Y V Reddy: Global financial turbulence and the financial sector in India -
a practitioner's perspective
Address by Dr Y V Reddy, Governor of the Reserve Bank of India, at the Meeting of the Task
Force on Financial Markets Regulation, organized by the Initiative for Policy Dialogue,
Manchester, United Kingdom, 1 July 2008.
* * *
Madam Chairperson, Governor Williams, and friends,
At the outset I would like to thank The Initiative for Policy Dialogue, and Professors Stiglitz,
Griffith-Jones, and Ocampo for providing me this opportunity to participate and incidentally
share my thoughts on the recent developments in the global financial markets and its
implications for both the developing and the developed countries. My presentation will initially
provide a broad overview of the global developments and then move on to briefly list the
aspects of market and regulatory failures which characterised the recent developments. I will
then lay down the broad contours of the financial sector policies in India, with the details of a
few specific initiatives relevant to financial stability. The concluding remarks will be in the
nature of a few broad issues for further debate.
I. Global financial markets
Recent developments
While the trigger for the global developments in the financial markets during the recent past
was the rising default rates on sub-prime mortgages in the US, the source of the problem
was perhaps not the macro-global imbalances but significant mispricing of risks in the
financial system. Easy monetary policy in major financial centres, globalisation of liquidity
flows, wide-spread use of highly complex structured debt instruments and the inadequacy of
banking supervision in coping with financial innovations, contributed to the severity of the
crisis. The persistent under pricing of risks was suspected by several central banks for quite
some time, but it was felt by many that these risks were widely dispersed through financial
innovation and that they would not pose any serious problems to the banking system. When
the sub-prime crisis did occur, however, it triggered a wide contagion affecting many of the
large global financial institutions. Banks, in particular, appear to have ceased to trust each
other's creditworthiness leading to difficulties in the money markets in the US, Europe and
the UK resulting in drying up of liquidity, since each financial institution attempted to shore up
its own liquidity to meet its obligations. The problems of maturity mismatch in the conduits or
structured investment vehicles (SIVs) created by the banks for purposes of securitisation
manifested themselves in a sudden spurt in demand for liquidity from banks to meet their
liquidity support obligations to the SIVs or to fund the assets of the SIVs that were taken on
to their balance sheets. It is now realised that the relevant banks have leveraged excessively
and had not fully recognised the risks or had seriously underpriced them, thus warranting
large capital infusion. Uncertainty about the possible losses yet to be disclosed by several of
them has not yet ceased.
These developments have brought forward several new realities that pose severe challenges
to macro-economic management, in particular to monetary and regulatory policies globally.
First, concerns relating to the US slowdown and its intensity have mounted in view of the
potential spill over on to the global economy. Second, threats to the global economy are
emanating from advanced economies in sharp contrast to earlier crises which stemmed from
the emerging world. Third, there are indications that protectionist tendencies have increased
around the world in anticipation of the growing possibilities of slower growth in advanced
economies. Fourth, linkages between financial sector developments and the real sector have
become more worrisome than before, with apprehensions that financial turmoil may spill over
to the real sector with adverse implications for employment and growth. With tightening in
lending standards, deterioration in asset quality and deceleration in consumer loan demand,
there are indications that events in the financial markets are beginning to have a persisting
impact on the real economy as well. Fifth, higher and more volatile prices of food, energy and
other commodities have compounded the problem, causing a significant upside bias to
inflation and inflation expectations across the world, complicating the conduct of monetary
policy at a time of severe financial stress. Further, while rising energy prices may be an
exogenous shock for several countries, for the global economy as a whole it is endogenous.
Sixth, terms-of-trade losses due to soaring commodity prices not only reduce the capacity of
a re-balancing of the world economy but also impact several countries in different ways but
essentially in an adverse fashion. In fact, it is possible that new global economic imbalances
are emerging on account of large movements in commodity prices, especially oil. Seventh,
Emerging Market Economies (EMEs) are exhibiting resilience until now in the face of the
global financial turmoil reflecting relatively stronger macroeconomic framework and
sustainable macroeconomic balances. However, until how long and to what extent it will
persist is uncertain. On the other hand, inflationary pressures appear to be common to
mature economies and EMEs but the latter are under greater stress.
