Duvvuri Subbarao: Post-crisis reforms to banking regulation and
supervision - think global, act local
Inaugural address by Dr D Subbarao, Governor of the Reserve Bank of India, at the
Federation of Indian Chambers of Commerce & Industry-Indian Banks' Association (FICCI-IBA)
Conference on "Global Banking: Paradigm Shift", Mumbai, 7 September 2010.
* * *
1. Thank you very much for inviting me to inaugurate this FICCI-IBA Conference on
"Global Banking: Paradigm
Shift". This Conference is a flagship event in the annual banking
calendar, and I attach a lot of value to this opportunity of speaking to and interacting with the
banking community.
2. When I spoke at this forum last year, I had touched on some of the early lessons of
the global crisis and how they were shaping the debate on reforms to banking regulation and
supervision. Over the last one year, there has been significant progress in crystallizing the
reform agenda and in reaching a shared understanding on most of the measures. The thrust
of the reform package has been to fortify the banking system, correct the incentive
framework and ensure its long term stability. Reflecting one of the big lessons of the crisis
that a collection of healthy banks does not necessarily result in a healthy banking system at
the aggregate level, the reforms focus on both the microprudential dimension at the
individual institution level and the macroprudential dimension at the systemic level.
3. The effort has been led by the Basel Committee on Banking Supervision (BCBS)
which held several meetings and consultations over the last year to define the reform
agenda and to flesh out the individual components. India, as you know, has been a
newly inducted member of the BCBS, and the Reserve Bank has been actively engaged
in the process of crystallizing what has now come to be called Basel III.
4. In July 2010, the BCBS put out a comprehensive paper indicating the broad
agreement reached on the Basel III proposals. Broadly, these reforms will require banks
to hold more and better quality capital and to carry more liquid assets, will limit their
leverage and mandate them to build up capital buffers in good times that can be drawn
down in periods of stress. The Basel III process is not yet complete. In particular, the
actual calibration of the measures and their phasing in is yet to be determined. This will
be done after a further assessment of the reasonableness of these measures and their
impact on banks' balance sheets as well as the national economies.
5. Quite understandably, there has been a lot of international media attention on
the implications of the Basel III proposals and their pros and cons. We have had some of
that in India too focusing on what the proposed reforms might mean for us. I thought the
most efficient way to use this FICCI-IBA platform that you have so kindly provided me is
to highlight the broad contours of the Basel III proposals and their potential implications
for Indian banks. The theme of this conference, "Banking 2020 - Making the Decade's
Promise Come True" is very appropriate as the banking sector needs to evaluate how
best it can contribute to the double digit growth and rapid poverty reduction that we are
aspiring to. Hopefully, the assessment of the Basel III package that I will give will
contribute to a more informed evaluation of the role that banks should play in our growth
process.
6. Let me start by taking each of the major components of the Basel III package.
On each, I will explain what the proposal implies in general and then look at it from an
Indian perspective.
I. Capital adequacy framework - BCBS proposals
Improving quality, consistency and transparency of capital
7. The proposals regarding the capital adequacy framework aim at ensuring that the
quality of capital is high, there is consistency in the definition of capital across various
jurisdictions and that there are appropriate disclosures to make the capital base transparent.
The focus is on making common equity the predominant form of bank capital and to enhance
the loss absorbing capacity of the other elements of regulatory capital. The key changes
include prescription of an explicit minimum Tier I requirement; deduction above a certain
threshold, from common equity, of significant investments in the common shares of
unconsolidated financial institutions and deferred tax assets arising from timing differences
etc.; limiting the recognition of minority interest in group capital to the extent of its share in
the minimum capital required for subsidiary banks; and appropriate disclosure of various
elements of capital.
Improving risk coverage of the Basel II framework
8. The crisis has exposed several flaws in the quantitative risk management models
used by banks. One of the flaws is the inability of the models to capture the market risk in
their trading book positions, particularly under stressed conditions. This is sought to be
corrected by requiring that the capital calculations be made on parameters calibrated to
stressed conditions.
