ssubbaiah@rbi.org.in Mukul G Asher (sppasher@nus.edu.sg) is with the National University of Singapore.
SPECIAL ARTICLEmarch 8, 2008 EPW Economic & Political Weekly66cautioned that unstable capital flows could pose a serious challenge to financial stability in Asia in future [IMF 2007a]. The Global Financial Stability Forum has also set up a working group to explore the consequences of capital flows for emerging market economies, both the macroeconomic effects and the impact on the domestic financial systems [RBI 2007]. Safeguarding financial stability, therefore, has become an increasingly dominant objective in economic policymaking as it has all the essential characteristics of a public good3 [Schinasi 2005b]. Nearly 50 central banks and other international agencies such as theIMF now publish regular reports on financial stability. Currently, asset bubbles and excessive leverage are engaging policy attention as the possible destabilising forces underlying the ongoing correction in global markets. It is in the above context that this paper examines financial stability issues confronting Asian economies. It also suggests pubic policy measures, which could help enhance financial stability. The rest of the paper is structured as follows. Section 1 provides a brief overview of the approaches to safeguard finan-cial stability. Section 2 reviews the various macroeconomic and analytical models to safeguard financial stability. Section 3 presents a policy cycle concept for addressing financial stability challenges. Section 4 briefly discusses financial stability challenges for India. The concluding section suggests public policy measures to enhance financial stability. 1 Definition and Approaches There is no consensus on what constitutes financial stability. In general, financial stability refers to the smooth functioning of financial markets and institutions without serious disruptions [RBI 2006b]. More formally, “financial stability is a condition in which an economy’s mechanisms for pricing, allocating, and managing financial risks (credit, liquidity, counterparty, market and so forth) are functioning well enough to contribute to the performance of the economy” [Schinasi 2005a].There are three important aspects involved in comprehensive assessment of financial stability.4 These are: (i) identifying the plausible and systemically important sources of risks and vulner-abilities that could pose challenges to financial stability in future; (ii) an appraisal of the potential costs, that is, the ability of the financial system to cope, should some combination of these identified risks and vulnerabilities materialise; and (iii) forming a judgment about the individual and collective strengths and robustness of the constituent parts of the financial system – insti-tutions, markets and infrastructures.In addition, the following aspects are also relevant: (i) taking steps to counteract risks and vulnerabilities and/or strengthening the financial system and/or its constituent parts if there is a chance that certain risks and vulnerabilities could overwhelm the financial system and the resulting costs are considered to be too great;5 and (ii) crisis management and resolution arrangements.The existing approaches to safeguard financial stability have limitations. For example, Goodhart (2005) provides insights into the limitations of existing measures of supervisory capital requirements in the globalised world. He argues that Basel II regulations and the new accounting standards for financial instruments (IAS 39) are likely to be of limited help in fostering financial stability. Stliglitz (2006) argues that the current global (dollar) reserve system has enormous costs for developing countries, exerts a deflationary pressure on the global economy and contributes to global instability. Financial Times (2006) highlighted some of the limitations of using value-at-risk (VaR) models and emphasised that market liquidity risk cannot be measured byVaR during a market panic, as large-scale selling in the fear of further price decline is common during a crisis, while some hedging programmes require sales in the falling markets. Several techniques and approaches have been suggested to cope with financial stability issues. The use of early warning signals to safeguard financial stability in emerging economies was studied by Goldstein et al (2000). The use of key standards and codes as a useful way of benchmarking progress in the reform of a financial system was advocated by Schneider (2003) based on the evidence that the adoption of standards and codes does lead to improved country credit rating, especially when standard assessments are allowed to be published. Both these approaches are quite popular and useful in understanding the possible sources of threats to financial stability. There is, however, a constant need to refine these approaches as the sources of threats are constantly changing thanks to innova-tions in financial instruments and risk transfer mechanisms, the derivative structures (collateralised debt obligations, popularly CDOs) involved in the sub-prime crisis being one such recent example. A similar argument was made by Brouwer (2003), who argued that the risks associated with hedge funds need to be regulated carefully and that constraining an excessive leverage of hedge funds effectively is particularly important from a public policy perspective. Similar sentiments were expressed by Asher (2008) for sovereign wealth funds. IMF (2007b) cautions that Asia remains too dependent on exports as an engine of growth and the financial sector needs to be developed further to cope with capital flows. 