The central banks in major countries have had to take recourse, in appropriate mix, to three
instruments to avoid serious spill-over of these issues in money or credit markets into the
wider economy: (i) adjustment of interest rates for borrowing and lending; (ii) money market
operations designed to inject special liquidity in order to avoid a break-down in payment
systems among banks, and (iii) to put in mechanisms for financial transactions among the
largest of the financial intermediaries which automatically impact the second and third rung
intermediaries. Central banks in major industrialised economies, by and large, responded
with injection of liquidity for a longer period than is usually done; they also resorted to dilution
in the quality of collateral required for liquidity support. Most of these operations have not
been conducted at the penal rates expected in such situations. This is an unprecedented
package which, some observers believe, is indicative of the seriousness of the underlying
problems. In addition, there were some specific-institution oriented operations, namely, in the
United States, Germany and the United Kingdom. While there have been inflationary
pressures in most economies, the USA has been faced with a threat of serious slowdown in
growth warranting a series of cuts in policy rates in recent months.
In recent weeks, concerns over inflationary pressures globally have taken the centre-stage
even while there are no indications as to whether threats to financial stability have been fully
resolved and whether persistent threats of recession in USA have abated. Consequently, the
policy dilemmas have become more acute at the current juncture. The most urgent and
short-term priority for central bankers at the current juncture seems to be to calm the nerves
about inflation or to anchor inflation expectations, with an implicit recognition that a
somewhat elevated headline inflation in the short-term may be difficult to avoid. Further, high
inflation rates when accompanied by higher variability of inflation, raises greater
uncertainties. These acute policy dilemmas at the current juncture between growth and
inflation have to be faced in the background of financial turbulence which is yet to calm
down. There are also calls for fundamental re-think on macro-economic, monetary and
financial sector policies to meet the new challenges and realities, which perhaps represent a
structural shift in the international financial architecture demanding potentially enhanced
degree of coordination among monetary authorities and regulators. A review of the policies
relating to financial regulation, in a way, needs to address both the acute policy dilemmas in
the short run and a fundamental re-think on broader frameworks of financial and economic
policies over the medium-term.
Market failures
What are some of the identifiable sources of market failures that led to the current financial
turbulence?
First, the prolonged benign macroeconomic conditions gave rise to complacency among
many market participants and led to an erosion of sound practices, resulting in adoption of
poor credit risk appraisal standards.
Second, some of the standard risk management tools and models used by market
participants were not equipped to estimate the potential impact of adverse events for
structured credit products and high uncertainty around model estimates that largely missed
the underlying combination of risks. Further, these risk models, generally tended to induce
the market participants to adopt a unidirectional approach.
Third, many investors, including institutional ones, with the capacity to undertake their own
credit analysis, did not undertake sufficient in-house examination of the risks in the assets
underlying structured investments.
Fourth, the role of credit rating agencies (CRAs) in the recent market developments has
attracted attention.
Fifth, the distortions in incentive structures can be seen from various perspectives namely
incentives for originators, arrangers, distributors and managers in the originate-to-distribute
model; the compensation schemes in financial institutions not distinguishing between
realised and unrealised profits; encouraging financial structures tailored to obtaining high
ratings etc.
Sixth, weaknesses in public disclosures by financial institutions on the type and magnitude of
risks associated with their on- and off-balance sheet exposures are noticeable.
Seventh, large commercial banks and investment banks have assumed increasingly similar
risk profiles, use similar models to assess and are subject to the same risk-management
challenges under the given circumstances.
Eighth, there is a new dimension to bank liquidity, with the shifting emphasis to a market
based wholesale or purchased liabilities. This makes banks increasingly dependent on the
market for raising liquidity, while markets may have a tendency to shy away from providing
liquidity when they are most needed.
Regulatory shortcomings
While the foregoing brings out the failures of the markets and of the market participants,
some of the regulatory shortcomings identified are as follows.
First, the regulators recognised some of the underlying vulnerabilities in the financial sector
but failed to take effective action, partly because they may have overestimated the strength
and resilience of the financial system or they assumed that the risks were well distributed
among entities outside the banking system. Many analysts and policymakers had raised
concerns about excessive risk taking, loose underwriting standards, and asset
overvaluations, all of which have in the absence of timely effective actions laid the seeds for
crises.
