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Banks have also been extending credit for investment in the asset market. Like many other EMEs, asset prices in India have also risen sharply in the last couple of years. Should there be reversal of capital flows, asset prices may decline sharply exposing the banks' balance sheets to credit risk. There is a risk that rise in interest rates in general could impact housing prices and expose the balance sheet of the households to interest rate risk, leading to some loan losses for banks. The overall banking sector's exposure to housing loans is relatively small and may not have serious systemic implications.

Likewise, the equity market has also seen a sustained uptrend. Reversal of capital flows could impact the equity market and some of the advances extended for investments in the equity market might turn non-performing. Again, Indian banks do not have large exposure in the asset market though, in the recent past, it has been increasing. Decline in asset prices could cause loan losses and capital losses, if the decline is significant, though the impact on banks' balance sheets might be muted, given their small exposure to the asset market.

The most significant impact on banks' balance sheet, however, could be felt through their investment portfolio. Banks in India hold substantial investments in Government and other fixed income securities. Such investments amounted to US $ 173 billion, constituting 35.1 per cent of their total assets as on September 16, 2005. To the extent a rise in international interest rates impacts the domestic interest rates, it would entail marked-to-market losses on the investment portfolios.

The banking sector, however, has acquired some added strength to absorb such probable shocks, largely aided by regulatory actions. Apart from having built up a significant capital base reflected in the capital to risk-weighted assets ratio (CRAR) for the sector of 12%, specific steps have been taken to meet the interest rate risk. First, separate provision for capital against market risk has been introduced. Second, a gradual building up of Investment

Fluctuation Reserve up to 5% of the marked-to-market portfolio (out of tax-free profits) by March 2006 has been mandated, and several banks have already achieved the target. Third, an enabling risk management environment has been provided to banks to hedge their risks through vanilla derivative instruments. Fourth, Conservative accounting norms followed did not allow banks to book unrealized gains. Fifth, as a one time measure, banks were allowed to transfer securities to HTM, after booking the MTM losses against these. Thus, banks in India, in general, have the resilience to withstand some rise in interest rates.

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