Shyamala Gopinath: Lessons for financial policymaking - interpreting
the dilemmas
Inaugural address by Ms Shyamala Gopinath, Deputy Governor of the Reserve Bank of
India, at the 10th FIMMDA-PDAI Annual Conference, Mumbai, 3 March 2009.
Assistance provided by Vaibhav Chaturvedi in preparation of the speech is gratefully acknowledged.
* * *
I was really struggling to select a theme for today's address. I intended it to be relevant but
not repetitive, comprehensive but not broad brush, having a policymaker's perspective but
not too uni-dimensional. Finally the theme I zeroed down on emerged out of this very
exercise of the balancing act - the dilemmas and conflicts thrown up for the policymakers by
the paradoxical character of recent turn of events in the global financial markets. It is rather
surprising for a crisis of this magnitude not to give clear directions for the future. Yes, there is
now a generally accepted sequence of events and the reasons for this crisis are well
understood. Also the global nature of the crisis in which all the advanced economies have
been impacted is striking. The failure of market discipline and self regulation is also apparent.
We already have the report on a framework for financial stability by the Group of Thirty, the
High Level Group on Financial Supervision in EU, and the G-20 has set up several working
groups. While some involve action that can be considered in the immediate future most
recommendations are long-term in nature since the priority now is to stabilize financial
markets and support growth and mitigate the consequences of the fall-out. It is quite possible
that the financial system post-crisis will be different from the one existing before the crisis.
However, the inherent paradoxes could constrain a fundamental breakout from the existing
framework. Importantly, implementation of longer term measures is dependent on the
outcomes of the responses to the present crisis. I intend to touch upon some of these
paradoxes which are also relevant in our context.
Prudential regulatory framework - limitations of the current capital centric approach
Since 1999, the predominant focus of the international supervisory community has been the
formulation and implementation of the Basel II framework. The assumptions underlying the
new framework were that the financial systems had become extremely sophisticated and
banks had in place strong risk management systems and therefore, it was possible to have a
capital adequacy framework which is based on the Internal Ratings Based (IRB) models
rather than a set of uniform risk weights, as was the case with Basel 1 regime. Similarly,
where the banks did not have such risk management systems in place, it could be based on
external credit ratings. The expectation was that under this framework, capital will get more
responsive to the risk profile of a bank. The current crisis, however, has called into question
the assumptions about the efficacy of internal risk management systems and a serious
failure of risk governance systems has been amply evident. Moreover, model-based risk
assessments underestimated the exposure to common shocks and tail risks and thereby the
overall risk exposure. Furthermore, banks were found to be indulging in regulatory arbitrage
and through off-balance sheet vehicles, expanded their business significantly without
maintaining capital, even though the risks were not entirely hived off and continued to remain
with the bank.
Almost all the prognostic analyses/reports on the crisis agree that current financial
regulations tend to encourage pro-cyclical risk taking which increases both the likelihood as
well as accentuates the severity of financial crises. One suggestion is to establish capital
benchmarks as a broad range, rather than as a point prescription, within which capital ratios
should be managed. The supervisory expectation should be that when markets are in an
upturn and there is a tendency to under price the risks, banks should operate at the upper
end of the range. A simpler alternative could be to tighten capital requirements during good
times and reduce them in downturns without actually specifying a range but working through
the Supervisory Review Process under Pillar 2 of Basel II Framework. In effect, it would
mean building up capital buffers in good times for using them when needed.
Dynamic provisioning
Simultaneously it may be necessary to adopt counter cyclical provisioning measures. The
case of Spain has been widely quoted, which introduced across the board increase in
provisioning requirements, the dynamic provisioning approach. This is based on the premise
that loans given at the top of the cycle tend to have higher losses as the cycle turns. In
downturns defaults tend to emerge requiring more provisions. Banks should therefore be
required to set aside a general provision against likely future loss each time they write a loan
on the basis of a formula which is sensitive to the cycle. This being an accounting provision,
would have the effect of reducing the distributable profits, and will thereby constrain the
dividends and profit-linked bonuses. These provisions could then be drawn down
automatically as losses appear. In effect, this approach requires banks to build up reserves
in the upswing of a cycle which can cushion their losses during the downswing.