9. The last decade witnessed a quantum jump in the derivatives activities of banks
leading to a phenomenal rise in counterparty credit risk. One of the shortcomings of the
prevailing Basel II framework is that it does not fully capture the unexpected rise in
counterparty exposures under stressed conditions. Besides, during the crisis we saw the
financial condition of counterparties worsen at the same time when they suffered losses on
their derivatives transactions, leading to the so called "wrong way risk". The counterparty
credit risk framework of Basel II is being revised to address these concerns.
Capital adequacy framework: impact on Indian banks
10. Indian banks are not likely to be significantly impacted by the proposed new capital
rules. As on June 30, 2010, the aggregate capital to risk weighted assets ratio of the Indian
banking system stood at 13.4 per cent of which Tier I capital constituted 9.3 per cent.
Although the Basel III norms are yet to be calibrated, it is unlikely that they will be higher than
the above figures. As such, we do not expect our banking system to be significantly stretched
in meeting the proposed new capital rules both in terms of the overall capital requirement
and the quality of capital.
11. Indian banks already make most of the deductions from capital now being proposed
under Basel III. Moreover, our banks do not have re-securitisation exposures and their
trading books are small. However, there may be some negative impact arising from shifting
some deductions from Tier I and Tier II capital to common equity.
12. The proposed changes relating to the counterparty credit risk framework are likely to
have capital adequacy implications for some Indian banks having large OTC bilateral
derivatives positions. This underscores the importance of enlarging the derivatives
transactions coming within the scope of a multilateral settlement mechanism through central
counterparties (CCPs).
II. Containment of financial leverage of banks: BCBS proposals
13. The severity of the downturn during the crisis was accentuated by the excessive
financial leverage of large international banks, typically as high as 50:1. The Basel
Committee's response to containing this excess is the introduction of a leverage ratio which
will be a simple, transparent, non-risk based measure calibrated to act as a credible
supplement and backstop to the risk-based requirements.
Containment of financial leverage of banks - impact on Indian banks
14. Estimates show that the leverage in the Indian banking system is quite moderate. In
the BCBS deliberations, we argued that the SLR portfolio of our banks, which is a regulatory
mandate, should be excluded from the calculation of the leverage ratio as this carries only a
moderate risk (i.e. no credit risk and only market risk). However, BCBS took an in-principle
position that no assets, including cash which obviously has the least risk, should be excluded
from the measurement of the leverage ratio. Nevertheless, since the Tier 1 capital of many
Indian banks is comfortable (more than 8%) and their derivatives activities are also not very
large, we do not expect the leverage ratio to be a binding constraint for Indian banks.
III. Reducing the pro-cyclicality of - financial sector regulation: BCBS proposals
15. Critics contend that a major flaw of the Basel II capital regulations is their inherent
procyclicality. The procyclicality debate came into sharp focus during the crisis. Banks found
themselves constrained in lending by already shrunk capital ratios owing to losses when
more lending would, in fact, have helped in containing the downturn. To minimise the
procyclical effects, BCBS has proposed to: (a) base the calculation of capital on more
conservative estimates of default probabilities, (b) promote more forward looking provisions,
(c) conserve capital to build capital buffers at individual banks and the banking sector that
can be used under stress, and (d) manage system-wide risk by containing excess credit
growth.
16. The concept of making countercyclical provisions and establishing capital buffers
simply implies that banks should build up higher levels of provision and capital in good times
which could be run down in times of economic contraction consistent with safety and
soundness considerations. This will be done by defining buffer ranges above the regulatory
minimum capital requirement. The concept has an intuitive appeal. Operationalizing it though
is a complex task and poses many challenges.
