V Leeladhar: Contemporary international and domestic banking
developments and the emerging challenges
Speech by Mr V Leeladhar, Deputy Governor of the Reserve Bank of India, at the Bankers'
Club, Kolkata, 24 November 2008.
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Dear Friends,
I am delighted to be here this evening at the meeting of the Bankers' Club, Kolkata, which, I
understand, is in the process of reactivating itself to provide a vibrant professional platform to
the bankers for an ongoing exchange of views on the areas of functional and contemporary
relevance to the banking community. I am grateful to the organisers for affording me this
opportunity to be with this august audience and to share some my thoughts on the very
topical subject of Contemporary International and Domestic Banking Developments and the
Emerging Challenges. The recent global developments point to a very important systemic
dimension which is closely intertwined with the core mandate of the Reserve Bank of India,
namely, maintaining monetary and financial stability in the system.
2. As you are aware, the credit markets in the western world have witnessed in the recent
past considerable turmoil leading to significant loss of market liquidity. This has had far
reaching consequences all around the world and a few major global financial institutions
either became insolvent or had to be rescued by the public authorities, at significant cost. Of
late, there has been an explosion of literature analysing threadbare the myriad aspects of the
global credit market crisis. I would however, like to present a broad overview, from the Indian
perspective, of the factors underlying the credit market crisis in the west, the implications of
the crisis for the financial sector, lessons learnt from it, the various suggestions made at
different fora for pre-empting the recurrence of such events, the Indian regulatory framework
for liquidity supervision, and the policy measures instituted by the Reserve Bank in the past
few weeks for augmenting liquidity and to safeguard the Indian system.
Factors leading to the sub-prime episode
3. The recent credit market episode is supposed to be the culmination of a variety of
unanticipated and unforeseen developments and many common drivers of the crisis have
been identified by the academics and analysts. However, taking a holistic perspective, the
credit market developments could be viewed to have been triggered by a combination of
circumstances, which, in turn, were precipitated by a complex interaction of several
variables. Let me briefly enumerate some of them.
The rapid asset growth in the housing mortgage sector in the USA had been fuelled by an
ongoing benign interest rate environment, which made the home mortgages affordable to
many borrowers, with limited means, for acquiring homes. However, the credit intermediaries
did not appear to have factored-in the impact pf potential changes in the macroeconomic /
interest-rate environment in their credit assessments of such borrowers and on their repaying
capacity. It is reported that the lenders also enticed the home loan borrowers through "teaser
rates", which were artificially low interest rates, valid only for a limited initial period.
There was wide-spread adoption of the "originate-to-distribute" model by the credit / banking
institutions under which the loans were granted not with the objective of holding till maturity
but for securitising them rapidly. Such an approach tended to weaken the incentives of the
lenders for ensuring rigorous due diligence at the credit appraisal stage - as they were
content in the knowledge that the asset would not remain on their balance sheet for long.
This, in turn, led to assumption of significant amount of credit risks by the lenders on low-
quality/sub-prime counterparties, and acquisition of low-quality assets, which were
subsequently securitised.
The credit intermediaries also resorted to large-scale reliance on credit-risk transfer (CRT)
instruments, including securitisation structures, which enabled the hiving off of such
exposures to a variety of Special Purpose Vehicles through issuance of securitised paper,
mortgaged backed securities and structured finance products. Such risk transfer resulted in
the investors in such products getting farther and farther removed from the underlying risks
on the borrowers whose loans had been securitised and the investors did not know the real
nature of risk and where the risk actually resided.
Also, the ready acceptance of the securitised products by the investors such as hedge funds,
asset managers, structured investment vehicles (SIVs) and other specially designed conduits
in various segments of the market led to a wide dispersal of the underlying credit risk to a
larger investor universe that was not necessarily better equipped than the originating lenders
to assess the underlying credit risks.
The provision of liquidity-support commitment by the banks to the structured investment
vehicles (SIVs) was yet another factor that exposed the banks to the liquidity risks faced by
the SIVs. The SIVs encountered the liquidity squeeze when they could not roll over their
short-term funding raised through the Asset-Backed Commercial Paper (ABCP) for financing
their long-term assets. This forced the banks, for reasons of reputational risk, to roll-in these
off-balance sheet vehicles and their exposures, on to their own balance sheets. This, in turn,
resulted in an involuntary and sudden expansion of the balance sheets of the banks -
bringing their capital adequacy under severe strain.
