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Indian banks' risk management needs to be improved further to address the challenges arising from fuller capital account convertibility. Prudential and regulatory measures are needed to prepare India's financial system to manage the risks arising from fuller capital account convertability.
Capital account convertibility refers to the policy change that permits capital to flow more freely in and out of a country, or loosely speaking to `open up' its capital account. Recent policy discussions in India, culminating with the publication of the Tarapore Committee Report (2006), have reopened the debate about the risks and benefits of capital account convertibility—a debate which had lost steam after the Asian crisis.
There are benefits to Fuller Capital Account Convertibility (FCAC) for financial institutions, including increased diversification, greater access to capital, and a broader range of risk management tools. However, policy-makers, financial institutions, and their clients typically face additional challenges with FCAC. At about $104 bn, total foreign bank claims on India are comparable to those on China and Russia. In contrast, Indian banks claim on other countries are four times less than this total. With FCAC, new risks will arise as cross-border transactions increase. Such activities will not only involve different currencies and span many countries but also include on-balance sheet lending and funding, as well as off-balance sheet derivatives and other complex financial transactions.
Increased cross-border transactions will augment the dimensions of risks that Indian financial institutions face in their domestic markets. Market risk—the risk of losses in on- and off-balance sheet positions arising from movements in market prices—changes with cross-border transactions. Similarly, credit and liquidity risks, the risk in derivatives transactions, legal risk, and the risk of regulatory arbitrage include new dimensions |
