K C Chakrabarty: Crisis preparedness in interconnected markets -
prevention is better than cure
Keynote address by Dr K C Chakrabarty, Deputy Governor of the Reserve Bank of India, at
the Programme on Crisis Preparedness in Interconnected Markets, jointly held by the Centre
for Advanced Financial Research and Learning (CAFRAL) and the Toronto Centre, Canada,
Hyderabad, 16 January 2012.
* * *
Assistance provided by Ms Dimple Bhandia in preparation of this address is gratefully acknowledged.
Mrs. Usha Thorat, Director, CAFRAL, learned faculty members of Toronto Centre, Canada,
Chief Executives and Executive Directors of banks, Principal, Jawaharlal Nehru Institute of
Development Banking, Hyderabad, participants, distinguished ladies and gentlemen.
Over the last five years, a word became very popular around the world. It dominated
discourses amongst policy makers. It consumed innumerable hours of prime time on
television. It spanned across meetings in offices, dinner table conversations, and informal
chit chat between friends. The word is "crisis". It has become almost a norm for speeches
and addresses such as this to start with a reference to the crisis. This address, and indeed
the subject of this seminar, is no different. Yet the subject remains as topical today as it was
five years back when the global financial crisis first came to light.
The subject matter of this seminar - "Crisis Management in Interconnected Markets" - is
indeed very apt. As recent experiences have shown, financial crises occur, albeit
infrequently. When they do, the potential costs to all stakeholders - the financial system, the
real economy, the governments and, above all, to the common man - are enormous. The
recent crises have also driven home the fact that the world, as we know it, is shrinking, as we
speak. Globalization is here to stay and no country can be immune from developments
elsewhere in the world. The increasing interconnectedness of global markets, economies
and institutions have only added to the potential of a crisis anywhere in the world to trigger
contagion in the rest of the world. All of this has only underscored the importance of
anticipating such low probability and high impact events, taking pre-emptive action for
preventing crises and responding effectively to such events, once they have set in - all key
components of any effective framework for crisis management.
I am happy to note that the coverage of this Seminar extends to all aspects of such an
effective crisis management framework. In particular, I am sure that the crisis simulation
exercises which have been designed as part of the programme will provide participants to
don different hats, experiment with different aspects of the crisis toolkit available with policy
makers and appreciate the importance of coordination between different authorities in
dealing with and attempting to minimize the systemic consequences of a crisis.
Crises and their origin
Let me begin first by attempting to define a crisis. The word crisis originates from the Greek
word "krisis" - which means "decisive moment". The Oxford dictionary defines a crisis as "a
time of intense difficulty or danger" while the Cambridge dictionary describes it as "a situation
that has reached an extremely difficult or dangerous point; a time of great
disagreement, uncertainty or suffering". The term financial crisis, to be more specific, is
broadly applied to a range of situations which encompass banking panics, disorderly
functioning of markets, stock market collapses, bursting of asset price bubbles, currency
collapses, sovereign defaults, amongst others.
Crises can happen anywhere, at any time, and often occur when they are least expected.
History is peppered with crises that have varying origins - starting from the Tulips mania of
the 17th century to the dot com bubble of the 2000s and to the 2007 sub-prime crisis and the
latest brouhaha over the sovereign debt crisis.
Origins of a crisis are hard to pinpoint. They can be caused by an act of nature - an
earthquake or a tsunami (as seen recently in Japan), for instance, which, within a very short
span of time, can cause untold damage to the real economy, which can, in turn, affect the
financial sector and governments. The origins of crises can also play out over a relatively
longer period of building up of systemic risks in the macrofinancial system, as the recent
global financial crisis demonstrated, shattering belief in what are now believed to be "myths"
- the "Great Moderation" and the "Goldilocks Economy".
As central bankers and policy makers tasked with fostering financial stability, we are
interested in both kinds of crisis. Both have the potential to cause financial instability. Both
will need swift action if the fallout has to be managed and the collateral damage contained.
