India, like most other emerging market economies, has so far, not been seriously affected by the recent financial turmoil in developed economies. In my remarks today, I will, first, briefly set out reasons for the relative resilience shown by the Indian economy to the ongoing international financial markets’ crisis. This will be followed by some discussion of the impact till date on the Indian economy and the likely implications in the near future. I then outline our approach to the management of the exposures of the Indian financial sector entities to the collapse of major financial institutions in the US. Orderly conditions have been maintained in the domestic financial markets, which is attributable to a range of instruments available with the monetary authority to manage a variety of situations. Finally, I would briefly set out my thinking on the extent of vulnerability of the Asian economies, in general, to the global financial market crisis.

The Indian economy is now a relatively open economy, despite the capital account not being fully open. The current account, as measured by the sum of current receipts and current payments, amounted to about 53 per cent of GDP in 2007-08, up from about 19 per cent of GDP in 1991. Similarly, on the capital account, the sum of gross capital inflows and outflows increased from 12 per cent of GDP in 1990-91 to around 64 per cent in 2007-08. With this degree of openness, developments in international markets are bound to affect the Indian economy and policy makers have to be vigilant in order to minimize the impact of adverse international developments on the domestic economy.

In order to further strengthen capital requirements, the credit conversion factors, risk weights and provisioning requirements for specific off-balance sheet items including derivatives have been reviewed. Furthermore, in India, complex structures like synthetic securitisation have not been permitted so far. Introduction of such products, when found appropriate, would be guided by the risk management capabilities of the system.

The Reserve Bank has also issued detailed guidelines on implementation of the Basel II framework covering all the three pillars with the guidelines on Pillar II being issued as recently as on March 27, 2008. In tune with RBI’s objective to have consistency and harmony with international standards, the Standardised Approach for credit risk and Basic Indicator Approach for operational risk have been prescribed. Minimum capital-to-risk-weighted asset ratio (CRAR) would be 9 per cent, but higher levels under Pillar II could be prescribed on the basis of risk profile and risk management systems. The banks have been asked to bring Tier I CRAR to at least 6 per cent before March 31, 2010. After analyzing the global schedule for implementation, it was decided that all foreign banks operating in India and Indian banks having a presence outside India should migrate to Basel II by March 31, 2008 and all other scheduled commercial banks encouraged to migrate to Basel II in alignment with them but not later than March 31, 2009.

In addition to the exercise of normal prudential requirements on banks, the Reserve Bank has also successively imposed additional prudential measures in respect of exposures to particular sectors, akin to a policy of dynamic provisioning. For example, in view of the accelerated exposure observed to the real estate sector, banks were advised to put in place a proper risk management system to contain the risks involved. Banks were advised to formulate specific policies covering exposure limits, collaterals to be considered, margins to be kept, sanctioning authority/level and sector to be financed. 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. The risk weight 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) was increased from 50 per cent to 75 per cent in December 2004, though this was later reduced to 50 per cent for lower value loans. Similarly, in light of the strong growth of consumer credit and the volatility in the capital markets, it was felt that the quality of lending could suffer during the phase of rapid expansion. Hence, as a counter cyclical measure, the Reserve Bank increased the risk weight for consumer credit and capital market exposures from 100 per cent to 125 per cent.

The rate of increase in foreign exchange market turnover in India between April 2004 and April 2007 was the highest amongst the 54 countries covered in the latest Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity conducted by the Bank for International Settlements (BIS). According to the survey, daily average turnover in India jumped almost 5-fold from US $ 7 billion in April 2004 to US $ 34 billion in April 2007; the share of India in global foreign exchange market turnover trebled from 0.3 per cent in April 2004 to 0.9 per cent in April 2007. There has been consistent development of well-functioning, relatively deep and liquid markets for government securities, currency and derivatives in India, though much further development needs to be done. However, as large segments of economic agents in India may not have adequate resilience to withstand volatility in currency and money markets, our approach has been to be increasingly vigilant and proactive to any incipient signs of volatility in financial markets.

In brief, the Indian approach has focused on gradual, phased and calibrated opening of the domestic financial and external sectors, taking into cognizance reforms in the other sectors of the economy. Financial markets are contributing to efficient channelling of domestic savings into productive uses and, by financing the overwhelming part of domestic investment, are supporting domestic growth. These characteristics of India's external and financial sector management coupled with ample forex reserves coverage and the growing underlying strength of the Indian economy reduce the susceptibility of the Indian economy to global turbulence.