17. The first and foremost challenge is the difficulty of identifying the inflection point in
an economic cycle based on objective and observable criteria which would indicate when to
begin building up a capital buffer and when to start using it. Second, what economic indicator
do we use? It is difficult to identify a single macroeconomic variable that can be a reliable
indicator of both good and bad times. For instance, credit growth could be a good indicator of
the build up phase but credit contraction is usually a lagging indicator of emerging strains in
the system. Third, any approach to creating a capital buffer whose size varies with the
economic cycle poses the challenge of defining an economic cycle in a global setting as
economic cycles are not globally synchronised. Fourth, experience shows that vulnerabilities
build up gradually, often over several years, but distress emerges quite rapidly. Hence, the
capital buffer may have to be released rather abruptly. Fifth, determining the right size of a
capital buffer is both a difficult task and also a contentious issue; it will need to be large
enough to absorb losses in a downturn and still enable banks to continue lending but not so
large as to make the insurance against failure too expensive. Finally, any scheme of capital
buffers needs to be simple and transparent, entail low implementation costs and be as
rulebased as possible. Can we design a framework for reducing procyclicality that meets all
these requirements?
18. BCBS is working on addressing all these issues. It must be recognised though that,
given the different structures and stages of development of financial systems across
countries, it will be absolutely essential to allow national discretion in applying the
"framework".
Reducing the pro-cyclicality of financial - sector regulation: Indian perspective
19. The proposed measures to contain the procyclicality of financial sector regulations
through capital buffers and provisioning will impose additional costs on banks. Apart from the
general concern in this regard, in India we have an additional concern about the variable
used to calibrate the countercyclical capital buffer. The most widely discussed candidate for
this is the credit to GDP ratio. Using the credit GDP ratio is, however, problematic. Unlike in
advanced economies where this ratio is stable, in emerging economies such as India, it will
likely go up for structural reasons - enhanced credit intermediation owing to higher growth as
well as efforts at deepening financial inclusion.
20. In fact, a study undertaken by the Reserve Bank shows that the credit to GDP ratio
has not historically been a good indicator of build up of systemic risk in our banking system.
Furthermore, some economic sectors such as real estate, housing, micro finance and
consumer credit are relatively new in India, and banks have only recently begun financing
them in a big way. The risk build up in such sectors cannot accurately be captured by the
aggregate credit to GDP ratio. We have therefore used sectoral approaches to
countercyclical policies, and I believe we need to continue to use them. To effectively deploy
countercyclical measures, we also need to improve our capabilities to predict business
cycles at the aggregate and sectoral levels, and identify them in real time. This will require
better quality of economic and financial data as well as improved analytical capabilities.
IV. Liquidity risk management: BCBS proposals
21. The financial turmoil highlighted the feedback loops through which institutional
liquidity constraints cascade into systemic solvency crises because of interconnectedness. A
typical chain reaction runs as follows. An institution gets into a liquidity problem, is unable to
tide over that because of a hostile funding environment, indulges in fire sale of its assets to
generate liquidity, incurs losses in the process which makes raising funding even more
difficult and is then forced into further fire sales. This leads to a sharp drop in asset prices
and the pressures transmit rapidly, and then explosively, to other banks and financial
institutions pulling the whole system into a "death spiral".
22. The BCBS proposals involve two regulatory standards for managing liquidity risk:
(i) a Liquidity Coverage Ratio to ensure resilience over the short term; and (ii) a Net Stable
Funding Ratio to promote resilience over the longer term. Reckoning that there is wide
diversity in the measures used by supervisors for monitoring the liquidity risk, the new
proposals also include a set of common liquidity-risk monitoring tools.
Liquidity risk management: Indian perspective
23. The major challenge for banks in India in implementing the liquidity standards is to
develop the capability to collect the relevant data accurately and granularly, and to formulate
and predict the liquidity stress scenarios with reasonable accuracy and consistent with their
own situation. Since our financial markets have not experienced the levels of stress that
advanced country markets have, predicting the appropriate stress scenario is going to be a
complex judgement call.
24. On the positive side, most of our banks follow a retail business model and also have
a substantial amount of liquid assets which should enable them to meet the new standards.
There is an issue about the extent to which statutory holdings of SLR are counted towards
the proposed liquidity ratios. An argument could be made that they should not be counted at
all as they are supposed to be maintained on an ongoing basis. However, it would be
reasonable to treat at least a part of the SLR holdings in calculating the liquidity ratio under
stressed conditions, particularly as these are government bonds against which RBI provides
liquidity.
