Global Financial Crisis: Causes, Impact, Policy Responses and Lessons

Although the global financial crisis is still ongoing, there has been a tremendous effort to research and analyze its causes. Though the crisis started with the subprime mortgage sector in the US, its genesis can be traced to excessively loose monetary policy in the US during 2002-04. Low interest rates encouraged the search for higher yield and consequently created large global imbalances. Coupling this environment with other factors such as lax lending standards, excessive leverage and underpricing of risk led to a crisis that quickly spread to global financial markets. In the case of India, there was no direct impact from the crisis as India had little exposure to toxic assets that afflicted Western countries’ financial institutions and foreign banks’ presence in India is circumscribed. However, following the Lehman failure, there was a dramatic change in the external environment, which caused capital outflows from India in late 2008 requiring urgent fiscal and monetary policy responses. India has weathered the storm relatively well compared to other countries. It is therefore important to understand why this was the case. Dynamic provisioning by the banking system provided buffers against negative shocks and strong balance sheets with transparency in bank operations prevented any crisis in inter-bank money markets or the banking system as a whole. Additionally, India’s approach to a gradual opening of the capital account and financial sector proved to be beneficial in shielding the financial system from drastic external shocks. The Reserve Bank of India has therefore taken both monetary and regulatory actions to prevent and contain the impact of the global financial crisis. As the debate now turns towards designing regulation of the financial system to maintain financial stability, we should also consider what can be learned from India’s approach of preemptive policy towards large volatility in capital flows and imbalances and in financial regulation