The Reserve Bank of India has hinted at the use of prudential measures to regulate the exposure of entities such as banks, non-banking finance companies and financial institutions to asset price cycles to strengthen the overall financial stability framework.

The central bank's comment is significant as it had, in its first quarter review of macroeconomic and monetary developments last month, expressed concern about the sustained and rapid rise in housing prices over successive quarters from the standpoint of their possible spill-over to demand pressures and the general price level.

Then, it also alluded to increasing uncertainties and corrections in domestic stock prices.

Bankers say the prudential measures that the RBI could resort to, could include upping risk weights and stepping up provision coverage so that credit becomes costly to sectors where credit is growing fast and the risk of default is high.

Stability framework

Referring to the persisting ambiguity about the role of monetary policy in relation to asset prices even after the global crisis, the RBI, in its annual report for 2009-10, said the use of prudential measures to regulate the exposure of regulated entities to asset price cycles could help strengthen the overall stability framework, even though volatility in asset prices may still persist.

The financial stability goal will require use of a combination of instruments involving regulation, supervision and monetary/macroeconomic policies to enhance the effectiveness of crisis prevention, the report said.

The central bank pointed out that monetary policy, in pursuing the growth objective, may remain accommodative for an extended period at times, which in turn could fuel credit and asset bubbles and thereby jeopardise the financial stability goal.

Similarly, the use of fiscal stimulus to limit the adverse real effects of a financial crisis could at times give rise to a fiscal crisis, which in turn could be a source of instability for the financial system.

Financial stability

Hence, in the process of balancing inflation and growth considerations in the conduct of macroeconomic policies, the RBI said financial stability has become a critical component which would add complexity to policy formulation.