2 AnalyticalModels The challenges to safeguarding financial stability are becoming increasingly complex and hence, need to be constantly monitored, measured and managed. However, issues such as increasing global imbalances, asset bubbles, complex risk-transfer instru-ments, increasing size of financial conglomerates, etc, could pose serious challenges to domestic financial stability. The use of statistical models in this process cannot be relied upon exclu-sively, given the behaviour of market participants. To counter these challenges, each country should put in place a rigorous analytical framework for safeguarding financial stability. However, the challenges in building an analytical framework are more complex than compared to developing a monetary policy framework. While the mandate of monetary policy is clear in terms of inflation levels, the financial stability challenge is a lot more complex, mainly because of the focus of financial stability policies on extreme (tail) events. A few analytical frameworks have been advanced recently, which aim to identify vulnerabili-ties to financial stability and means of preventing or controlling resulting risks. The Financial Sector Assessment Programme (FSAP) of the IMF and World Bank, the Bank of England framework and 
SPECIAL ARTICLEEconomic & Political Weekly EPW march 8, 200867the analytical framework developed by Garry J Schinasi are the most comprehensive of them. 2.1 IMF-World Bank FrameworkIn practice, analytical frameworks to monitor financial stability are centred on the surveillance of macroeconomic conditions and financial market developments, macro-prudential surveillance and analysis of macro financial linkages which are mutually supportive and reinforcing [World Bank and IMF 2005]. At the international level, the IMF and World Bank have launched the FSAP, which examines selected countries’ financial soundness and assesses their compliance with financial system standards and codes. 2.2 Bank of England Framework The 2005 analytical framework of the Bank of England (BOE) for financial stability is a suit of models for better gauging the fragilities and frictions in the financial system.TheBOE framework recognises that the vulnerabilities of the financial system to developments (such as credit risk transfers by new holders of credit risk like hedge funds, growth of derivative instruments and advent of a range of new asset classes) have added to the risks of financial instability arising through leverage, volatility, and opacity. The most important elements of the financial stability function at the BOE are to assess threats to financial stability, oversight of payment systems, provision of liquidity and preparation for a financial crisis. 2.3 Garry J Schinasi’s FrameworkA key aspect of the framework developed by Schinasi (2005b) is that it brings together macroeconomic, monetary, financial market, supervisory, and regulatory inputs. The purpose of this framework is to (i) foster early identification of potential risks and vulnerabilities; (ii) promote preventive and timely remedial policies to avoid financial stability; and (iii) resolve instabilities when preventive and remedial measures fail.The framework has the objective of preventing problems from occurring or resolving difficulties if prevention fails. Factors affecting the financial system performance are identified under endogenous and exogenous factors. The focus is on identifying and dealing with the build-up of vulnerabilities prior to downward corrections in the market, prior to problems within institutions or prior to failures in financial infrastructure. 2.4 Review of ModelsThe review of models suggest a few policy considerations. These are (a) financial stability assessments carry a higher degree of uncertainty than that ordinarily associated with forecasts based on macro-econometric models; (b) normal distribution and log-linear relationships that models follow may not be relevant in assessment of financial sector stability as crises can have unpredictable non-linearity; (c) analytical frameworks could be useful in constantly monitoring risks and vulnerabilities and initi-ating suitable pro-active or remedial actions; (d) undergoing the FSAP of the IMF-Word Bank at regular intervals could point out the areas requiring focus from a financial stability angle; (e) the sources of threats to financial stability cannot be captured by any single model or framework and require constant vigil and ongoing surveillance for early identification and suitable preven-tive or remedial action; (f) policy communication is a power tool to manage market perceptions of the macroeconomic, market,institutional and infrastructure factors affecting finan-cial stability; and (g) an eclectic framework, appropriate in the context of a specific country is needed requiring substantial capacity and expertise. 