Indian Banks Look Safe Now, But For How Long?.

Historically, the ripples of recession first reach the banking sector, and quickly exert a multiplier effect with ramifications across industries in terms of cash flow. Its direct effect on fund-raising in the corporate sector stymies both expansion and industrial output which, in turn, have implications for gross domestic product (GDP) and employment.

However, it is instructive to consider both the likely impact of the current financial crisis on the Indian economy and the knock-on effect for the banking sector. Of course, there exists a direct correlation between the effects of recession and the openness of the economy.

In terms of both structure and scale, the Indian economy has changed drastically over the last 30 years. In percentage terms relative to GDP, India's exports and imports have doubled from 23% in 1991-2000 to 49.80% in 2009-2011. At the same time, the inflow and outflow of capital into one of the world's most closely monitored emerging economies have increased exponentially.

Until recently, the effects of the deterioration of Europe's banking system has placed a strain on short-term funding markets with traditional lenders to banks, such as US money-market funds and fellow banks, becoming wary of lending except for extremely short periods. That reticence prompted fears that large European banks were prone to life-threatening liquidity problems. In the ensuing rush to address the issue, many central banks have come to the fore in liquidity management and have underscored the critical importance of liquidity in maintaining financial stability.

The current crisis has sharpened the focus on systematic risk and increased the emphasis on the interconnectedness of key financial entities. Indeed, the increasing strength of the interconnection is graphically illustrated by the downgrading of major French banks with large exposures to Greece.

But there are fundamental differences between the crisis of 2008 and that of 2011. In 2008, many financial institutions were bailed out by their respective governments and forced to seek the support of their central banks. Three years on, the ramifications have spread to sovereign risk. Many countries have been downgraded and have been forced to look to other countries for a bailout. The International Monetary Fund ( IMF) has not only cautioned nation states that they will be unable to resolve the issue alone but also warned that independent debt management has the potential to jeopardize monetary and financial stability. So far, economists continue to scratch their heads in search of a solution.

At the same time, central banks across the world have metamorphosed from passive observers to active participants while the scope of responsibility for central banks now encompasses sovereign debt management as well as setting monetary policy. Recent currency volatility has prompted investors to call for central bank intervention to manage capital flows and so liquidity and reserve requirements.

The depth and scale of the crisis has brought major changes to regulatory infrastructure across the globe and has redefined central banks as the ultimately-accountable systemic regulators. It also placed central banks as micro-prudential.

Financial crises in US and Europe have highlighted the need for greater international co-operation and co-ordination to promote open, flexible and resilient financial systems, which recognise the interconnectedness of economies and co-ordinate the implementation of global reform.

Keynes' General Theory, which was written during the Great Depression and emphasised the natural restoration of the economy without government intervention, is no longer relevant in a world in which financial systems are increasingly complex and increasingly integrated.

Indian banks should be careful not to fall into complacency. They are not ring fenced. Irrespective of the emerging regulatory contours, central banks will continue to occupy a pivotal role in the pursuit of financial stability.

Source : economictimes.indiatimes.com