Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Y V Reddy on Indian Financial Stability

Reserve Bank of India Governor, Dr. Y V Reddy in a speech
at the Meeting of the Task Force on Financial Markets Regulation in
the United Kingdom earlier this month talked about how “India
has by-and-large been spared of global financial contagion due to the
sub-prime turmoil”:

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 resident 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. As a result, while there are orderly
conditions in financial markets, the financial institutions,
especially banks, reflect strength and resilience.

First of all, I would have liked the word “yet” to be
added while talking about India being spared the turmoil because it is
too early to say whether India will emerge unscathed out of all
this. It has been my view that the global turmoil is first and
foremost about the bursting of an asset price bubble in real estate
and secondly about excessive leverage. The specifics of the financial
products involved – credit derivatives, financial guarantees,
securitization, CDOs and SIVs – are relatively less
important. India has not yet had an equally severe correction in
property prices though correction in the share prices of real estate
companies suggests that such a correction is in progress. I also think
that there is a high degree of leverage in Indian real estate and a
fair degree of sub prime lending too. One part of the sub prime
lending (unsecured personal loans) has already witnessed severe losses
mainly for finance companies. A 20% nation wide fall in real estate
prices in India is not inconceivable, and if that were to happen, the
consequences would be ugly for the financial sector.

Second, the idea that institutions in India are prevented from
excessive risk taking is quite incorrect. Indian banks can make bad
loans as easily as banks elsewhere in the world, and there is little
evidence that the culture of credit appraisal is particularly strong
in large parts of the banking system. Low levels of non performing
assets in an (until recently) booming economy prove nothing.

Third, the assertion that financial markets in India do not become
extremely volatile is plainly wrong. I would recall January 16, 1998
in the fixed income markets, August 20, 1998 in the currency markets
and January 21, 2008 in our equity markets as evidence of what can
happen in a single day in three different financial markets. Low
volatility during benign periods is irrelevant; what matters is the
volatility when things go wrong.

The speech refers to several counter cyclical policies of the

  • encouraging banks to create an Investment Fluctuation Reserve
  • permitting them to transfer bonds to the Held to Maturity
  • increasing the risk weight for real estate loans, consumer credit
    and capital market exposures.

The first and the third are valid points and highly creditable. The
second is quite dubious as it only allowed banks to avoid mark to
market losses.


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