2008. The CRR was again increased by 50 basis points
to 8.75 per cent in two stages from July 5, 2008 and July 19, 2008 by 25 basis
points each. 7.88 Inflation, in terms of the WPI,
softened steadily from the level of 12.9 per cent on August 9, 2008 and has declined
to 8.4 per cent for the week-ended November 22, 2008, reflecting decline in prices
of freely priced petroleum products (in the range of 15-22 per cent) in line with
decline in international crude oil prices (by 45 per cent since July 2008) as
well as easing in other commodity prices such as oilseeds/edible oils/oil cakes,
raw cotton and cotton textiles following global trends. Globally, pressures from
commodity prices, including crude, appear to be abating. The international crude
prices which hardened from an average level of US $ 57 per barrel at end-2005
to an average level of US $ 73 per barrel by July 2006, and thereafter rose sharply
to reach a historic high of US $ 145.3 per barrel by early July 2008, eased significantly
to around US $ 44 per barrel by December 10, 2008 reflecting decline in demand
in OECD countries and improved near-term supply prospects in non-OPEC countries.
The moderation in key global commodity prices, if sustained, would further reduce
inflationary pressures. 7.89 The adverse global developments
have led to moderation of growth in the industrial and services sectors in the
first-half of 2008-09. In recent weeks, the impact on liquidity and credit has
also been felt. On the growth front, it is important to ensure that credit requirements
for productive purposes are adequately met so as to support the growth momentum
of the economy. The Reserve Bank has kept a close vigil on the entire financial
system to prevent pressures from building up in the financial markets. This includes
liquidity enhancing measures to ease liquidity pressures. 7.90 The global
financial situation, described as the worst since the Great Depression, continues
to be uncertain and unsettled. Currently, it is difficult to speculate about the
trajectory of global downturn, and its consequent fallout for the Indian economy.
This remains uncharted territory and experience suggests that there is at times
the need to go beyond standard or conventional solutions. The Reserve Bank has
endeavoured to be proactive, and has taken measures to manage the rapid developments
and ease pressures stemming from the global crisis. The stance of monetary policy
has been eased with the reduction in CRR by 350 basis points, repo rate by 250
basis points and reverse repo rate by 100 basis points between October and December
6, 2008 (refer Chapter II, Box II.2). Asset Prices
7.91 The role of real estate exposure's (REE) in financial crises has been
recognised since long. In the late 1990s, the 'Asian crisis' amply demonstrated
the interlocking of credit booms and real estate bubbles in the economic upswing,
followed by the damaging impacts of prolonged real estate slumps on the solvency
of banks, the availability of credit and general economic growth. 7.92
The recent global financial turmoil caused by the crisis in the mortgage market
in the US has once again brought into focus the dangerous inter-dependence between
real estate cycles, bank crisis and the ultimate threat to financial stability.
The major portion of real estate exposure consists of mortgage related assets
which are long-term in nature having dynamic cash flow characteristics which render
them as risky ventures. It, therefore, becomes imperative on the part of the banks
to manage the balance sheet risks associated with real estate exposure, particularly
in the current scenario of slowdown in the economy with its expected ramifications
on real estate prices, given the historically positive correlation between economic
downturn and its adverse impact on real estate prices (Box VII.5).
7.93 Asset prices (real estate and equity prices) in India rose sharply beginning
2005. The BSE Sensex rose by 240.2 per cent between April 19, 2005 and January
8, 2008, when the market was at its peak. Real estate prices also rose sharply.
Although no firm information is available on the extent of the rise in real estate
prices, anecdotal evidence suggests that real estate price rose between two to
four times during the last three to four years in different parts of the country.
A pilot survey on Real Estate Prices and Rent in Greater Mumbai conducted
by the Reserve Bank also showed that the rent and sale/ resale prices of residential
properties in Mumbai increased significantly over the last four years.
7.94 The phenomenon of sharply rising asset prices is not confined to India alone
but has also occurred around the world. For instance, the US, Australia, Denmark,
France, Sweden, Spain, New Zealand, and the United Kingdom have all had rapid
appreciation of real estate prices in recent years. Box
VII.5: Banks' Exposure to the Real Estate Sector - Various Risks Real
estate lending involves a variety of inherent and interrelated risks. There are
various channels through which risks may be transmitted to a bank's balance sheet
in respect of its REE: (i) Credit Risk: A downturn in the economic cycle
could result in a depletion in the households' surplus which in turn would increase
the default risk and reduction in collateral values. Also the probability of adverse
selection during credit boom raises the delinquencies during economic downturn.
Further, rise in interest rates leads to increase in EMIs for floating rate exposure,
especially in retail housing loans, which borrowers may find difficult to pay.
(ii) Interest Rate Risk: As interest rate goes up, fixed rate real estate
advances could have a negative effect on banks' profitability due to increase
in funding costs. Management of assets and liabilities becomes essential with
enhanced efforts to garner long-term deposits as a risk mitigating measure.