Second, the limitations in regulatory arrangements, including the capital adequacy
framework, contributed to the growth of unregulated exposures, excessive risk-taking and
weak liquidity risk management.
Third, weaknesses in the application of accounting standards and the shortcomings
associated with the valuation and financial reporting of structured products played a
significant role in the current turbulence through pro-cyclical valuations and lack of full
disclosure of banks' true risk profile through the cycle.
Fourth, the crisis revealed the need to adapt some of the tools and practices of central banks
to manage system liquidity in the light of banks' cross-border operations. The recent
experiences have highlighted the differences in emergency liquidity frameworks of central
banks, on aspects such as range of collateral, range of eligible counterparties; and the
differences in central bank practices.
Fifth, supervisors did not adequately address deterioration in risk management standards in
the regulated entities, which did not fully reckon the risks associated with new financial
instruments, and there were shortcomings in consolidated supervision.
Sixth, deficiencies in crisis management and bank resolution frameworks, including deposit
insurance, have been observed, especially where central banks do not have a central
supervisory role.
Seventh, the complex inter-relationship between regulation, the inappropriate accounting
practices, and regulators' excessive dependence on external ratings may have exacerbated
the market turbulence.
Menu of solutions
The above underlying factors clearly demonstrate a need to enhance the resilience of the
global system and consider some of the prescriptions that have been proffered for the
consideration of the policy makers. The recent developments in the global financial markets
have been closely followed by many. These include market participants, central bankers,
supervisors, multilateral institutions, political leaders, analysts, academicians, and also the
layman. With so much attention being focused on the ongoing turbulence, by so many
stakeholders, we have a wide menu of solutions and prescriptions. I will quickly run-through
some of these.
First, risk management frameworks including the governance arrangements in banks and
financial institutions need to be reviewed by the managements in the light of the recent
experiences.
Second, supervisors need to play a more active role in scrutinizing the risk management
practices, including stress testing and governance arrangements, off balance sheet entities
and structured products.. At the same time, it is crucial to recognize that risk management
cannot be achieved solely by regulation. Consolidated supervision and prudential reporting
should be applied to off balance sheet entities associated with financial institutions and to
loans sold with implicit or explicit recourse. There is a need to review the prudential norms
linked to external ratings assigned by the CRAs.
Third, supervisors should encourage institutions to develop more robust models which use
more prudent and reliable assumptions and stress testing methodologies; and monitor more
closely the internal processes, and controls for managing risk.
Fourth, there is a need to rationalise the regulatory and supervisory prescriptions with a view
to reducing the scope for arbitraging. This also calls for closer coordination of the relevant
supervisors / supervisory arms.
Fifth, it is necessary to correct the imbalances in the incentive mechanisms at various levels.
Sixth, greater transparency is not only necessary to make the markets more efficient and to
optimise the allocation of capital, but it is also considered to be the best insurance policy
against irrational herd behaviour and unjustified contagion in times of stress.
Seventh, there is a need to collectively review and resolve the element of pro-cyclicality in
prudential regulations, accounting rules, and the attitude of the authorities that tend to apply
these.
Eighth, it is necessary for the CRAs to improve their governance and rating methodologies.
Ninth, arguably it is useful to re-visit the relevant accounting standards and explore the scope
for applying fair value accounting through the cycle so as to mitigate pro-cyclicality.
Tenth, supervisors should have clear authority to intervene at the first sign of weakness,
preferably much before the institution's net worth turns negative.
Finally, deposit insurance systems should aim to limit the likelihood of retail depositor runs in
troubled banks through adequate coverage, and have the capacity to pay depositors quickly.
II. Indian experience
Ensuring financial stability
In contrast to the above global scenario, India has by-and-large been spared of global
financial contagion due to the sub-prime turmoil for a variety of reasons. The credit
derivatives market is in an embryonic stage; the originate-to-distribute model in India is not
comparable to the ones prevailing in advanced markets; there are restrictions on investments
by resident in such products issued abroad; and regulatory guidelines on securitisation do
not permit immediate profit recognition. Financial stability in India has been achieved through
perseverance of prudential policies which prevent institutions from excessive risk taking, and
financial markets from becoming extremely volatile and turbulent. As a result, while there are
orderly conditions in financial markets, the financial institutions, especially banks, reflect
strength and resilience. While supervision is exercised by a quasi-independent Board carved
out of the RBI Board, the interface between regulation and supervision is close in respect of
banks and financial institutions, and on market regulation, a close coordination with other
regulators exists. Let me recount this experience which, in some ways, reflects a policy that
aimed to assure financial stability while maintaining growth momentum at reasonable levels
and giving a high priority to price stability.