But what interests us most are the crises which are a result of build up of risks over time and
which we can take policy initiatives to influence and, perhaps, avert.
Each crisis has certain unique features and there is a tendency to consider each crisis as
different. This illusion is furthered by the fact that each crisis originates in different markets,
through varied products and is propagated through different sets of economic agents. But
there are always similar strands which cut across these superficial differences. In any case,
the cornerstone of any crisis is the same - aptly summed by Mahatma Gandhi who stated,
albeit in a different context, that "There is enough in the world for everybody's need, but not
enough for anybody's greed". When "greed" takes over "need" and a group of "mischievous
elements" are able to hold the "good" to ransom, the seeds of a crisis are sown.
Each crisis is preceded by excesses e.g. excessive credit growth or excessive asset price
spirals, for example. Each crisis leaves behind its own set of lessons. And as the dust settles
on each crisis, these lessons are forgotten by all concerned. As Hyman Minsky aptly
remarked, "As a previous crisis recedes in time, it's quite natural ... to believe that a new era
has arrived. Cassandra-like warnings that nothing has changed, that there is a financial
breaking point that will lead to a deep depression, are naturally ignored in these
circumstances."
Crisis and interconnectedness
This global financial crisis has brought to the fore the importance of interconnections -
amongst the banking system, financial markets, and payment and settlement systems. It has
underlined the fact that focussing on only one part of the financial system can obscure
vulnerabilities that may prove very important from the perspective of systemic stability.
Concomitant with the rapid financial globalization of the past three decades - reflected in the
manifold increase in the external assets and liabilities of nations as a share of GDP, has
been an increase in the degree of financial interconnectedness. According to BIS data,
consolidated banking assets have risen from US $13.2 trillion in 2002 to over US$ 30 trillion.
Financial linkages between countries have been increasing exponentially, especially since
the mid-1990s, through an intricate web of claims and obligations which link the balance
sheets of sovereigns, financial institutions, and corporations. The trend has only been
reinforced by rapid growth in cross border capital flows. In the last decade or so, the
proliferation of sophisticated financial products has further heightened the complexity of
these balance sheet connections.
A highly interconnected world tends to increase both the probability and the impact of crisis.
The potential for systemic risks increase, for example, due to potential build-up of leverage
and liquidity mismatches at the same time or due to exposures to common networks of
intermediaries. This leaves the financial system vulnerable to adverse changes in the
macrofinancial environment, on the one hand, while, on the other, pervasive interconnections
can result in a rapid transmission of adverse shocks across the global financial system at an
amplified speed. The system dynamics of a set of networked markets and institutions can,
thus, play a critical role in the amplification as well as the propagation mechanisms of
shocks.
The potential of interconnected markets to render more severe the reach and impact of
financial crisis through contagion has been demonstrated time and again. In the case of the
Mexican crisis, a number of other Latin American countries felt pressures and were forced to
intervene and/or raise interest rates. This, despite the fact that they had virtually no trade and
investment links with Mexico. In East Asia, the crisis that began in Thailand spread
throughout the region and reverberated as far away as South Africa, the Czech Republic and
South America. The financial crisis of 2007-09 began in the sub-prime market in the US but
had soon engulfed the global economy through real, trade and financial channels. The
European debt crisis is proving to be no different. The crises in the 1990s originated in the
emerging market economies but affected the advanced economies. In the 2000s, the crises
originated in the developed economies but soon engulfed the developing world.
Management of crises
The recent financial crisis has emphatically demonstrated the potential impact of a crisis. The
sub-prime crisis, which originated in the financial sector, left deep scars on the real economy
affecting growth in advanced and emerging nations alike. The buck, not surprisingly, stopped
at the common man, especially in emerging markets such as ours, who was left to bear the
brunt of any crisis. The potentially devastating impact of financial crises gave rise to a felt
need to manage such crises, in particular, to put in place a framework to manage crisis, if
and when they arise.