4. It would thus appear that the sub-prime lending by the credit intermediaries in the
developed world was premised on the assumption of continued benign interest rate
environment and an enduring uptrend in the housing prices. This, in turn, was expected to
keep increasing the extent of "equity" of the homeowners in the houses purchased, thus,
enabling them to refinance their mortgages at lower interest rates. However, a change in the
macroeconomic conditions and the reversal in the interest rate cycle coupled with the
moderation in the house prices, belied the assumptions. This strained the borrowers' ability
to service their mortgages, leading to large-scale delinquencies. This, in turn, impacted the
servicing of the dues on the MBS and other structured finance products, held by a variety of
investors.
5. On account of default on the structured securities, the rating agencies had to resort to a
large-scale down-gradation of numerous structured finance products. This, in turn, paralysed
the new issuances and trading in these papers, eliminating the market liquidity in these
instruments. The attempt of some of the large investors in such products, facing redemption
pressures and margin calls, to liquidate their portfolio, also sharply depressed the market
prices. The drying up of market liquidity affected the funding liquidity of the SIVs and other
conduits, which were unable to roll over / renew their market funding, raised predominantly
through asset-backed commercial paper (ABCP). The conduits, therefore, had to invoke the
liquidity lines committed to them by the banks which, in turn, resulted in the banks having to
induct these illiquid assets on their balance sheets, as per contractual obligations for
providing liquidity. This increased the demand for liquidity from the banks. However, given
the uncertainty and the lack of transparency in regard to the level of problem exposures of
the counterparty banks, the banks were reluctant to deal with each other in the inter-bank
markets and tended to hoard liquidity for their potential future needs. This necessitated
significant liquidity injection by some of the major central banks to ease market liquidity, even
contrary to their own monetary policy stance.
Implications of the credit market turmoil for the financial sector
6. Recent financial developments have brought to the fore several issues that carry
significant implications for the safety and soundness of the financial sector. Allow me to
briefly dwell on some of these aspects.
First, there is closer scrutiny of the business strategies of banks and financial institutions
which are based on the model of "originate and distribute".
Second, issues relating to securitisation are being debated in the context of incentive
structures that encourage economising on capital requirements and enhancement of
offbalance sheet exposures of banks relative to the considerations of their safety and
soundness.
Third, recent events have also underscored the need for enhanced market transparency
relating to disclosures of off-balance sheet exposures of banks, particularly with regard to
their liquidity commitments to conduits, valuations of structured credit products dealt by them,
and the like.
Fourth, the apparent inadequacy of financial institutions' capital cushions has been exposed.
In this context, the role of sovereign wealth funds as providers of capital is being carefully
assessed by supervisory authorities across the world.
Fifth, the sharp re-pricing of risks that began in the middle of 2007 has raised issues relating
to the fair value accounting and marking-to-market of portfolios of financial institutions and
the attendant issues relating to capital provision.
Sixth, there are concerns that existing risk pricing and risk management tools and
techniques employed in banks and financial institutions are inadequate in relation to the risks
evolving in the financial markets.
Seventh, there is a progressive blurring of the boundaries between liquidity and solvency
stress faced by the banks in situations of generalised uncertainty in the markets and the loss
of confidence amongst financial entities.
Eighth, the role of structured investment vehicles (SIVs), the potential liquidity demands
that could crystallise on the balance sheets of the sponsoring banks and the degree of
leverage embedded in the global financial system has been largely underestimated - which
has implications for the soundness and efficiency of the financial sector as a whole.
Finally, the functioning of the credit rating agencies, role conflict in their operations and
excessive reliance on the credit ratings even by the institutional investors, are under scrutiny.
Lessons from sub-prime crisis
7. While India has been relatively insulated from the impact of the credit market turmoil, the
sub-prime episode, in retrospect, provides several useful lessons for the banks as also for
the banking supervisors all over the world. Allow me to briefly touch upon some of the major
lessons emanating from the episode.