Investment portfolio
In the year 2000 the Reserve Bank of India (RBI) conducted a stress test of the banks'
investment portfolio in an increasing interest rate scenario, when the general trend then was
decreasing interest rates. At that time, banks in India were maintaining a surrogate capital
charge for market risk, which was at a variance from the Basel norms. On the basis of the
findings, in order to equip the banking system to be better positioned to meet the adverse
impact of interest rate risk, banks were advised in January 2002 to build up an Investment
Fluctuation Reserve (IFR) within a period of five years. The prudential target for the IFR was
5 per cent of their investments in "Held for Trading" (HFT) and "Available for Sale" (AFS)
categories. Banks were encouraged to build up a higher percentage of IFR up to 10 per cent
of their AFS and HFT investments. This counter-cyclical prudential requirement enabled
banks to absorb some of the adverse impact when interest rates began moving in the
opposite direction in late 2004. Banks have been maintaining capital charge for market risk
as envisaged under the Basel norms since end-March 2006.
The regulatory guidelines in India require banks to classify their investments in three
categories, similar to the international standards. The investments included in the Held to
Maturity (HTM) category was capped at 25 per cent of the total investments and banks are
allowed to carry the investments in the HTM category at cost, subject amortisation of
premium, if any. With the change in the direction of the movement of interest rates in 2004,
the cap on the HTM category was reviewed in the light of the statutory prescriptions (referred
to as statutory liquidity ratio (SLR) in India) requiring banks to mandatorily invest up to 25 per
cent of their Demand and Time Liabilities (DTL) in eligible government securities. In view of
the statutory pre-emption and the long duration of the government securities, banks were
permitted to exceed the limit of 25 per cent of total investments under Held to Maturity (HTM)
category provided the excess comprised only of the SLR securities, and the total SLR
securities held in the HTM category was not more than 25 per cent of their DTL. Such
shifting was allowed at acquisition cost or book value or market value on the date of transfer,
whichever is the least, and the depreciation, if any, on such transfer was required to be fully
provided for. The above transition is consistent with international standards that do not place
any cap on HTM category, and was considered advisable taking into account the statutory
nature of the SLR while ensuring prudence and transparency in valuation on transfer to HTM
category. While the earlier prescription for this category was relatively more conservative, the
changes in September 2004 recognised the dynamic interface with the interest rate cycles
and were counter-cyclical.
Capital adequacy - risk weights
In view of the increase in growth of advances to the real estate sector, banks were advised to
put in place a proper risk management system to contain the risks involved. Banks were also
advised to put in place a system for ensuring proper checking and documentation of related
papers before sanctioning / disbursing of such loans. In June 2005, the RBI advised banks to
have a board mandated policy in respect of their real estate exposure covering exposure
limits, collaterals to be considered, margins to be kept, sanctioning authority/level and sector
to be financed. In view of the rapid increase in loans to the real estate sector raising
concerns about asset quality and the potential systemic risks posed by such exposure, the
risk weight on banks' exposure to commercial real estate was increased from 100 per cent to
125 per cent in July 2005 and further to 150 per cent in April 2006. The risk weights on
housing loans extended by banks to individuals against mortgage of housing properties and
investments in mortgage backed securities (MBS) of housing finance companies (HFCs),
recognised and supervised by National Housing Bank (NHB) were increased from 50 per
cent to 75 per cent in December 2004. However, on a review, banks were advised to reduce
the risk weight in respect of exposures arising out of housing loans up to Rs.30 lakh (USD
75,000 approx) to individuals against the mortgage of residential housing properties from 75
per cent to 50 per cent, in view of the lower perception of risks in these exposures.
In the light of the strong growth of consumer credit and the volatility in the capital markets, it
was felt that the quality of lending could suffer during the phase of rapid expansion. Hence,
as a counter cyclical measure, we increased the risk weight for consumer credit and capital
market exposures from 100 per cent to 125 per cent.