A key attribute of the crisis situation is that it calls for decision and action with a view to
managing and containing the fallout of the consequences of the crisis. Management of
financial crisis typically involves some basic phases, as discussed in the case of the 2007
global financial crisis in a Congressional Research Service Report.1 Management of crisis
would involve intervention to contain the contagion and restore confidence in the system in
the first phase. The second phase would typically involve coping with the secondary effects
of the crisis, for example, recession, if any, flight of capital, etc. The third phase of this
process would involve affecting changes in the financial system to reduce risk and prevent
future crises.
Simultaneously, the other key features of a crisis situation, viz., the unpredictability
associated with the event, the speed with which it typically unfolds and the uncertain but
dangerous outcomes that it can spawn, suggest that it is necessary to lay down a
comprehensive contingency plan which envisages, in a given context, all possible crisis
situations of varying gravity and possible decisions and actions as well as the framework
under which decisions can be taken and implemented.
A crisis management framework
Evolving events since August 2007 have put to test arrangements for crisis management and
financial stability across the globe. Swift and proactive action was indeed taken once the
contours of the crisis started becoming clearer. Once the crisis broke, central banks,
governments and other regulators across the globe, including in India, managed to
coordinate effectively to improvise solutions to the problems they faced. The experience,
however, also revealed several shortcomings in the arrangements in place to manage the
crisis, ahead of the crisis.
Drawing from the lessons learnt during this crisis, let me lay down some broad attributes,
which I believe, are key to the design of an effective crisis management framework. Let me
confess at the very outset, however, that this list is far from exhaustive. Crisis management
remains an inexact science and I, along with all of you in central banks and other policy
making institutions, continue to learn.
First, there should be a clear assignment of responsibility for financial stability.

Where this responsibility is shared amongst different agencies, roles and
responsibilities need to be clearly delineated and the protocol for coordination during
crisis clearly spelt out.
 Crisis management plans need to be flexible. The characteristics of a crisis can
always differ from earlier crises, so authorities need to be prepared to apply
flexibility rather than working from a set framework.
Effective crisis management hinges on the authorities identifying and addressing

problems at an early stage implying that the processes that enable early
identification of emerging systemic risks need to be strengthened.
 The framework for crisis management needs to strike an appropriate balance
between rules and judgment. While rules foster transparency and aid in avoiding
moral hazard, use of judgment is critical as crises or crisis like situations differ from
one another and warrant suitably "customised" solution.
 Availability of accurate, relevant and timely information is key for any effective
framework for financial stability. It is even more critical for crisis management where
time is of the very essence. A framework for managing crises must, therefore, take
cognisance of need to ensure availability of timely and relevant information by
addressing legal and other hurdles to information collection and obstacles to
information-sharing among the agencies.
 A crisis management framework needs to be dynamic and responsive to the
evolving macrofinancial environment and developments in the financial markets.
Most importantly, the framework should be, and should continue to remain,
commensurate to the degree of complexity in the financial system.
The crisis management framework needs to take cognisance of global

interdependence and integration. Certain crisis actions may need to be
internationally coordinated and without adequate preparation and groundwork,
efforts to manage crises by authorities in different countries could become a
demonstration of the Prisoners' Dilemma where each country looks out for itself.
Above all, a crisis management framework must enable nimble footed decision

making. This will necessitate the creation of a framework which involves all the
agencies that will be involved in the decision making process, with clearly defined
responsibilities and mechanism for information exchange and coordination.
 Also critical for the management of crises, would be an effective strategy for
communication. Measured transparency, especially during a crisis, can help prevent
panic and also add to credibility of policy initiatives.
Finally, the framework should include a continuous program of work on crisis

preparation including ensuring that effective coordination and information-sharing
arrangements are in place and that crisis management tools remain up-to-date and
are tested to meet any potential risks to financial stability.