The financial crisis in the advanced economies and the likely slowdown in these economies could have some impact on the IT sector. According to the latest assessment by the NASSCOM, the software trade association, the current developments with respect to the US financial markets are very eventful, and may have a direct impact on the IT industry and likely to create a downstream impact on other sectors of the US economy and worldwide markets. About 15 per cent to 18 per cent of the business coming to Indian outsourcers includes projects from banking, insurance, and the financial services sector which is now uncertain.

In summary, the combined impact of the reversal of portfolio equity flows, the reduced availability of international capital both debt and equity, the perceived increase in the price of equity with lower equity valuations, and pressure on the exchange rate, growth in the Indian corporate sector is likely to feel some impact of the global financial turmoil. On the other hand, on a macro basis, with external savings utilisation having been low traditionally, between one to two percent of GDP, and the sustained high domestic savings rate, this impact can be expected to be at the margin. Moreover, the continued buoyancy of foreign direct investment suggests that confidence in Indian growth prospects remains healthy.

A detailed study undertaken by the RBI in September 2007 on the impact of the sub-prime episode on the Indian banks had revealed that none of the Indian banks or the foreign banks, with whom the discussions had been held, had any direct exposure to the sub-prime markets in the USA or other markets. However, a few Indian banks had invested in the collateralised debt obligations (CDOs) / bonds which had a few underlying entities with sub-prime exposures. Thus, no direct impact on account of direct exposure to the sub-prime market was in evidence. However, a few of these banks did suffer some losses on account of the mark-to-market losses caused by the widening of the credit spreads arising from the sub-prime episode on term liquidity in the market, even though the overnight markets remained stable.

Consequent upon filling of bankruptcy under Chapter 11 by Lehman Brothers, all banks were advised to report the details of their exposures to Lehman Brothers and related entities both in India and abroad. Out of 77 reporting banks, 14 reported exposures to Lehman Brothers and its related entities either in India or abroad. An analysis of the information reported by these banks revealed that majority of the exposures reported by the banks pertained to subsidiaries of Lehman Bros Holdings Inc. which are not covered by the bankruptcy proceedings. Overall, these banks’ exposure especially to Lehman Brothers Holding Inc. which has filed for bankruptcy is not significant and banks are reported to have made adequate provisions.

In the aftermath of the turmoil caused by bankruptcy, the Reserve Bank has announced a series of measures to facilitate orderly operation of financial markets and to ensure financial stability which predominantly includes extension of additional liquidity support to banks.

In contrast to the extreme volatility leading to freezing of money markets in major advanced economies, money markets in India have been, by and large, functioning in an orderly fashion, albeit with some pressures. Large swings in capital flows – as has been experienced between 2007-08 and 2008-09 so far – in response to the global financial market turmoil have made the conduct of monetary policy and liquidity management more complicated in the recent months. However, the Reserve Bank has been effectively able to manage domestic liquidity and monetary conditions consistent with its monetary policy stance.

While LAF and MSS have been able to bear a large part of the burden, some modulations in CRR and SLR have also been resorted, purely as temporary measures, to meet the liquidity mismatches. For instance, on September 16, 2008, in regard to SLR, the Reserve Bank permitted banks to use upto an additional 1 percent of their NDTL, for a temporary period, for drawing liquidity support under LAF from RBI. This has imparted a sense of confidence in the market in terms of availability of short-term liquidity. The CRR which had been gradually increased from 4.5 per cent in 2004 to 9 per cent by August 2008 was cut by 50 basis points on October 6 (to be effective October 11, 2008) – the first cut after a gap of over five years - on a review of the liquidity situation in the context of global and domestic developments. Thus, as the very recent experience shows, temporary changes in the prudential ratios such as CRR and SLR combined with flexible use of the MSS, could be considered as a vast pool of back-up liquidity that is available for liquidity management as the situation may warrant for relieving market pressure at any given time. The recent innovation with respect to SLR for combating temporary systemic illiquidity is particularly noteworthy. The relative stability in domestic financial markets, despite extreme turmoil in the global financial markets, is reflective of prudent practices, strengthened reserves and the strong growth performance in recent years in an environment of flexibility in the conduct of policies.