Provisions against standard assets
The prudential norms relating to income recognition, asset classification and provisioning,
introduced during 1992-93 are being continuously monitored and refined to bring them on par
with international best practices. In keeping with this, several measures were initiated in
2005-06. The provisions for standard assets were revised progressively in November 2005,
May 2006 and January 2007, in stages in view of the continued high credit growth in the real
estate sector, personal loans, credit card receivables, and loans and advances qualifying as
capital market exposure and a higher default rate with regard to personal loans and credit
card receivables, which emerged as a matter of concern. The standard assets in the
following categories of loans and advances attract a two per cent provisioning requirement (i)
personal loans (including credit card receivables); (ii) loans and advances qualifying as
capital market exposure; (iii) real estate loans (excluding residential housing loans), and (iv)
loans and advances to systemically important non-deposit accepting non-banking finance
companies (NBFC-ND-SI). In order to ensure continued and adequate availability of credit to
the highly productive sectors of the economy, the provisioning requirement for all other loans
and advances, classified as standard assets was kept unchanged, viz., (i) direct advances to
the agricultural and SME sectors at 0.25 per cent; and (ii) all other loans and advances at 0.4
per cent.
Exposure to Inter-Bank Liability
In order to reduce the extent of concentration of bank's liabilities the RBI had issued
guidelines to banks in March 2007 placing prudential limits on the extent of their Inter-Bank
Liability (IBL) as a proportion of their networth (200%). Those banks which had a higher
capital adequacy ratio of 125% of the regulatory minimum were allowed a higher limit of
300% of networth. In addition, prudential limits have also been placed on the extent to which
banks may access the inter-bank call money market both as a lender and as a borrower.
Financial regulation of systemically important NBFCs and banks' relationship with
them
The RBI has been strengthening the regulatory and supervisory framework for non-banking
finance companies (NBFCs) since 1997 with the objective of making the NBFC sector vibrant
and healthy. The focus was initially on deposit-taking NBFCs. These efforts were pursued
further during 2006-07, when a major thrust was on strengthening the regulatory framework
with regard to systemically important non-banking financial companies so as to reduce the
regulatory gaps. At that time, the regulatory focus was also widened to include systemically
important non-deposit taking NBFCs and prudential norms were specified for these entities.
The application of different levels of regulations to the activities of banks and NBFCs, and
even among different categories of NBFCs, had given rise to some issues relating to uneven
coverage of regulations. Based on the recommendations of an Internal Group and taking into
consideration the feedback received thereon, a revised framework to address the issues
pertaining to the overall regulation of systemically important NBFCs and the relationship
between banks and NBFCs was put in place in December 2006.
Securitisation guidelines
The RBI has issued guidelines on securitisation of standard assets in February 2006. The
guidelines are applicable to banks and financial institutions, including non-banking financial
companies (NBFCs). These guidelines provide for a conservative treatment of securitisation
exposures for capital adequacy purposes, especially in regard to the credit enhancement and
liquidity facilities. The regulatory framework encourages greater participation by third parties
with a view to ensure better governance in the structuring of special purpose vehicles
(SPVs), the products, and the provision of support facilities. A unique feature of these
guidelines, which may be at a variance with the accounting standards, is that any profits on
sale of assets to the SPV are not allowed to be recognised immediately on sale but over the
life of the pass through certificates issued by the SPV. We believe that these guidelines, as a
package, have ensured an appropriate incentive mechanism for securitisation transactions.
Banks' investment in non-SLR securities
RBI had emphasised that banks should observe prudence in order to contain the risk arising
out of their non-SLR (i.e., non government) investment portfolio, in particular through the
private placement route. Detailed prudential guidelines on the subject were issued in June
2001, which were reviewed and revised in November 2003. These guidelines, inter alia,
address aspects of coverage, regulatory requirements, listing and rating requirements, fixing
of prudential limits, internal assessments, role of Boards, disclosures, and trading and
settlement in debt securities. Banks were specifically advised that they should not be solely
guided by the ratings assigned to these securities by the external rating agencies but that
they should do a detailed appraisal as in the case of direct lending.
