"A question needs to be asked whether the time has come to review the deposit insurance system and the concept of the lender of the last resort," Reddy said while delivering the valedictory speech at the 21st Bank Economists' Conference. Supervision along with the deposit insurance scheme and the lender of the last resort concept are the three pillors of the monetary policy.

"Worldwide, the government has bailed out private sector banks. But a debate has to be kicked off in the Indian context with the entry of private sector banks. Questions need to asked whether the central bank and indirectly the government will continue to be the lender of the last resort to banks. The issue of deposit insurance also needs to be reviewed, now that private banks have also made an entry," Reddy told the conference.

"So far, the roles have not been reviewed as public sector banks are owned by the government. But with the entry of private sector banks, this role has to be reviewed... I think the government still has a role in bailing these private sector banks even though they are not owners in the strict sense," Reddy said.

Reddy pointed out the weak banks in the banking system are turning out to be an impediment to the conduct of monetary policy. "Unsound banks are unable to respond to monetary policy changes in the same speed as the sound banks do," Reddy said. The deputy governor also pointed out that the monetary authority was concerned about the health of these banks as the banking system will continue to provide the monetary signals.

"Whether it is recap funds or the setting up of asset reconstruction companies, ultimately the cost is borne by the government," he said emphasising on the burden of the recap funds on the fiscal situation.

The government has made it clear that it will be setting up asset reconstuction companies to bail out the three public sector banks -- Indian Bank, United Bank of India and Uco Bank.

Reddy pointed out that tighter prudential norms in line with international standards and higher capital adequacy requirements would be put in place in the next three to four years so that the institutions can comply with the new norms without getting hurt. "Legal changes also need to take place for better recovery of debt," Reddy said.

He added that with further deregulation there is a case for better supervision and the risk profile for the banks also needs to be controlled.

Drawing a link between macro-management of the economy and the soundness of the banking system, Reddy said that the large fluctuations in the real economy lead to unprecedented problems for banks. "If for one year the economy grows at 10 per cent and the year after it grows by just 2 per cent, it leads to problems for banks," Reddy said.

He added that the cyclical fluctuations in the economy also affect the banking sector. "My belief is that prudential norms can lead to pro-cyclical behaviour," he said adding that a volatile forex market and a volatile interest rate movement lead to further deepening of problems for banks.

He pointed out that even the fiscal stimulus that the government seeks to give to kickstart the economy may come a cropper if the working capital is not available to corporates.