We, in India, also adopted a similar approach through a calibrated increase in the risk
weights and provisioning requirements during the period of rapid credit growth. However, the
important difference was that our approach entailed sector-specific prescriptions. The
objective was not so much to lean against the wind of rising asset prices but as a cautionary
measure to contain the exposure of the banking sector to sensitive asset classes where rapid
credit expansion was observed. It is commonly agreed now that the monetary authorities
can't avoid creation of bubbles by targeting asset prices. However, they should communicate
their concerns on the sustainability of strong increase in asset prices and contribute to a
more objective assessment of systemic risks.
However, this is where there is a tension between the regulatory approach and the
accounting rule makers who, view such counter-cyclical measures as being liable to be
misused for profit smoothening and find it against their basic principles of transparency and
reporting plain economic reality. According to the critics, dynamic provisioning is a form of
"cookie-jar accounting" and has the potential for misuse. Earnings management of an entity
is not something which is acceptable to the accounting profession since there have been
accounting frauds which involved cookie jars. A solution that is being considered for
resolving this tension is to add a separate line, further down the balance sheet into
shareholders' equity instead. The envisaged counter-cyclical provisions will, therefore, be
made after the net profit has been arrived at and will be in the nature of an appropriation of
profits. This would be called something like "undistributable reserves" and to my mind, should
also not be allowed to be included in regulatory capital - even though the general provisions
are allowed to be treated as a part of Tier II capital, subject to the prescribed caps.
Going beyond "capital"
As you are aware, over the years, the definition of "regulatory capital" of banks has gradually
widened to include certain innovative and hybrid forms of capital also. For instance, besides
the Tier I capital, banks are allowed to treat their external liabilities, meeting certain well
defined criteria, as part of Tier II capital. A portion of capital towards securities business is
also allowed in certain countries to be maintained as Tier III capital. The expectation was that
yields on subordinated debt would reflect the perceived strength of the bank and would,
therefore, function as an instrument of market discipline. Clearly, these expectations have
not been met.
In the medium term, therefore, what may also need to be relooked into is the interpretation of
the term "regulatory capital". When there are attempts to stress test the banks' balance
sheets, the focus is on the tangible networth, which is the purest form of capital. The crisis,
therefore, provides us an impetus to review the permissibility of hybrid/ innovative forms of
capital instruments and the extent to which these should be allowed as a component of the
banks' regulatory capital and greater emphasis has to be given to maintenance of Core
capital.
Another important instrument to contain excessive leverage during an upswing is to introduce
a "leverage ratio", in addition to the risk weighted capital ratio, covering both, the on-balance
sheet assets and off balance sheet items. This practice is already in vogue in certain
jurisdictions.
A more fundamental issue with a capital-centric approach of bank regulation is that even the
most well capitalised banks have been found to have been caught up in the crisis spiral due
to massive and immediate demands on liquidity. The capital buffers are of virtually no
assistance in such times and what matters is the liquidity of the assets held by the bank and
the nature of its interconnected dealings with other institutions. One view is that the financial
regulator could give up its strong focus on capital adequacy alone in favor of a broader
approach, which should encompass liquidity as a major determinant of the soundness of the
financial system. It is, however, preferable to consider counter-cyclical liquidity requirements
along with capital requirements. A proposal is to require banks to hold a varying proportion of
their assets in a war-chest of government bonds and other highly liquid assets or there
should be certain constraints on the extent to which they are allowed to tap wholesale funds.
The overall framework should ensure availability of ample liquidity even in stressed
conditions. This must include an assessment of the potential externalities across institutions.
It is gratifying to note that the significance of the age-old SLR requirement in India and the
ceiling prescribed on the inter-bank liabilities a few years ago is now getting recognised
internationally, in the wake of the crisis.
It is important to note that while the gains of financial stability are not easily quantifiable nor
its beneficiaries can be easily identified, the costs of regulation are much more obvious and
transparent. Hence, crises that had been obviated are imperceptible and the demand for
prudential regulations declines during prolonged good times, thereby increasing the ultimate
cost of eventual crises.