3 Financial Stability Cycle Framework Given the nature of financial stability issues, limitations of mathematical models and the emerging role of Asia in the global order, financial stability can be safeguarded by putting in place a “financial stability cycle” framework. The cycle gives a “helicopter” approach to financial stability and could foster inter-departmental coordination within the central banks and inter-agency coordination in a country. The components of the cycle are already in place in most of the countries and having them organised in a cycle form and reviewing it, say every six months, could bring about an organised and systematic way of safeguard-ing financial stability. Setting up a dedicated group with the support of top management to work on financial stability cycle issues would serve the function well. Though this could put strain on scarce human resources, the trade-offs are worth the invest-ment. The broad components of this framework are listed below: 3.1 PolicyActors Economic policy falls under “incremental approach” with the policy framework evolving over a period [Dye 2005]. Financial stability can also be treated as an incrementally developed approach. The policy actors in preserving financial stability can be grouped under the following categories:International System: Financial stability is fostered through international cooperation and is contingent upon global order. Any imbalances in the global economic order might pose a substantial risk to financial stability. The actors of the inter-national system that have a bearing on the financial system are the major economies and their central banks, financial market players like foreign institutional investor, hedge funds, sovereign wealth funds, and financial institutions and international organi-sations such asIMF/World Bank, etc. International think tanks and press are becoming increasingly important.Domestic State System: The capacity and autonomy of individual countries and their central banks to pursue sound macro-economic, prudent supervisory and pragmatic exchange rate policies influence the financial stability of individual countries. The most important actor here is the central bank of the country. Other players include the government, particularly the finance ministry, regulators of the financial system and market players. Business media plays an important role in this process by highlighting the instances of “wrong signals” to financial stabil-ity and keeps the regulators on guard. Think tanks and research organisations also play a role in finding enduring solutions to the problems to financial stability. A robust database on financial market players and financial instruments is essential. As such a 
6 Policy evaluation and communication. E g: Financial stability reports, speeches, briefs, etc. 1 Monitoring/analysis of macroeconomy, markets, institutions and infrastructure. E g: Macro prudential indicators 2 Assessment of likely impact of the potential risks to financial stability. E g: Stress testing, Scenario analysis 3 Prevention of problems and identifying potential problems E g: Penalising off market deals, guidelines on new products 4 Remedial Action for potential high value problems E g: Prudential measures to check asset price inflation and credit growth 5 Resolution of potential crisis. E g: Payments not settled in time, replacing unrealisable collaterals 
SPECIAL ARTICLEEconomic & Political Weekly EPW march 8, 200869The cycle can have a renewal period of six months for under-taking a system health check for stability and communicate the status to markets.4 Financial Stability Challenges for IndiaSince adopting the open economy, open society paradigm in 1991, India is increasingly becoming integrated with the rest of the world in terms of international trade, investment and financial markets. However, the risks associated with globalisation have also sensitised domestic policymakers to the need for stability of the financial system. Financial stability has, therefore, become a dominant objective of economic policy in India [RBI 2006a]. Perseverance of domestic financial stability in the wake of several global financial crises in the 1990s and the early part of this decade bears testimony to the institutional strength and capacity of the government andRBI. However, the stock market volatility in May 2006 and the continued risks of financial markets turbu-lences are a constant reminder of the challenges that lie ahead in safeguarding financial stability in India. India, like most Asian economies, is traditionally a bank dominated financial system, and hence regulation and super-vision of banks is at the core of financial stability policies. Pruden-tial regulation using risk management principles, development of sound payment and settlement systems, sound governance and disclosures, monitoring the macro prudential indicators and self-regulation have been the key instruments of financial stability policies in India. The regulatory