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Capital account convertibility refers to a policy change that permits capital to flow more freely in and out of a country. Ishii and Habermeier (2002) provide a thorough analysis of the implications of capital account convertibility for financial stability. In India, recent policy discussions culminating with the publication of the Tarapore 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. This paper attempts to contribute to this debate and takes a closer look at the prudential and regulatory measures needed to prepare India’s financial system to manage the risks arising from fuller capital account convertibility (FCAC).

There are benefits to fuller capital account convertibility for financial institutions, including increased diversification, greater access to capital, and a broader range of risk management tools. However, policymakers, financial institutions, and their clients typically face additional challenges with fuller capital account convertibility. At about US$104 billion, total foreign bank claims on India are comparable to those on China and Russia. In contrast, Indian banks claims on other countries are four times less than this total. With fuller capital account convertibility, 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:

• Market risks such as interest rate and foreign exchange risks become more complex as financial institutions and corporates gain access to new securities and markets, and foreign participation changes the dynamics of domestic markets. For instance, banks will have to quote rates and take unhedged open positions in new and possibly more volatile currencies. Similarly, changes in foreign interest rates will affect banks’ interest sensitive assets and liabilities. Foreign participation can also be a channel through which volatility can spill-over from foreign to domestic markets.
• Credit risk will include new dimensions with cross-border transactions. For instance, transfer risk will arise when the currency of obligation becomes unavailable to borrowers. Settlement risk (or Herstatt risk) is typical in foreign exchange operations because several hours can elapse between payments in different currencies due to time zone differences. Cross-border transactions also introduce domestic market participants to country risk, the risk associated with the economic, social, and political environment of the borrower’s country, including sovereign risk.
• With FCAC, liquidity risk will include the risk from positions in foreign currency denominated assets and liabilities. Potentially large and uneven flows of funds, in different currencies, will expose the banks to greater fluctuations in their liquidity position and complicate their asset-liability management as banks can find it difficult to fund an increase in assets or accommodate decreases in liabilities at a reasonable price and in a timely fashion.
• Risk in derivatives transactions become more important with capital account convertibility as such instruments are the main tool for hedging risks. Risks in derivatives transactions include both market and credit risks. For instance, OTC derivatives transactions include counterparty credit risk. In particular, counterparties that have liability positions in OTC derivatives may not be able to meet their obligations, and collateral may not be sufficient to cover that risk. Collecting and analyzing information on all these risks will become more challenging with FCAC because the number of foreign counterparts will increase and their nature change.
• Operational risk may increase with FCAC. For instance, legal risk stemming from the difference between domestic and foreign legal rights and obligations and their enforcement s becomes important with fuller capital account convertibility. For instance, differences in bankruptcy codes can complicate the assessment of recovery values. Similarly, differences in the legal treatment of secured transactions for repos can lead to unanticipated losses.
• Regulatory issues include the risk of regulatory arbitrage as differences in regulatory and supervisory regimes among countries may create incentives for capital to flow from countries with higher standards to those with lower ones. FCAC can also bring a proliferation of new instruments and market participants, complicating the task of financial supervisors and regulators. The entry of large and complex institutions operating in different countries will increase the need for cooperation and coordination between domestic regulatory and supervisory agencies and also with their foreign counterparts.

The preparedness of financial institutions to adequately manage the risks of FCAC depends largely on how well they manage existing financial risks. Financial institutions’ ability to identify, measure, and manage risk will vary depending on the quality of internal risk management and control policies“the first line of defense.”

Adequate prudential regulation and supervision, and developed capital markets will also be key in addressing the challenges from FCAC. Prudential regulation and supervision will need to encompass the existing and new risks associated with FCAC. In addition, developed capital markets with adequate liquidity, infrastructure, and market discipline are necessary to provide market participants with the relevant risk management instruments.

Contents

Glossary
I. Introduction
II. What Are the Existing Challenges to FCAC?
III. How Is Prudential Regulation and Supervision Addressing the Challenges From FCAC?
IV. Conclusions
Table
1. Selected Risk Management Initiatives

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