(iii) Liquidity Risk: Real estate exposures are essentially illiquid and
are difficult to liquidate at short notice without incurring loss. Thus, banks
need to have a thorough understanding of variability of mortgage cash flows and
corresponding impact on balance sheet which is inversely related to the movements
in interest rates. (iv) Prepayment Risk: This risk is related to interest
rate cycle. It increases in a falling interest rate scenario. There is also the
inherent asset-liability mismatch arising from very long maturity real estate
loans such as retail housing loans. (v) Transfer of Risks from Subsidiaries:
The risk that difficulties faced by specialised non-bank subsidiaries or connected
entities involved in the real estate sector may get transferred to the parent
bank. (vi) Operational Risk (frauds): The incidence of frauds in the
area of housing loans has witnessed a sharp increase in the recent years. Submission
of forged documents, laxity in conduct of due diligence of borrowers / builders,
non-observance of appraisal procedures and laxity in post-disbursement supervision
mainly contributed to frauds in this area. Apart from these, there could
be 'second round' effects in that the risks related to adverse changes in the
macroeconomic and financial environment could get linked to a period of declining
real estate prices. Internationally, loan-to-value ratio (LTV) is regarded as
a dominant indicator of default probability of residential mortgage loans, loans
with high LTV (say, above 80 per cent) could be assigned higher risk weight. The
suggestion is based on empirical evidence from some countries. While acknowledging
the obvious shortcomings of LTV being positively correlated with probability of
default, it needs to be pointed out that in India there is no reliable real estate
price index as yet and any estimation of LTV is thus only a conjecture.
7.95 While equity prices have since corrected by 56.8 per
cent (as on November 26, 2008) from the peak level, real estate prices continue
at their elevated levels, although some reports do suggest some softening of prices
in some parts of the country in recent months. 7.96 Sharp rise in asset
prices raises some concerns for financial stability (Box VII.6).
Real estate prices, like other asset prices, have important effects on output
and inflation. There are primarily two ways through which real estate prices affect
the economy. First, in a rising prices scenario, the expectation of further appreciation
is factored into the prices. That expectation stimulates demand for homes, which,
in turn, stimulates new construction activity and aggregate demand. Second, higher
real estate prices increase household wealth, which stimulates consumer spending.
If real estate prices rise above the level than what is justified by the fundamentals,
too many houses will be built. At some point, the correction would set in and
asset prices then return to their fundamental values. When this happens, the sharp
downward revision of asset prices can lead to a sharp contraction in the economy,
both directly, through effects on investment, and indirectly, through the effects
of reduced household wealth on consumer spending. There is, thus, concern that
rapid rise in real estate prices at some stage might have adverse effects on the
economy. 7.97 Over the years, banks in India enlarged their exposure
to the real estate market. Such exposure at end-March 2008 constituted 19.3 per
cent of total bank credit as against 1.6 per cent at end-March 2004. The Reserve
Bank alerted banks about 'early signs of overheating of the Indian economy' during
2006-07 on the back of some evidence of firming up of demand pressures, in particular,
the combination of high growth and consumer inflation coupled with escalating
asset prices and tightening infrastructural bottlenecks. In this context, to supplement
monetary measures and to protect the banking system from a possible enduring asset
bubble without undermining growth impulses, prudential measures were also initiated
in the form of enhanced provisioning requirements and risk weights in specific
sectors in addition to select supervisory reviews. Box
VII.6: Real Estate Price and Financial Stability Asset prices such
as real estate prices and stock prices, are conceptually different from the prices
of current consumption goods and services. Real estate prices are somewhat special
in that they are forward looking and reflect the market expectations on valuations
of future stream of services associated with the asset. That is, they convey information
about future demand and supply conditions. In addition, changes in real estate
prices influence household wealth and, therefore, impact consumer spending and
aggregate demand. Accordingly, asset prices contain important information about
the current and future state of the economy and can play an important role in
monetary policy setting with the overall objectives of price stability and sustainable
output growth. Standard economic principles suggest that prices are determined
by the fundamentals of supply and demand. So rising prices typically reflect growth
in demand relative to supply. In the case of real estate price movements, however,
many of these fundamental factors that shape the market's expectations of future
supply and demand are not directly observable. As a result, it is difficult to
ascertain whether rapid shifts in real estate prices are reflecting changes in
the underlying fundamentals or not. When the expectations turn out to be wrong
or get revised as new information becomes available, the real estate market may
witness dramatic adjustments in prices and raises concern that prices have lost
touch with the underlying fundamentals. In such a circumstance, there is the fear
that a 'bubble' may be developing that may eventually burst. Price bubbles
in the real estate market have distinct features - a price bubble implies that
the market is sending misleading price signals and, therefore, distorting resource
allocations. For example, overinvestment in some assets and under-investment in
others is a likely outcome. The bubble may also be accompanied by excessive accumulation
of debt. Second, given the distortions and imbalances created during the run-up
in prices, the bursting of the bubble and associated rapid decline in prices can
wreak havoc with the balance sheets of individuals and financial institutions.