Underwriting standards
The episode has once again brought to the fore the imperative of observing prudent
underwriting standards by the credit intermediaries. The traditional banking tools such as the
loan to value ratio, debt service ratio (particularly, after the initial "teaser rates" came to an
end), purpose of the loan, verification of documentary evidence of income and assets of the
borrowers, and ongoing monitoring of the borrowers' affairs have demonstrated their
continued relevance, despite rapid advancements in the financial technology and products. It
is important to note that the products created through sophisticated financial engineering
may not be sustainable over the long term if their building blocks are not underpinned by
rigorous underwriting standards.
Risk transfer
The risk transfer by adoption of "originate-to-distribute" models by the credit intermediaries
needs closer supervisory attention. The episode has demonstrated that there was insufficient
understanding of how complex structured products work, the nature of the risks to which the
investors were actually exposed, and, in the case of risk transfer through securitisation, etc.,
where the risk ultimately resided, and indeed, whether any risk has really been transferred
from the originators.
Liquidity risk
There had been an insufficient recognition on the part of supervisors and banks of the close
market liquidity
link between (ability to rapidly sell assets without impacting prices) and an
individual bank's funding liquidity (ability to raise funds from the market). The recent credit
turmoil has highlighted the importance, for both banks and supervisors, of considering
market disruption scenarios as well as institution-specific scenarios in liquidity planning. This
should also encompass the liquidity demands arising from off-balance sheet commitments,
implicit or explicit, of the credit intermediaries. Also, the assumptions underlying the liquidity
contingency plans need to be realistic and not overly optimistic.
Valuation
The recent market turmoil and resulting illiquidity has highlighted the importance of reliable
valuations and transparency of risk exposures. Some banks seemed to have used
inappropriately optimistic valuation and modelling methodologies to determine the value of
certain securitisation exposures, such as collateralised debt obligations (CDOs) and residual
interests. It has been demonstrated that liberal and unsubstantiated valuation assumptions
can result in material inaccuracies in financial statements and substantial write-downs of
structured products, and in case of excessive concentration, even demise of the sponsoring
institution. Supervisors and banks, therefore, need to understand the potentially significant
effect that market volatility on the financials of a bank.
Residual risks in structured products
There was insufficient recognition of residual risks in the structured products on the part of
investing banks, as well as those banks acting as issuers and sponsors of asset-backed
commercial paper (ABCP) programmes. For instance, banks that extended liquidity facilities
to ABCP programmes were exposed to high degrees of credit risk, of the underlying asset
pool, which may be subtly embedded within the liquidity facilities' provisions. Securitisation
exposures can also expose banks to significant reputational risks, as observed in the recent
episode, on account of which the banks had to roll-in the SIVs on to their own balance
sheets. Supervisors and banks, therefore, need to take cognisance of the residual risks
entailed in structured products.
Transparency and disclosure
The recent difficulties experienced by banks as well as investors, with respect to complex
structured products highlighted the lack of transparency due to insufficient disclosure. Much
of the current turmoil in the credit markets related to questions about the soundness of
certain types of collateralised debt obligations (CDOs) and asset-backed commercial paper.
These problems might perhaps been avoided, or at least mitigated, through greater
transparency, particularly with respect to the exposures of some large international
institutions to CDOs of securities backed by sub-prime mortgages originated in the United
States.
Regulatory scope
In view of ever-increasing integration of different segments of the financial market, the
potential of the unregulated market participants for infecting the regulated parts of the
system, no matter how well supervised, needs better recognition by the financial supervisors.
The regulatory gaps in which the unregulated entities operate need to be identified and
effectively addressed so that the systemically-important regulated entities are not put to
undue risk by the activities of the unregulated entities, entailing significant public cost.
Employee-compensation structure
The remuneration structure of the employees is also stated to have played a role in the
recent crisis. The pay structure was flawed in as much as the employee bonuses formed a
large part of the entire remuneration package. The performance-based remuneration did
induce risky behavior in the investment managers of the major global financial entities. The
compensation structure was also reportedly front-loaded in many cases and the
compensation systems rewarded very short-term employee performance instead of
reckoning the long-term effect of their actions. Moreover, when things went wrong, there was
little penalty, except maybe the loss of a job - often with millions of dollars in compensation.
Thus, the distorting impact of the design of compensation structure on the incentive
framework of the employees needs to be clearly recognised by the banks as also the
supervisors.