There are two further points I would like to make in respect of some of the tools which form a
critical part on any crisis management framework. The first is the lender of last resort function
of the central bank and the second relates to the recovery and resolution planning of financial
institutions in distress.
The first important tool at the disposal of crisis management is the role of the central banker
as a lender of last resort. The recent financial crisis, during which central banks in the
advanced economies used tools through a series of conventional and unconventional
measures underscored the importance of the lender of last resort function of the central bank
for crisis management. Going forward, it would be important to clearly define principles for
access to emergency liquidity assistance from the central bank. The principles will need to
balance the imperatives of ensuing capacity to provide adequate liquidity support during the
crisis while ensuring that perverse incentives for lax liquidity management are not built up in
the banking system. The principles may also need to address issues relating to collateral
standards, given the experiences of recent crises.
The spectre of "too big to fail" institutions raised its ugly head during the 2007 global financial
crisis focusing attention on the lack of the necessary arrangements for orderly resolution of
such institutions. A crisis management framework will need to be alive and open to the
possibility of failure, if only to prevent the associated moral hazard problems. For the
"nofailure" perception to be altered, robust arrangements, which allow orderly resolution and
mitigate systemic consequences of such failures will need to be put in place, especially for
the resolution of cross border financial firms. The Financial Stability Board has recently
released the "Key Attributes of Effective Resolution Regimes" that would lay down the
essential features and tools that national resolution regimes for financial institutions,
including non-bank financial institutions, should have. For the large and complex financial
institutions, ex ante resolution plans, or "living wills" are one solution being contemplated
internationally in this regard. Recent initiatives towards introducing contingent capital
instruments may also potentially play an important role in banks' recovery and resolution
plans, going forward.
Crisis prevention
While the subject of this seminar is Crisis Management, let me emphasize that the most
preferable approach to fostering financial stability is crisis prevention.
A series of reforms to the regulatory architecture and plethora of reforms are underway
globally which seek to reduce the probability of a crisis occurring. The Basel III reforms aim
at increasing the resilience of banks through prescription of a higher quality, quantity and
consistency and better risk coverage of capital. The set of reforms for Systemically Important
Financial Institutions are aimed at reducing the probability of failure of these large and
complex financial institutions and at putting in place a robust resolution framework so that the
institutions can be winded down in an orderly manner, should they fail. Regulatory perimeter
issues are being addressed by putting in place a regulatory framework for the shadow
banking system. Another set of reforms are aimed at addressing issues in the OTC
derivatives markets by ensuring that the transactions in these markets are reported, centrally
cleared and, where possible, settled through a central counterparty. Compensation
structures are being streamlined to ensure that compensation is aligned to the risks
assumed. Financial market infrastructures are being strengthened and deposit insurance
systems reformed to take cognisance of the lessons of the crisis. A macroprudential overlay
to the entire regulatory framework is being proposed to address issues related to
procyclicality and the cross sectional dimensions of systemic risks. Most importantly,
organized frameworks for pursuit of financial stability and crisis management, which promote
inter agency cooperation, are being put in place both nationally and internationally.
Notwithstanding the improvements in the regulatory framework, putting in place a robust
system for the assessment of systemic risks which enables identification of emerging
excesses and facilitates timely intervention to prevent such risks from materializing, is critical
for an effective crisis prevention framework. In order words, putting in place a robust Early
Warning System is a sine quo non for any effective crisis prevention framework.
Frameworks for systemic risk identification are taking place around the world as part of an
overall framework for macroprudential framework even as there is a growing realization that
systemic risks are complex and measuring them with precision may be challenging -
exercise of judgment is hence critical. Notwithstanding the complexities, there is a need for
the framework for systemic risk assessment to be comprehensive; to take cognizance of
interconnectedness, risk concentrations and the channels for cross-sector and cross-border
spillovers; to identify key risk drivers; and to conduct periodic stress tests to check the
capacity of financial institutions to withstand severe shocks.