In contrast to the previous episodes of global turmoil, EMEs have exhibited relative resilience, though equity market and exchange rate pressures have intensified in recent days. So far, the investment sentiment is positive for the Asian EMEs reflecting their strong economic performance and, for some countries, favourable investment opportunities associated with elevated commodity prices, though they have adjusted downwards in recent times, while being somewhat volatile. Credit policy reforms, better structuring of banking sector debt and improved fiscal positions have also played their role making the EMEs resilient from the crisis. In addition, large foreign exchange reserves, particularly in Asia, also provide a degree of protection against possible sudden stops. Another factor that could be of relevance for this favourable situation is the relatively smaller presence of foreign banks in the Asian banking sector. This is evident from the fact that the share of banking assets held by foreign banks in these economies generally lies between 0 and 10 percent (Global Development Finance, 2008).

The spillovers to the EMEs from the current global financial market crisis have occurred mainly in and through financial markets, reflecting the relatively high level of integration of such markets in the global financial system. In this respect, there have been four major spillovers, viz., (i) a rise in the price of risk; (ii) a reduction in international bond issuance; (iii) a sell-off in equity markets; and (iv) some unwinding of carry-trade positions. The major EMEs in Asia have been recording surpluses on the current account in recent years, with the exception of Korea and India. Thus, the vulnerability of Asia, other than Korea and India, is relatively contained to that extent. It is in this context the foreign exchange markets in India and Korea have experienced greater pressure in recent times.

Despite the fact that no significant macroeconomic disruption has taken place in EMEs, some vulnerabilities exist. There are indications that the current crisis will have some implications in terms of higher funding costs and raising external finance, particularly, for lower rated firms. Further, countries with significant foreign bank presence, mostly in East European economies, might be vulnerable to financial stress faced by a parent bank. Similarly, slowdown in advanced countries might impact the remittances to EMEs.

As regards the impact of financial turbulence on the real sector, Asian EMEs may not be entirely immune to slowing growth in developed economies. For East Asian economies, since most of these economies are small and their trade sector (export plus imports) as proportion of GDP varies at a significantly higher level between over 200 per cent and 60 per cent as opposed to the weight of domestic demand as in India, it could be an area of concern for these countries. Therefore, for these set of countries, the crises could be transmitted through the trade channel. While strong regional sources of growth within EMEs may be a mitigating factor, most EMEs still retain substantial trade linkages with developed economies. In Asia, while intra-regional trade has been growing rapidly over recent years, much of this activity is still driven by developed economies as a major destination for final goods.

According to the analysis contained in the IMF’s latest Global Financial Stability Report (October 2008) (IMF, 2008a), both domestic and global factors are important in explaining the movement in equity prices in the EMEs. Correlation of equity markets in EMEs with those in the advanced economies has risen, suggesting a growing transmission channel for equity price movements. Amongst the three group of EMEs (Latin America, Asia and Emerging Europe), the spillover from global factors is found to be strongest in Latin American EMEs followed by Emerging Europe and Asia. The wealth effect of stock market changes on consumption and investment, although statistically significant, is found to be weaker in EMEs vis-à-vis the advanced economies. Furthermore, such wealth effects tend to play out gradually.

During the financial turmoil, commodity prices may have been pushed higher to some extent by increased demand for commodities as a hedge against a depreciating US dollar and possibly also as a hedge against higher inflation. As global growth slows, a fall in commodity prices represents a downside risk to commodity-exporting EMEs, which is particularly relevant for some Latin American EMEs. In an extreme scenario, where commodity prices fall dramatically, this could have significant implications for economies that have had a heavy reliance on the performance of commodities in recent years, and might furthermore pose some risks to the financial stability in these countries. On the other hand, Asian EMEs which are commodity importers may benefit from the correction in global commodity prices. This may alleviate inflationary pressures in these economies and may provide the necessary flexibility to monetary policy in these countries. However, the beneficial impact of softening commodity prices is getting partly eroded by the depreciation pressures in some of the EMEs, thus, limiting to some extent the manoeuvrability available to the monetary policy.