V. Dealing with systemically important - financial institutions (SIFIs): BCBS
proposals
25. BCBS is engaged in evolving an appropriate framework for dealing with systemically
important banks and financial institutions in the international context. This involves a host of
tasks: development of indicators of systemic risk, identification of systemically important
financial institutions (SIFIs), differential systems for SIFIs by way of capital and liquidity
surcharge and enhanced supervision, improving the capacity to resolve SIFIs without
recourse to taxpayer money, reducing the probability and impact of a SIFI failure,
strengthening the core financial market infrastructure to reduce contagion risks if failure
occurs and improving the oversight of SIFIs.
26. Even if we accept that SIFIs should be subject to some additional regulation on top
of the base level regulations, there are several issues that need to be addressed in fleshing
out the necessary framework. The first issue is of evolving objective criteria for identifying
systemically important institutions. Second, how do we apply the criteria since the systemic
importance of an institution is likely to be time-varying and state-dependent as per the
economic environment? Finally, drawing a sharp distinction between a SIFI and a non-SIFI
requires considerable judgement and has a moral hazard downside.
Containment of systemic risk: Indian perspective
27. The framework for identification of SIFIs that will evolve is expected to be applicable
uniformly to all countries. India will also need to adopt that. The identification under the
BCBS framework will happen from an international perspective, and we need to do a
supplementary exercise to identify SIFIs in the domestic context even if they are not in the
international list. In either case, if the proposal for levying systemic risk capital and liquidity
charge is eventually agreed upon, a few Indian banks may be called upon to maintain
additional capital and liquidity charges.
28. Then there is the issue of resolution of SIFIs in the event of failure. We also need to
promote structures which make such resolutions smooth and orderly. The recent Reserve
Bank initiative to constitute a working group to examine the suitability of financial holding
companies in India is a step in this direction. RBI has also been constantly upgrading the
regulatory and supervisory framework for financial conglomerates. Efforts are also under way
to bring a larger number of financial transactions within the ambit of multilateral settlement
through central counterparties.
VI. Regulation of compensation practices of banks: BCBS proposals
29. It is now widely acknowledged that the flawed incentive framework underlying the
compensation structures in the advanced country banking sectors fuelled the crisis. The
performance-based compensation of bank executives is typically justified on the ground that
banks need to acquire and retain talent. We now know, with the benefit of hindsight, that the
compensation framework overlooked the perverse incentives it would engender. Bank
executives focused too much on short-term profits and compromised long term interests with
disastrous consequences. The Financial Stability Board has since evolved a set of principles
to govern compensation practices and the Basel Committee has developed a methodology
for assessing compliance with these principles. The proposed framework involves increasing
the proportion of variable pay, aligning it with long-term value creation and instituting deferral
and claw-back clauses to offset future losses caused by the executives.
Regulation of compensation practices of banks: Indian perspective
30. Since 70 per cent of our banking sector is accounted for by public sector banks
where compensation is determined by the government, and where the variable component is
very limited, the proposed reform to compensation structures is relevant in India only to the
remaining 30 per cent of the non-public sector industry segment. Private, foreign and local
area banks in India are statutorily required to obtain RBI's regulatory approval for the
remuneration of their whole time directors and chief executive officers. In evaluating these
proposals in respect of Indian banks, Reserve Bank has historically ensured that the
compensation is not excessive, is consistent with industry norms, is aligned to the size of the
bank's business and that the variable pay component is limited. In respect of foreign banks,
the Reserve Bank has largely gone by the recommendation of the bank's head office.
31. However, reflecting the spirit of the global initiative on compensation structures, we
determined that there is need for reform in India too towards aligning compensation
structures to FSB principles. Accordingly, in July 2010, RBI issued draft guidelines on
Compensation of Whole Time Directors/Chief Executive Officers /Risk Takers and Control
Staff inviting public comments. The intent behind the guidelines is to encourage banks to
ensure effective governance of compensation, align the compensation with prudent risk
taking, improve supervisory oversight of compensation and facilitate constructive
engagement by all stakeholders. The guidelines require banks' boards to formulate and
adopt a comprehensive compensation policy covering all employees (risk takers and
control/compliance staff). We have advised that variable pay should be risk aligned, but we
have not proposed any limit on the variable components. As regards foreign banks, we will
require them to submit an annual declaration that their compensation structure in India is in
conformity with FSB principles and standards.
