The Macroeconomic and Monetary Developments mid-term review 2008-09 release by the Reserve Bank of India said the recent episode of global financial market distress, especially during June-October 2008, has raised several issues. First, the conditions of global financial markets have witnessed a transition from a broad-based cyclical deterioration to the viability of systemically important financial institutions.
The financial crisis seems to be spreading across markets, institutions and countries, reflecting problem of contagion. It needs to be recognised that there has been a breakdown of trust in inter-bank and inter-institutional lending. The reversal of such extreme kind of risk perception and full resolution of the crisis will inevitably take time. Second, in drawing a lesson of the need for financial regulation and supervision of staying ahead of innovation in financial market, there is a distinct risk that too much stringency in regulation may stifle innovation, the report said.
This risk needs to be guarded. Third, there is a need for inter-agency coordination in which the role of banks, regulators, supervisors and fiscal authorities regarding financial stability needs to be revisited. Central banks should play a central role in maintaining financial stability and should have the necessary informational base to do so effectively. This implies close co-operation among all the agencies entrusted with the task of maintaining financial stability.
Fourth, the unfolding of the crisis has revealed the weaknesses of structured products and derivatives in the credit markets and their financial stability implications thereby raising issues on appropriateness of such products and the need to eliminate shortcomings. Fifth, it is wrongly perceived that the near meltdown of the US financial sector reflects that markets and competition do not work.
The right lesson to draw is that markets and institutions do succumb occasionally to excesses, which is why regulators have to be vigilant, constantly finding the right balance between attenuating risk-taking and inhibiting growth.
Sixth, the consequence of massive injection of liquidity in an environment of high inflation may lead to moral hazard issues.
Seventh, with the failure of systemically important financial institutions, there is a possibility that the overall size of the financial sector would shrink in many markets. In these circumstances, the key is to strike a balance between limiting moral hazard and safeguarding the financial system?s effectiveness.
Finally, notwithstanding the recent use of innovative and unconventional measures, a more systematic approach would be required to deal with disposition of distressed assets, the degree of protection offered to depositors, and the scale and scope of liquidity support that is offered to institutions and markets.