Overall, while the real sector in the major Asian EMEs has held up relatively well, it needs to be recognised that the financial crisis in the US has deepened significantly over the past couple of months and there are signs of its spreading to the mature economies in Europe. The deepening and widening of the financial crisis is already getting reflecting in elevated volatility in the financial markets of key EMEs and widening of spreads of the EME assets. Although a large amount of liquidity has been injected by the central banks of the major advanced economies, short-term market rates remain well above policy rates. Financing costs for the EMEs have increased over the past few weeks and could thus deteriorate in the coming months. If the financial crisis were to linger longer and the economic activity in these regions slows down significantly, the adverse impact on the real economies in the major EMEs could turn out to be stronger than that has been observed so far. According to the IMF’s latest World Economic Outlook (October 2008) (IMF, 2008b), major advanced economies are already in or close to recession and the recovery is likely to be unusually gradual. Global output growth (at purchasing power parity (PPP) exchange rates) is now seen at 3.0 per cent in 2009, down from the likely 3.9 per cent in 2008 and the robust growth of almost 5 per cent each during 2006 and 2007. Growth in advanced economies is projected to decelerate from an average of 2.8 per cent during 2006-2007 to 1.5 per cent in 2008 and only 0.5 per cent in 2009. Policy rates have been cut in a coordinated manner, an unprecedented move, by central banks of major advanced economies on October 8, 2008 in view of the substantial downside risks to growth. Thus, financial headwinds – both through reduced capital flows, widening of spreads and elevated volatility in domestic financial markets of the EMEs and through weakening of demand in major advanced economies – have increased downside risks of the major EMEs, especially for the relatively more open economies in the region.

India has by-and-large been spared of global financial contagion due to the sub-prime turmoil for a variety of reasons. India’s growth process has been largely domestic demand driven and its reliance on foreign savings has remained around 1.5 per cent in recent period. It also has a very comfortable level of forex reserves. The credit derivatives market is in an embryonic stage; the originate-to-distribute model in India is not comparable to the ones prevailing in advanced markets; there are restrictions on investments by residents in such products issued abroad; and regulatory guidelines on securitisation do not permit immediate profit recognition. Financial stability in India has been achieved through perseverance of prudential policies which prevent institutions from excessive risk taking, and financial markets from becoming extremely volatile and turbulent.

1. Strengthened Prudential Oversight of Capital, Liquidity and Risk Management

The minimum capital to risk-weighted asset ratio (CRAR) in India is placed at 9 per cent, one percentage point above the Basel II requirement. Further, regular monitoring of banks' exposure to sensitive sectors and their liquidity position is also undertaken. In India, off-balance sheet vehicles in the form of SPVs for the purpose of securitisation are in existence for which extensive guidelines, in line with the international best practices, have already been issued. Liquidity facilities to such SPVs are subject to capital charge. Banks have been required to put in place appropriate stress test policies and relevant stress test frameworks for various risk factors by March 31, 2008.

In order to further strengthen capital requirements, the credit conversion factors, risk weights and provisioning requirements for specific off-balance sheet items including derivatives have been reviewed. Further, in India, complex structures like synthetic securitisation have not been permitted so far. Introduction of such products, when found appropriate, would be guided by the risk management capabilities of the system.

The Reserve Bank had issued broad guidelines for asset-liability management and banks have flexibility in devising their own risk management strategies as per board-approved policies. However, in regard to liquidity risks at the very short end, the Reserve Bank has taken steps to mitigate risks at the systemic level and at the institution level as well. The Reserve Bank has introduced greater granularity to measurement of liquidity risk by splitting the first time bucket (1-14 days, at present) into three time buckets, viz., next day, 2-7 days and 8-14 days. The net cumulative negative mismatches in the three time buckets have been capped at 5 per cent, 10 per cent, and 15 per cent of the cumulative cash outflows.

The Reserve Bank had recognised the risks of allowing access to unsecured overnight market funds to all entities and, therefore, restricted the overnight unsecured market for funds only to banks and primary dealers (PD). Since August 2005, the overnight call market is a pure inter-bank market. Accordingly, trading volumes have shifted from the overnight unsecured market to the collateralised market.

Greater inter-linkages and excessive reliance on call money borrowings by banks could cause systemic problems. The Reserve Bank has, therefore, introduced prudential measures to address the extent to which banks can borrow and lend in the call money market. On a fortnightly average basis, call market borrowings outstanding should not exceed 100 per cent of capital funds (i.e., sum of Tier I and Tier II capital) in the latest audited balance sheet.

Recognising the potential of 'purchased inter-bank liabilities' (IBL) to create systemic problems, the Reserve Bank had issued guidelines in March 2007 prescribing that IBL of a bank should not exceed 200 per cent of its net worth (300 per cent for banks with a CRAR more than 11.25 per cent).

2. Enhancing Transparency and Valuation

In recognition of the fact that market discipline can contribute to a safe and sound banking environment and as part of the ongoing efforts to implement the Basel II Accord, the Reserve Bank issued guidelines on minimum capital ratio (Pillar 1) and market discipline (Pillar 3) in April 2007 and guidelines for Pillar 2 (supervisory review process) were issued in March 2008. Under these guidelines, non-compliance with the prescribed disclosure requirements would attract a penalty, including financial penalty.