Micro and macro prudential supervision
The framework for regulating the financial sector has traditionally been built on a
microprudential foundation, where the primary objective is to limit the risk of financial distress
of individual financial institutions. This approach is consistent with the objective of protecting
depositor's interest and the integrity of the payments system. In contrast, the objective of
macroprudential oversight is to limit systemic risk. It is not only important to consider the risk
of distress of an individual bank but the aggregate risks of all interconnected entities entities
in the system. Hence, there is a need to evolve an appropriate mix of the micro-prudential
regulations within an overarching macro-prudential framework.
One of the lessons of the current crisis is that regulators need to understand the signals and
identify appropriate tools to mitigate the build-up of systemic financial vulnerabilities more
effectively. While financial stability reports did make such analysis particularly relating to the
excess leverage and the under pricing of risk, such analysis was not translated into action in
view of the seemingly benign environment and confidence in risk management system,
market discipline and self regulation.
A challenge for policymakers is to achieve the appropriate balance between the
microprudential and macroprudential approaches to financial sector oversight. The micro
prudential approach is bottom up while the macro approach is top down. In the case of the
banking sector the macro prudential analysis is based on both back ward looking indicators
such as balance sheet profitability asset quality and capital adequacy as well as forward
looking indicators which identify major risk facing the banking sector. Several MPIs are
constructed to summarise the available quantitative information covering competitive
conditions in the banking sector, credit growth, asset market developments and the
concentration of risks in the household and corporate sector.
Unregulated nodes in the financial architecture
The global financial system over the years has evolved into a huge behemoth with strikingly
monolithic characteristics and close inter-linkages. The innovations in financial products and
technology have also enabled the market players to acquire a variety of risk exposures,
transcending their customary role definitions. Furthermore, the regulation of investment
banks did not cover prudential oversight and they were allowed to build up excessive
leverage. There was clear dichotomy here between the homogeneous financial profiles of
various entities and the regulatory prescriptions they were subjected to. Besides, there were
also economic agents in the system which did not attract any regulations or were only
nominally regulated but were active players in the system. These dimensions was sharply
brought to the fore by the inability of international regulators to even assess the extent of
exposure of major entities and distribution of risk in the system through the chain of
interlinkages, during the initial period of the crisis.
It is therefore not surprising that regulation of hitherto unregulated entities has been one of
the key recommendations of many committees. The G-20 has called for a review of the
scope of financial regulation. The November 15th communiqué referred to special emphasis
on institutions instruments and markets that are currently unregulated along with ensuring
that all systemically important institutions are appropriately regulated. In regard to
sponsorship and management of comingled private pools of capital, the Group of Thirty has
suggested that they should ordinarily be prohibited and large proprietary trading should be
limited by strict capital and liquidity requirements. The Group has noted that "...the increased
emphasis on financial stability in the mandates of prudential regulators and central banks
points to the need for greater, more systemic access to information crucial to understanding
the potential for growing risk imbalances in the system." The High Level Group on Financial
Supervision in the EU has suggested application of appropriate regulation in a proportionate
manner to all firms or entities conducting financial activities which may have a systemic
impact. These include hedge funds investment banks, various off balance sheet items etc.
Also that increased capital should be required for proprietary trading activities.
Dealing with cross-border issues
This leads us to the more complex issue of regulation and supervision of large complex
financial conglomerates. It is even more challenging in the event of crisis resolution,
especially for cross-border institutions. Experience has shown that the resolution of a crisis of
a cross border nature is further complicated by a mismatch between the global nature of
some financial institutions that operate in several jurisdictions and the national nature of
solvency.
While developing harmonised insolvency regimes governing the resolution of large
crossborder financial firms and remedial action frameworks would be desirable, the challenge is
the responsibility of the national regulator to protect depositors and other creditors within its
jurisdiction. While the crisis has seen a high degree of international cooperation, increasingly
national regulators may look to ensuring that foreign entities maintain adequate liquidity and
capital within their jurisdiction to protect domestic investors.
Does a central clearing counterparty reduce counterparty risk?
