Build strong banking system before moving on Capital Account Convertibility (CAC), says a joint study of ASSOCHAM-PwC

March 11, 2010: India would need to work on sustaining its economic fundamentals over a period of time with a strong banking system before going ahead with the implementation of Capital Account Convertibility (CAC), says a joint study of The Associated Chambers of Commerce and Industry of India (ASSOCHAM) & Pricewaterhouse Coopers (PwC).

It points out that as recognized in the recent Tarapore Committee Report, the ability of financial institutions to identify, measure, and manage risk will also depend on the availability of instruments to manage risk, the liquidity of financial markets and the quality of market infrastructure, and level of market discipline.

However, key segments of the Indian capital markets remain underdeveloped. The term money market is limited and although there is a domestic yield curve for government securities with maturities up to 30 years, its depth and liquidity are limited. The corporate bond market is relatively small and illiquid, and the market for securitized assets has fallen short of expectations. The OTC derivatives market is growing rapidly but its prudential and regulatory framework has just been laid out.



Releasing its findings here today, the ASSOCHAM spokesman said that Regulators and market participants have been warning for years about the dangers of the unchecked growth of the credit default swap market and about the difficulty of assessing, who could be at risk for derivative market failures.

The study points out that in India, delinquencies in retail portfolios of banks have still not reached panic levels. Nonetheless, they are inching up slowly but surely. Add that to the sudden drying up of liquidity and the domestic mutual fund industry emerges as India's weakest link in the securitisation food chain. The bigger fear is that that this exposure could have a cascading effect on the entire banking sector, with the risk getting transferred to many of the parent companies of these MFs. The dominance of mutual funds in securitisation coincided with private sector banks slipping into overdrive to hawk retail loans.



As regards, dangers with securitized products, the ASSOCHAM-PwC study points out that high-risk, high-return products originated by private sector banks, Non-banking Financial Companies (NBFCs) and companies; the mutual funds that pick them up have no control over their credit quality, highly illiquid with no secondary market; Mutual funds have no option but to hold the ABS or MBS till maturity, not very transparent products; disclosures are on a monthly basis to rating agencies (in contrast to corporate debentures or bonds, in which information is always available about the company on a stock exchange on a daily basis).Globally, despite rating agencies rating them highly, a sudden chain of defaults in the underlying assets (mortgages) brought down the big institutions.

Innovative financial products have played a key role in the development of the current financial crisis, and have also compounded the difficulty of resolving it. This is because the difficulty of valuing such products has, in many cases, caused markets for them to cease functioning. This has led to great uncertainty regarding the financial position of institutions holding these products, which has, in turn, frozen the process of trying to separate good assets from bad assets, an important step in restoring the normal functioning of credit markets.


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