The Reserve Bank has undertaken a detailed process of identifying the eligible credit rating agencies whose ratings may be used by banks for assigning risk weights for credit risk. Banks should use the chosen credit rating agencies and their ratings consistently for each type of claim, for both risk weighting and risk management purposes. Banks are not allowed to ‘cherry pick’ the assessments provided by different credit rating agencies. If a bank has decided to use the ratings of some of the chosen credit rating agencies for a given type of claim, it can use only the ratings of those credit rating agencies, despite the fact that some of these claims may be rated by other chosen credit rating agencies whose ratings the bank has decided not to use. External assessments for one entity within a corporate group cannot be used to risk weight other entities within the same group.

Banks must disclose the names of the credit rating agencies that they use for the risk weighting of their assets, the risk weights associated with the particular rating grades as determined by the Reserve Bank through the mapping process for each eligible credit rating agency as well as the aggregated risk weighted assets as required.

In India, complex structures like synthetic securitisations have not been permitted so far. As and when such products are to be introduced, the Reserve Bank would put in place the necessary enabling regulatory framework, including calibrating the role and capacity building of the rating agencies.

• A college of supervisors will be put in place by end-2008 for each of the largest global financial institutions.

In the Indian context, there has been exchange of supervisory information on specific issues between the Reserve Bank and few other overseas banking supervisors/regulators. Supervisory cooperation has been working smoothly and efficiently.

The Mid-Term Review of October 2007 had announced the constitution of a Working Group to lay down a road-map for adoption of a suitable framework for cross-border supervision and supervisory cooperation with overseas regulators, consistent with the framework envisaged in the Basel Committee on Banking Supervision (BCBS). A Working Group was constituted in March 2008 and is in the process of finalising its Report. A number of overseas regulators of countries such as the USA, the UK, Canada, Hong Kong, Australia and Singapore have been formally approached to share systems and practices, including legal positions, in the matter of supervisory cooperation and sharing of information with overseas regulators. The response from a few countries has been received and is being examined. The 'Supervisory College' arrangement for this purpose is also being examined by the Group.

In the Reserve Bank, there is an institutional arrangement in place to oversee the functioning of the financial markets on a daily basis. There is a Financial Market Committee monitoring and assessing the functioning of different financial markets. Based on such an oversight, appropriate and prompt action is taken, whenever necessary.

The Reserve Bank has the necessary framework for provision of liquidity to the banking system, in terms of Sections 17 and 18 of the Reserve Bank of India Act, 1934. The regular liquidity management facilities of the Reserve Bank include the LAF, OMO and MSS besides standing facilities such as export credit refinance (ECR) and the liquidity facility for standalone PDs. The Reserve Bank can undertake purchase/sale of securities of the Central or State Governments and can purchase, sell and rediscount bills of exchange and promissory notes drawn on and payable in India and arising out of bona fide commercial or trade transactions for provision/absorption of liquidity for normal day-to-day liquidity management operations as also for provision of emergency liquidity assistance to the banks under the lender of last resort function.

The Reserve Bank is empowered under the existing legal framework to deal with the resolution of weak and failing banks. The Banking Regulation Act provides the legal framework for voluntary amalgamation and compulsory merger of banks under Sections 44 (A) and 45, respectively. The Deposit Insurance and Credit Guarantee Corporation (DICGC) offers deposit insurance cover in India. The mergers of many weak private sector banks with healthy banks have improved overall stability of the system. Not a single scheduled commercial bank in the country has capital adequacy ratio which is less than the minimum regulatory requirement of nine per cent.

Henry, Peter Blair (2007), "Capital Account Liberalization: Theory, Evidence, and Speculation", Journal of Economic Literature, Vol. XLV, December.

International Monetary Fund (2008a), "Global Financial Stability Report", October

--- (2008b), "World Economic Outlook", October.

Mohan, Rakesh (2006), "Coping With Liquidity Management in India: A Practitioner's View", Reserve Bank of India Bulletin, April.

---- (2007a), "Development of Financial Markets in India", Reserve Bank of India Bulletin, June.

---- (2007b), "India's Financial Sector Reforms: Fostering Growth While Containing Risk", Reserve Bank of India Bulletin, December.

Prasad, Eswar S., Raghuram G. Rajan and Arvind Subramanian (2007), "Foreign Capital and Economic Growth", Brookings Papers on Economic Activity, 1.

Reserve Bank of India (2008), Annual Policy Statement for the Year 2008-09, April,

World Bank (2008), "Global Development Finance 2008", June.