Counterparty risk became one of the key factors contributing to the clogging of financial
markets as risk aversion increased globally. This was particularly evident in case of longer
maturity derivative contracts in the OTC market. Coupled with the non-transparent nature of
the OTC markets which made the exact assessment of positions and exposures of various
parties through maze of interconnected chains impossible, this shifted the preference for
more standardized simple products to be traded on exchanges. Even where products are
traded in OTC markets such as the CDS, there is a move already in US and Europe to move
the CDS markets to the clearing houses - various models are being debated including
central clearing vis-à-vis mere centralized settlement. Since the central counterparty, by
definition, interposes itself in any transaction settled through it, the counterparty in any
transaction cleared by a CCP would not be another market participant but the CCP itself. The
key advantage of the CCP mechanism is the possibility of multilateral netting, which reduces
counterparty risk for each member of the CCP, by reducing the net credit exposure.
However, the creation of a CCP means that the counterparty risk is now concentrated in a
single agent, the clearing house. A universal acceptance of CCP model for everything will
result in the concentration of risks at one point, which will become the single point of failure
for market stability. In case of exchange traded products, there is also the issue of legal
separation between the exchange and the CCP. Obviously then, the CCP has to be a highly
regulated entity. The regulatory focus would be on the overall risk management systems in
place, including the margining system and the nature and quality of collateral held by the
CCP as part of the settlement guarantee fund. From a systemic perspective also, this will be
a critical issue since in crisis times, these will need to be invoked/liquidated. The implications
of unwinding such collaterals on the market will be critical.
Even in term of effectiveness of the CCP in reducing exposures, a recent paper concludes
that introducing a CCP for a particular asset class is helpful if the number of dealers is
sufficiently large relative to the exposure-weighted number of other asset classes that
continue to be bilaterally netted; for plausible cases, adding a CCP for one class of
derivatives such as credit default swaps (CDS) can actually reduce netting efficiency and
thereby lead to an increase in collateral demands and average exposure to counterparty
default.1
As the participants are aware, the Reserve Bank has favored a CCP model for settlement of
forex and government securities trade and intend to extend this to OTC interest rate swaps
and forwards.
Systemic risk measurement
Like any other risk category, the first step towards regulating systemic risk is to identify its
source and measure it. The most popular measure of risk for individual institutions, the VaR
has been severely tested. Like many other financial models, the VaR model essentially
hinges on the estimation of correlations between different assets and risk factors, which have
to put it, simply have just broken down. There are already problems with this institution
specific framework. How do we go to the next level of "systemic risk"? How do we define how
much a particular firm contributes to systemic risk?
Some recent proposals attempt to incorporate systemic risk into the standard VaR measures.
For instance, the Geneva report argues for CoVaR, based on the work of Adrian and
Brunnermeier (2008), where CoVaR is the VaR of financial institutions conditional on other
institutions being in distress. Another report by the New York University (Stern School of
Business) proposes a systemic capital requirement based on the individual firm's contribution
to aggregate tail risk. The problem with such solutions is that they attempt to give clean
solutions to complex problems - their simplicity becomes their undoing.
Besides VaR, stress testing was another pillar on which the risk management framework at
the banks rested. The stress tests were specifically intended to capture the tail risks, which
were not captured by the VaR models. Here also, as with other models, the undoing was in
the inputting the stress parameters which were conditioned by the prevailing perceptions of
future risks and price movements. The more fundamental issue here, I feel, was the absence
of a robust correspondence between the results of these stress tests and the response of the
institutions thereto. The incentive structures and competitive forces prevented concrete
action on adverse findings from the stress tests. Therefore such adverse scenarios would
need to be captured again under the Pillar 2 process, in the capital requirements or the
liquidity requirements, which carry huge costs. Ideally, the response has to come from within
the institutions in the form of realignment of business focus, which I realize is not a feasible
model to bank upon given the breakdown of self regulation. The supervisory review
processes are meant to address such institution specific issues and still seem to be the best
bet going forward.
