The Reserve Bank of India (RBI) has done well to set up a new financial stability unit to monitor the strength of the financial system. The central bank has said that a multidisciplinary team drawn from its regulatory, supervisory, statistics, economics and financial markets departments will conduct periodic stress tests and prepare financial stability reports.
However, it is not yet clear what this will entail. The Thursday press release does not provide too many details. RBI has been ahead of the curve as far as recognizing the importance of financial stability goes during the years when the central banking orthodoxy was all about inflation targeting. But its responses to hot money flows into the stock market or imprudent bank lending to the real estate sector seemed episodic rather than part of an overarching strategy to maintain financial stability; or, perhaps, there was such a strategy but it was not publicly articulated, which is why periodic financial stability reports will be welcome.
The nature of threats to financial stability in India could be very different from those in developed market economies. The recent financial crisis taught us two things as far as stability goes. One, there are certain financial institutions that are too big to fail. Two, interconnected bond, derivative and currency markets—as well as securitization—can make it very difficult to know where risk resides.
RBI has been keeping an eye on large financial conglomerates for many years now, but none is so big as to pose a systemic risk in times of trouble. We really do not have an animal like Citigroup or American International Group.
Various financial markets are weakly interconnected in India, which makes the transmission of financial shocks that much slower. The lack of large financial intermediaries or shallow financial markets is not necessarily a good thing. Despite the heated debates about the pace of financial sector reforms—with Mint firmly in the gradualist camp—there is little doubt that India will have to keep developing its financial markets in tandem with its economic development.
A more structured approach to financial sector stability through the new RBI unit is a welcome advance.
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