32. As I have said earlier, the remuneration and incentive structure of public sector bank
executives are determined by the Government. The executive compensation in the public
sector, as is well known, is lower than that in the private sector. Notwithstanding the historical
reasons for this, there is perhaps a good reason to revisit this. If public sector banks are
required to compete with private banks on a level playing field, there is a good case for
compensating them too on a competitive base. There is also the risk that if the public sector
bank compensation is not improved, the public sector may lose talent to the private sector.
VII. International financial reporting standards (IFRS): reform proposals
33. In the wake of the crisis, fair value accounting has come in for criticism for its
inadequacy to deal with the typical features of a financial crisis: illiquid markets and distress
sale of assets. It is argued that fair value accounting, no matter that it has logical appeal, is
too rigid for a crisis situation and that it, in fact, fuels a downturn. The G-20 Working Group
on Enhancing Sound Regulation and Strengthening Transparency recommended that the
accounting standards setters and prudential supervisors should work together to identify
solutions that are consistent with the complementary objectives of promoting the stability of
the financial sector and improving the transparency of results in the financial reports.
Accordingly, the IASB has initiated appropriate modifications to the relevant accounting
standards.
International financial reporting standards (IFRS) - Indian perspective
34. For banks in India, the Accounting Standards issued by the Institute of Chartered
Accountants of India (ICAI) together with the prudential regulations of the Reserve Bank
constitute the framework of the "Indian GAAP" (Generally Accepted Accounting Principles).
Given India's growing global integration, the ICAI recognized the need for Indian companies
to converge to global standards in presenting their financial results. The Core Group
appointed by the Ministry of Corporate Affairs (MCA) has since put out phased road maps for
convergence of Indian corporates and banks with IFRSs. Accordingly, scheduled commercial
banks in India will have to adopt the converged Indian Accounting Standards for preparing
their opening balance sheets as at April 1, 2013.
35. In moving towards convergence with the IFRSs, there will be challenges for Indian
banks. First, the Accounting Standard IFRS 9 relating to financial instruments, which is the
crucial standard for banks, is itself still evolving and thus convergence with IFRS becomes a
moving target. Second, the IT systems of banks which are programmed to producing
financial results as per Indian GAAP will need to be modified. Third, as for any other new
venture, banks will need to build capacity for making a seamless transition to the new
standards and for the adoption of the expected-loss approach to loan loss provisioning.
36. The Reserve Bank has constituted a Working Group to address the implementation
issues and to formulate operational guidelines to facilitate the convergence of the Indian
banking system with the IFRS. The members of the Group include representatives from the
Indian Banks' Association (IBA), the Institute of Chartered Accountants of India (ICAI) and
various regulatory and market related departments of the Reserve Bank. Besides,
professionals with core competence, expertise and experience in IFRS implementation have
been drafted in as special invitees.
Macroeconomic impact of the proposed BCBS reforms
37. The benefits of the reform package arise from reducing the frequency, severity and
public costs of financial crises and minimizing the consequent output losses. The costs arise
by way of possible higher lending rates and lower overall lending. Will the benefits of more
stringent regulation and supervision outweigh the potential costs? Will the result be the same
in the short-run as well as in the long-run? These are the questions uppermost in everyone's
mind, most of all in the minds of governments and regulators. Three recent studies have
addressed this question - two by the Bank for International Settlements (BIS) and the third
by the Institute for Industrial Finance (IIF), a Washington based private sector body which
articulates the banks' point of view.
38. The BIS studies report that if the new requirements are phased in over four years,
each percentage point increase in capital would reduce annual growth by 0.04 to
0.05 percentage points during the implementation period or about 0.2 per cent over the four
year period. However, as the financial system makes the required adjustment, these costs
will dissipate and then reverse in the medium term, and the growth path will revert to its
original trajectory. To summarize, the cost-benefit calculus will possibly be negative in the
short-term, albeit modestly, but will be distinctly positive in the medium to long term.