Centrality of market prices
"Market prices cannot save us from market failures." I have borrowed that phrase from one of
the commentaries of Avinash Persaud, who has been one of the most vocal critics of reliance
on "market prices" for regulatory and accounting frameworks. The inherent paradox is quite
appealing and intuitive. The response of the regulated entity and the regulatory prescriptions
to price movements in prices is standard and symmetric. The issues of reliability of "market
prices" apart, where does the cycle get broken?
The well functioning deep and liquid financial markets were supposed to reflect the "true"
price of a financial instrument, close to the theoretical, model dictated values. However, in
reality, the market prices were determined as much by the funding positions of the market
makers. This in turn, as it turned out, was critically driven by (i) the availability of systemic
liquidity and well oiled money markets globally and (ii) the till then taken for granted,
readiness of counterparties to extend funding - the counterparty credit risk. If it is these
externalities which determine the "market prices", the issue is how to filter out these
components?
It will be a real challenge for the regulators to find ways to address these issues, given that
market prices will continue to be at the heart of the regulatory framework.
Accounting framework
The dilemma for the accounting policymakers is to push for a harmonised set of guidelines
for all economic entities vis-à-vis the differential approach demanded in certain cases by the
prudential requirements.
The present accounting approach is indifferent to the inter-temporal financial impacts of
individual transactions as long as the net impact is accounted for over a period. From an
accounting perspective, this may make sense but it does not recognise the incentive
structure it induces in the conduct of business operations, which may not be healthy for the
system as a whole. Ideally, accounting conventions need to be neutral with respect to the
behaviour of financial players and market dynamics. While it is true that accounting can't
capture future risks, the treatment of gains attributable to the future risks needs to address
this aspect.
A related issue, from the financial stability perspective, is the extent of discretion the
principles-based accounting framework provides the business entities in deciding the nature
of each financial instrument. This could result in furthering a certain kind of herd behaviour
among all the businesses depending on the phase of business cycle.
Reliance on ratings
The rating agencies have already received their share of blame for the crisis. That's the
easier part; the difficult part is to find viable alternatives - the rating agencies were part of a
big machine that was working well as long as the going was good. Obviously, any alternative
framework has to be in sync with the changed realities of the market. Its will not be possible
to think of any changes in this regard in isolation. At a fundamental level, what needs to
change, and hopefully will change, is an understanding about what the ratings convey. What
needs to change is an understanding of the difference between a AAA bond and a AAA CDO
tranche. Here, more than the rating agencies, the responsibility will lie on the regulators to
capture the differential risk characteristics of various instruments, even though identically
rated, in a very specific manner in their prescriptions. Uniform capital requirements just
based on credit ratings will need to be replaced by a more granular and nuanced regulatory
approach.
Financial innovation
Much of the development in the financial sector internationally over the past couple of
decades or so owes much to the open spirit of financial innovation. The recent turn of events,
I would say, can be attributed more to the way the financial industry functions, given the
underlying regulatory and the incentive structures, rather than on financial innovation, per se.
The risk-return payoff in the financial sector is quite different than any other sector. The only
blame I would put on the model-centric financial innovations was the false sense of certainty
and comfort they provided to not merely those who did not understand the black boxes but
even the institutional investors and rating agencies. The critical element of judgement while
interpreting and applying the models was found wanting. I am sure lessons would be learnt in
this regard.
Conclusion
The financial system in India has been resilient in these trying times. Whatever fault points
have been felt in the recent months do not owe their origin within the financial sector. As
Governor Dr. Subbarao has aptly remarked in one of his speeches, Indian experience has
been different in the sense that the strain in the real sector got transmitted to the financial
sector unlike the other countries where it was the other way round. It is only thorough a
constant process of mutual consultation between the market participants and the RBI that we
will ride the difficult period. Going forward, the test for further market development will be
based on an assessment of not only implications for an individual institution - micro
prudential but also implications for systemic risks.
References
1. Report of The High Level Group on Financial Supervision in the EU, February
25, 2009.
2. Financial Reform: A Framework for Financial Stability, Group of Thirty, January
15, 2009.
3. Declaration: Summit on Financial Markets and the World Economy, G-20,
November 15, 2008.
4. Asset price bubbles: implications for monetary, regulatory and international
policies, Speech by the Governor Bank of Spain, February 24, 2002.