The global crisis is not a reason for India abandoning financial system reform. In fact the opposite is true.

Financial instruments, vehicles and techniques (such as derivatives and securitisation) should not be seen as being inherently dysfunctional when the people who use them lapse in judgement. Knives are not inherently dangerous. Capital adequacy throughout the financial system is crucial. No financial institution of any sort in India should be exempt from capital adequacy requirements of a prudent level whether they are deposit taking or not. The right level of capital adequacy for India would be in a range of 7-10%.

Transparency in financial instrumentation and regulation is equally crucial as is accountability in financial management. Managers of financial institutions need to be held to public regulatory account and not just to shareholder account.

For that reason all ?off-budget? and ?off-balance sheet? accounting on the part of governments and financial firms is a bad idea.

To the extent possible all financial instruments should be designed to be ?marketised? and exchange-traded rather than being bank-driven or intra-institutionally contracted. Regulatory practice must make finer distinctions between liquidity and solvency and be more adept in identifying the tipping point when illiquidity threatens to induce insolvency. Creating liquidity to solve problems of under-capitalisation/solvency can be counterproductive. Financial regulation must be unified but be distinct from the functions of the monetary authority.

Central banks should become limited monetary authorities that are not primarily concerned with creating liquidity to fuel growth, or stabilising exchange rates when capital accounts are closed. Their focus should be on financial stability first and minimising inflation second. Those who claim the absence of correlations between liquidity creation and inflation are not looking at asset price inflation as an essential part of the equation.

India would now be better off with an open capital account than a partially closed one. The partially closed capital account, which discriminates only against resident Indian individuals, is a distortion that is corrected by a plethora of supposedly off-setting distortions that do not have the desired effect.

Price inflation in any traded asset (whether securities, property, commodities) must be a fundamental consideration in the pursuit of monetary policy. RBI needs to ?invent? an appropriate model for taking asset price inflation into account in formulating interest rate policy and in assigning risk weights for bank and institutional portfolios. Central banks should not run bond trading platforms or direct primary or secondary trading in bonds. That is a market function best left to exchanges to undertake in a transparent fashion, supervised by the exchange regulator when financial system regulation is not unified. RBI needs to shift its bond trading platform to the BSE and NSE, now.

Fiscal deficits (whether on-budget or off-budget) are usually the root of most financial evil. The roots of financial systemic distress invariably lie in government neglect of the relentless growth of public expenditure and deficits, whose impact is exacerbated when accompanied by large current account deficits. Resorting to off-budget and creative opaque accounting to hide the true size of deficits is not clever. When such deficits are financed by resort to money creation (as they have been in the US since 2000) that distorts global liquidity creation especially when excess liquidity is being created by the global reserve currency issuer. That in turn provides the wrong signals and incentives for risk-taking to financial system operators and adversely affects the adequacy of capitalisation.

In India it is the fiscal deficit that has distorted the financial system and made state ownership of the financial system, along with the massive pre-emption it entails (through CRR and SLR), an expedient device to escape market discipline over deficit control and government expenditure. That dynamic needs to be reversed.

The Indian fiscal deficit should be financed openly by the world market and not just by Indian institutions and markets. The purchase and sale of G-Secs should be opened up to all buyers whether foreign or domestic, institutional or individual. These sovereign bonds should be traded on Indian and world markets. Those markets should be sending daily signals to governments about what they can get away with and what they cannot. For that to happen, rapid progress needs to be made in introducing currency futures and options including contracts against the rupee for all significant internationally traded currencies. Rapid progress also needs to be made in introducing interest rate futures and options contracts. Lopsided financial markets (as in India where equity markets are developed but the debt market is not) are dangerous. They distort incentives and preferences for one type of financing over another. They either exacerbate risk or make financial assets less productive than they otherwise might be.

The Indian bond market is not a market. It has basically one issuer (GoI) standing behind the credit of almost every issue traded and 80% of the buyers are instrumentalities of that issuer. That is not a market. It is a rigged platform that enables GoI to get away with murder and sends the wrong signals by exerting no fiscal discipline. That needs to change and soon. If even some of these lessons are learnt and acted upon by the Indian authorities some good would have come out of this dreadful crisis.

Concluded

The author is an economist and corporate finance expert. He chaired the high-powered committee on making Mumbai an international financial centre