Central banks around the world are engaged in developing tools and techniques to
accurately assess such risks to the financial system. In India too, upgrading technologies and
adding to its existing toolkit for identifying and measuring systemic risks is a continuing
endeavour.
Concomitantly with the setting up of an Early Warning System, an Early Action System also
needs to be put in place. There is, thus, a need for greater emphasis on remedial measures
e.g. through pre-resolution and supervisory intervention to ensure that identified risks are
managed well before they reach their respective tipping points.
A number of countries are in the process of introducing a framework for such early
intervention, especially in case of financial institutions. Denmark, for instance, proposed to
introduce the "Diamond framework" from 2013. Under this framework, a set of five
quantitative indicators relating to, inter alia, credit growth, lending to real estate, large
exposures, funding ratio and liquidity coverage, have been defined and the supervisor will
take remedial action in case the limits are breached by any financial institution. The
Canadian framework consists of five stages viz., a "normal" stage, an "early warning" stage,
a "Risk to financial viability or solvency" stage, a "Future financial stability in serious doubt"
stage and a "Non-viability/insolvency imminent" stage. Each stage is identified by a set of
conditions and a number of options for supervisory measures. In India, an early intervention
system in the form of a Prompt Corrective Action based on three indicators - Capital to Risk
weighted Assets, Non performing Advances and Return on Assets, has existed since 2002.
Threshold values for each of the indicators have been defined along with associated
structured and discretionary actions.
Interconnectedness as a potential source of crisis was recognized in India much before the
onset of the crisis and, as a result, in March 2007, RBI limited a bank's Inter Bank Liabilities
to twice its net worth. A higher IBL limit of 300 per cent of net worth is allowed for banks
whose CRAR is 11.25 per cent. Further, crisis prevention has been an integral part of
regulatory framework in India.
More recently, we set up the Financial Stability Unit (FSU) within the Reserve Bank to
interalia carry out macroprudential surveillance. Since its formation in 2009, the FSU has
published four Financial Stability Reports (FSRs) on a biannual basis. In the most recent
report published in December 2011, we introduced the Financial Stability Indicator based on
a combination of Financial Market Stability, Macroeconomic Stability and Banking Stability
Indicators. We also introduced new tools for risk assessment such as the Systemic Risk
Survey and the Systemic Liquidity indicator in addition to improving the coverage of the
network model analysis introduced in the previous FSR.
Most people are aware of RBI's counter cyclical policies that won us accolades in our
management of the crisis. However, we have also taken several measures to address
systemic risk arising out of interconnectedness amongst financial institutions such as placing
prudential limits on call borrowing and lending, limits on banks cross holdings of bank's
ownership, limits on exposure to single and group borrowers, etc. The further use and
development of a macro-prudential policy toolkit to manage systemic risk is actively being
pursued within the Bank.
Concluding remarks
Recent experiences have clearly demonstrated that resolving a financial crisis is complex
and costly. This holds true regardless of what caused the crisis, and regardless of the
solution. The best crisis management framework is one that prevents crises. Having said
this, no financial system can be completely immune from episodes of financial instability from
time to time and there will be a need to manage crisis. As central bankers and regulators
carrying the responsibility of fostering financial stability, the best service we can do to our
objective, therefore, is to remain prepared to manage crisis. There are important lessons to
be learnt from each crisis. Yet, we can count on each crisis to be sufficiently different from
every other crisis so as to make their identification a challenge. We can but be alert and
flexible to evolving risks. Let me conclude with an extract from Carmen M. Reinhart &
Kenneth S. Rogoff's book "This time is different: Eight Centuries of Financial Folly"
"This time many seem different, but all too often a deeper look shows it is not.
Encouragingly, history does point to warning signs that policy makers can look at
to assess risk - if only they do not become too drunk with their credit
bubblefueled success and say, as their predecessors have for centuries, "This time is
different"."
I wish you successful deliberations over the course of the next few days.