Marking-to-market
The Indian accounting standards are generally aligned to the International Financial
Reporting Standards, though there are some differences. In India, we are yet to fully adopt
the marking-to-market requirements as available in the international standards. The Indian
standards are relatively conservative and do not permit recognition of unrealised gains in the
profit and loss account or equity, though unrealised losses are required to be accounted.
Banks are required to mark-to-market the investments in the Held for Trading (HFT) and
Available for Sale (AFS) categories at periodical intervals, on a portfolio basis, and provide
for the net losses and ignore the net gains. This has proved to be a stabilising factor,
inasmuch as it has not induced an imbalance in the incentive structures and has also proved
to be less pro-cyclical.
Moral suasion and supervisory review
Moral suasion and public articulation of concerns has helped in achieving a desired
rebalancing of suspected excesses in risk-taking among banks. Some of the areas where
moral suasion has been used are the need for banks to monitor unhedged foreign currency
exposures of their corporate clients, adoption of appropriate incentive mechanisms by banks
for encouraging disclosures of derivative exposures by their corporate clients, banks' reliance
on non-deposit resources to finance assets, their excessive reliance on wholesale deposits
and uncomfortable loan-to-value (LTV) ratios in respect of housing loans etc.
A supervisory review process (SRP) was initiated with select banks having significant
exposure to sensitive sectors, including reliance on call money market, in order to ensure
that effective risk mitigants and sound internal control systems are in place. In the first round,
a framework was developed for monitoring the systemically important individual banks. The
second round of SRP was directed to analyse banks' exposure to sensitive sectors and
identify outliers. Based on the analyses of these outlier banks, guidelines were issued to all
banks indicating the need for better risk management systems in banks at operating levels.
In brief, in India the focus is on regulatory comfort, going beyond regulatory compliance. In a
choice between emphasis of regulations on saving capital and protecting depositors'
interests or reinforcing financial system stability, the latter have always prevailed.
III. Indian experience of financial sector liberalisation and development
It is necessary to clarify that while the measures mentioned above are aimed at fostering
financial stability, in order to enhance efficiency several other initiatives have been taken to
liberalise the macro-policy environment in which banks operate through a re-orientation of
regulatory prescriptions by replacing micro regulations with macro-prudential regulations,
providing an enabling environment for universal banking, improved corporate governance in
private sector banks, and enabling consolidation of banks in the private sector. Some other
important measures that promoted a vibrant and robust operating environment and
framework for the banking system that promoted growth and business opportunities include a
reduction in pre-emption through reserve requirements; shift to market determined pricing for
government securities; disbanding of some of the administered interest rates; auction-based
repos-reverse repos for short-term liquidity management; facilitation of improved payments
and settlement mechanism; setting up of the Clearing Corporation of India Limited (CCIL) to
act as central counter party for facilitating payments and settlement system relating to fixed
income securities, money market instruments and foreign exchange transactions; setting up
of INFINET as the communication backbone for the financial sector; introduction of
Negotiated Dealing System (NDS) for screen-based trading in government securities;
introduction of Real Time Gross Settlement (RTGS) System; debt recovery tribunals, asset
reconstruction companies, settlement advisory committees, corporate debt restructuring
etc.
mechanism, for quicker recovery/ restructuring of stressed assets; promulgation of
Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest
(SARFAESI) Act, 2002 and its subsequent amendment to ensure creditor rights; setting up of
Credit Information Bureau of India Limited (CIBIL) for information sharing on defaulters as
also other borrowers. These growth oriented initiatives have appropriately complemented the
stability oriented initiatives.
Development orientation
In the context of the rapidly evolving financial landscape, the RBI has also been suitably
reorienting its regulatory and supervisory framework to meet the needs of the common man.
It has also been the endeavour of the RBI to improve credit delivery and customer service by
banks. The RBI has simultaneously focussed on financial inclusion and extension of banking
services to the unbanked areas of the economy. The guidelines on lending to the priority
sector included improvement of credit delivery to those sectors of the economy that impact
large segment of the population, the weaker section and to the sectors which are
employment-intensive such as agriculture and tiny and small enterprises. In order to improve
credit delivery to micro and small and medium enterprises (MSMEs), the RBI has urged
banks to review their institutional arrangements for delivering credit to the SME sector,
especially in identified