structure is that of multiple regulators and necessary institutional arrangements have been put in place to ensure that risks, particularly those emanating from financial conglomerates, are better managed through inter-agency regulatory coordination. To safeguard financial stability, theRBI adopted a multi-pronged strategy based on international best practices with suitable adaptations to promote stability of institutions, markets and the financial infrastructure. Monetary policy also fostered a financial stability function by lowering inflation and stabilising inflation expectations [RBI 2005]. Thus, theRBI has pursued measures aimed at both micro and macro prudential controls. The key to financial stability policies has been strengthening financial institutions like commercial and cooperative banks, financial and non-financial companies, mutual funds, insurance companies, etc. Of these, the banking sector, being the most dominant class of players in the financial system, has become strong, healthy and resilient. With an asset quality, profitability and capital base that are comparable to international standards, the banking sector has become a source of stability. With the present policies of consolidation, cost reduction, improved govern-ance and technological innovations, they are even aspiring to compete at the international level. Strong prudential regulation, development of financial markets, deregulation of banking indus-try and rationalisation of statutory requirements have been the most important factors in strengthening the banking sector. TheRBI places an equal emphasis on measurement, manage-ment and containment of risks of financial instruments, players and markets. Regulatory policies have focused on strengthening risk management systems, practices and management of market players and the appropriate regulatory monitoring mechanism of the system’s aggregate risk. Broader issues like anti-money laundering and combating the financing of terrorism have also been addressed through proactive regulation. Risk based super-vision, off-site monitoring and surveillance, encouraging banks to strengthen their internal controls, mandating consolidated accounts of banks and institutionalising a scheme of prompt corrective action as a structured early intervention system and involving external auditors have been the supervisory measures for fostering a stable banking system. Other segments of the financial system have also been strengthened in a calibrated manner, even though the outcomes, especially in case of urban cooperative banks are not as encouraging. Financial markets development has been at the core of finan-cial stability policies in India, since they have a direct impact on the health of financial institutions through portfolio holdings andrisk management. The money, forex and debt markets have developed with a vigour and this has enabled better management of liquidity, transmission of monetary policy objectives, pricing of assets and risk management. At the same time, the Securities Exchange Board of India has made efforts to develop the equity market. A closely related aspect is the thrust given to transpar-ency, data dissemination and disclosures – both by market players and the central bank. The involvement of market participants through committees and groups in advising the RBI has enabled market development and consolidation. The growth of financial markets is partly reflected in the phenomenal growth of deriva-tives markets – equity, forex, interest rate and commodity, and the availability of reasonable market liquidity, even though at times it could be a one-way market reflecting the shallowness of these markets. A mention of the strength of the payment and settlement systems and its role in preserving financial stability should be made. Several measures such as the delivery versus payment system and guaranteed settlement have already been put in place and recently a board for supervision and regulation of payment and settlement systems has been constituted and real time gross settlement in large-value funds transfer systems has been opera-tionalised. Implementation of international standards and codes is another positive aspect.Thus, the financial stability function has been rather robust in India. More recently, the government of India in consultation with the RBI constituted a Committee on Financial Sector Assessment under the chairmanship of Rakesh Mohan to undertake a self-assessment of financial sector stability and development, using the IMF-World Bank FSAP framework. While this will definitely contribute to the strengthening of domestic financial stability, the financial stability policy cycle framework suggested in the paper could play a complementary role. Also, in the light of the risks posed by the international movements of capital, risk transfer, proxy pricing and other factors, the following suggestions may complement the ongoing efforts of the policymakers to strengthen financial stability function in India in future. (i) Organisational set up: Dedicated organisational division to monitor and coordinate the financial stability function may be set up.
S_Speeches