39. The IIF study estimates significantly higher sacrifice ratios. According to this study,
the G3 (US, Euro Area and Japan) will, if they implement the reform package in full, lose
growth of up to 0.6 percentage points over the five-year period 2011-15 and 0.3 percentage
points over the ten-year period 2011-20. The differences between the two sets of studies
stem obviously from differing assumptions. Notably, the IIF study assumes a much larger
increase in lending rates but does not take into account the putative benefits arising from
improvements in operational efficiency, a more resilient financial system and an executive
incentive structure aligned to sustainable profitability.
40. Such significant differences in the projection of the macroeconomic impact of the
reform package should not be surprising given the weak database as also the fact that many
of the relationships are non-linear. What is significant though is that notwithstanding the
differences in projected outcomes, all studies agree that the benefits of a stronger and
healthier financial system will be there for years to come.
41. The Reserve Bank has also made a preliminary assessment of the impact of
increased capital requirements on our GDP growth path. We will calibrate the phase in of the
new standards to ensure that the sacrifice ratio is within acceptable limits.
Implementation of Basel III in India
42. Basel III reflects the lessons of the crisis, and I believe it is going to be quite game
changing. However, as I indicated, not all the reform measures are going to be binding
constraints for us. Nevertheless, we should not underestimate the challenge of implementing
Basel III. It will demand greater capacity on the part of both banks and the regulators. I urge
this conference to flesh out the specifics in this regard.
43. As is well known, India's prudential regulations are ownership neutral. They will be
applicable uniformly to public sector banks, private banks and foreign banks. The impact of
the measures will of course vary and will depend on the business model and risk profile of
the banks and their domestic and overseas balance sheets. The buffers built into the reform
package are expected to provide automatic stabilizers obviating the need for external support
during a downturn. Also, as the buffers will be built-up over time and during the upturn of the
business cycle, the system should not be unduly stretched.
44. In the case of public sector banks, Government, as the owner, will have to contribute
to building the capital buffers so as to maintain the floor of 51 per cent in the ownership. This
is unlikely to put undue pressure on the Government's fiscal position as it will happen during
the cyclical upturn when banks' profits and Government's revenues would be buoyant.
Consequently, public sector banks should anticipate no problem in building the buffers
contemplated under Basel III.
Conclusion
45. Let me now conclude. My attempt in this address has been to highlight the important
components of the global reform package on bank supervision and regulation and to
evaluate them from an Indian perspective. I have also given an assessment of the estimates
made at the global level of the macroeconomic impact of these reform proposals.
46. Several concerns persist - some immediate and some long-term. By far the most
pressing immediate concern is about the calibration of the standards and their phasing in.
The BCBS and the regulators are sensitive to these concerns, and are mindful of the need to
facilitate a smooth transition to the new norms, and in particular, to ensure that the more
stringent capital and liquidity requirements do not impede as yet fragile recovery process.
47. Two features of the reform package warrant special mention because of the
communication effort they require. First, banks across the world are apprehensive that even
as they incur the cost of building the capital buffers they will not be able to use them during a
downturn, because ironically that is when markets would expect and demand higher capital.
Second, some components of the reform package may have a "comply or explain"
framework which allows individual jurisdictions to deviate from any specific provision of the
package by explaining why it has made deviations. There is a risk though that even well
reasoned and perfectly justifiable deviations may be interpreted as wilful non-compliance, or
worse still as unwarranted regulatory forbearance, and markets may penalize such
jurisdictions. What these problems basically highlight is the need for effective and timely
communication to explain the rationale for opting for deviations. Central banks have
traditionally attached considerable importance to communication regarding monetary policy
to guide market expectations. Now regulators too need to hone their communication skills.
48. There are many reasons cited for India having moved up to a higher growth
trajectory. Most of the reasons are familiar. But one of the big unacknowledged drivers of
India's growth has been the impressive improvement in the quality and quantum of financial
intermediation over the last decade. The Indian financial sector in general, and Indian banks
in particular, can be proud of this very credible achievement. As you contemplate, during this
conference and beyond, the challenge of delivering on your promise over the next decade, I
urge you to think global and act local.