This can impart ripple effects through the rest of the economy. For example, rapid
declines in asset prices have at times been associated with sharp contractions
of economic activity and severe financial problems as the imbalances and distortions
are reversed. Finally, the biggest hurdle is to determine if there is a bubble
or not. There is general agreement among policymakers that, regardless
of the cause of a rapid rise in housing or other asset prices, the rapid unwinding
of such price booms should be monitored carefully by policymakers. Otherwise,
the risk of misallocating resources and risk-bearing, as well as increased moral
hazard problems could ultimately make the financial system more fragile. Therefore,
a key ingredient for ensuring asset price bursts triggering widespread adverse
effects on the financial system is to develop a healthy banking system providing
real estate loans and monitor real estate price movement across regions on a regular
basis. References : Bernanke, B. and M. Gertler.
2001. "Should Central Banks Respond to Movements in Asset Prices?" American
Economic Review. 912. 253-257. Hunter, W.C., G. G. Kaufman and M. Pomerleano.(eds).
2003. "Asset Price Bubbles: The Implications for Monetary, Regulatory and
International Policies." MIT Press. Plosser, C.I. 2007. House Prices
and Monetary Policy. Speech by the President, Federal Reserve Bank of Philadelphia.
European Economics and Financial Centre. Distinguished Speakers Series.
7.98 In view of the risks posed by accelerated exposures to
the real estate sector, the Reserve Bank initiated several regulatory measures
including advising banks to frame Board approved policy, prescribing higher risk
weights, disclosure and reporting of the REE, and even revising the definition
of REE. In June 2005, the Reserve Bank advised banks to have a Board mandated
policy in respect of their real estate exposure, robust risk management framework
covering single/ group exposure limits, margins, collaterals/ security, repayment
schedule and availability of supplementary finance. In view of 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 from 100 per cent to 125 per cent in July
2005 and further to 150 per cent in April 2006. However, as a counter cyclical
measure, it was decided on November 15, 2008 to reduce the risk weights on claims
secured by commercial real estate to 100 per cent and to reduce the provisioning
requirements for all types of standard assets to a uniform level of 0.40 per cent
except in the case of direct advances to the agricultural and SME sectors, which
would continue to attract a provisioning of 0.25 per cent, as hitherto.
7.99 The risk weights on housing loans extended by banks to individuals against
mortgage of housing properties and investments in mortgage backed securities (MBS)
of housing finance companies (HFCs), recognised and supervised by National Housing
Bank (NHB), were increased from 50 per cent to 75 per cent in December 2004. However,
on a review, banks were advised to reduce the risk weight in respect of exposures
arising out of housing loans up to Rs.30 lakh to individuals against the mortgage
of residential housing properties from 75 per cent to 50 per cent, in view of
the lower perception of risks in these exposures. 7.100 Banks are required
to disclose their gross exposure to the real estate sector in their published
balance sheets to act as market discipline. As part of the regular off-site reporting
mechanism, banks are required to report on a monthly basis their gross exposures
to various real estate sectors. Real estate exposures both at macro and micro
levels are closely monitored and any unusual spurt in exposures are taken up with
respective banks for further discussion. 7.101 Apart from the above-mentioned
regulatory measures, several measures were taken to prevent/contain the frauds
in the area of housing loans such as: (i) caution advices against borrowers/developers/
builders, etc., in all cases of frauds in housing loans in which amount
involved was Rs.5 lakh and above against each individual borrower; (ii) modus
operandi circulars/making the banks aware of the various practices being
adopted by fraudsters; (iii) dialogues with the State Governments impressing upon
them the need for rationalising stamp duty/registration fees in order to tackle
the problem of availing multiple finance by borrowers by mortgaging the same property
with different banks; and (iv) detailed instructions to banks in May 2006 highlighting
the need for adopting best risk management practices covering credit appraisal,
verification of documents, pre and post sanction appraisal, ensuring due diligence,
among others, in order to reduce the incidence of frauds in the residential mortgage
segment. 4. Mitigating Risks through Financial
Sector Policies 7.102 Owing to globalisation and integration,
any disruption in the financial system has a tendency to spill over to other segments
of the economy and also spread to other geographical regions, thereby causing
a contagion effect. The loss of confidence, if it happens, has the potential to
cause large scale damages, and ultimately adversely affect the real economy. In
view of the cross border contagion and disruptive herd behavior, any imbalance
or any anticipated risks in the economy, which starts materialising, needs to
be mitigated immediately. The strategy to mitigate the risk depends upon various
factors such as the nature of the risk, its extent of reach and the emerging macrofinancial
conditions. At the same time, policy trade-offs between inflation, growth, and
financial stability are becoming increasingly difficult. 7.103 The turbulence
in the global financial markets during most part of 2007-08 and 2008-09 so far,
has been characterised by an abrupt and widespread increase in the pricing of
credit risk alongwith a significant demand for liquidity in many asset markets,
most notably in the inter-bank market. Contingency consultations among central
banks about 11 Novation is the process by which Government securities transactions
are settled through CCIL. This means that CCIL will act as a buyer to the seller
of security and simultaneously will act as a seller to the buyer of the security.
This will in effect remove the credit risk faced by members vis-à-vis their
counterparties. Besides, CCIL provides the additional comfort of improved risk
management practices through daily marking to market of collateral, maintenance
of daily margins by members and through a Guarantee Fund. |