Conflict of interest in the role of rating agencies
It is well known that the rating agencies are paid for their rating exercise by the issuers of
securities and not by the investors in those securities. There were instances where the rating
agencies, while rating of securities, also tendered advice on the structuring of those
securities so as to be able to improve their rating. Such structured obligations were then
assigned a rating. Thus, their role of providing to the investors an objective and independent
assessment of the risks entailed in the securities rated by them, took a back seat while their
primary loyalty lay with the issuers of securities. Moreover, the dual role of the rating
agencies in structuring as well as rating of securities also created a conflict of interest in their
functioning.
Remedial and pre-emptive measures suggested for future
8. In this background, a variety of suggestions have emerged from different quarters to
obviate the recurrence of such episodes in future. Several strands of broad policy measures
have been suggested from time to time towards this goal. The reports of the International
Institute of Finance and the Financial Stability Forum are particularly notable in this regard.
The suggestions made so far include ensuring a greater emphasis on improving the market
transparency through better market governance and securing full accountability of the market
players for adverse market developments. Permit me to briefly enumerate some of the
salient suggestions that have been made in this regard.
9. As the institutions that generate and grant loans with the intention of subsequently hiving
them off in the market, have less incentive to control credit risk than a traditional bank, which
keeps loans on their balance sheet till full repayment, it has been suggested that the
regulatory framework for them should be reviewed and strengthened. In other words, the
banks adopting "originate-to-distribute" model should receive closer regulatory
oversight.
10. The rating agencies play a vital role in the process of securitisation, through rating the
paper issued by the SPVs. It has therefore been suggested that (a) appropriate mechanisms
should be evolved to ensure that the information received by the rating agencies is reliable;
(b) appropriate rules-based structures should be established to particularly prevent the
conflicts of interest in their functioning; (c) a closer attention to the liquidity risks faced by the
rated entity / product should be mandated for the rating agencies in their rating process; and
(d) an appropriate road map for the rating agency reforms, should be evolved to address the
weaknesses revealed as also to promote competition in the rating industry.
11. As the investors in the securitised paper were apparently unaware of the true quality of
the underlying loans, suggestions have been made to improve the transparency of
securitisation transactions as also of the characteristics of the underlying loans. Mandating a
certain degree of standardisation of the securitisation transactions, packages and of the
reporting requirements has also been suggested to improve transparency.
12. As I mentioned, one of the causes for the banks' distress was the invocation of liquidity
support lines by the SIVs sponsored by the banks. Since unlike the Basel I Framework, the
Basel II framework does require a capital charge for such liquidity support provided by the
banks, accelerating and encouraging the implementation of Basel II in all jurisdictions has
also been suggested.
13. The financial innovation has transformed the contours of liquidity risks on account of the
general trend toward the "marketisation" of assets through various securitisation structures,
Since the imposition of additional regulatory capital charge alone can not be an answer to the
liquidity problems faced by the banks, efficient and effective management of liquidity by the
banks has acquired crucial significance. Hence, suggestions were made for modernising and
upgrading international norms for liquidity management, with greater emphasis on simulation,
scenario analysis and stress testing of the liquidity needs. The Basel Committee on Banking
Principles for Sound Liquidity Risk Management and
Supervision has since published the
Supervision, in June 2008, which provide a good starting point.
14. With progressive marketisation of banking assets, the current accounting standards also
increasingly rely on the "mark to market" valuation of financial assets. However, the need for
a more cautious approach has been highlighted in relying upon such valuations since the
recent upheavals seem to have cast a doubt over the reliability of this model when markets
are quite thin and shallow, not to mention short-lived. While the essential information value
embedded in the market prices is beyond dispute, it is necessary to recognise that in
stressful times, such market-based valuations could prove quite illusory due to market
illiquidity.
15. In the wake of the sponsor/parent banks being forced to bail out their SIVs, due to
reputational risk, the legal independence of such SIVs for regulatory and accounting
purposes has come into question. Hence, a review of the boundaries of consolidated
supervision has been suggested. This would require a re-assessment as to whether the
accounting boundaries between the parent and its off-balance sheet affiliates correctly reflect
the risks to which the parent entity remains exposed.
16. A certain class of unregulated entities in the financial sector had also been instrumental
in the recent credit crisis. A careful examination of the modalities for periodical review of the
regulatory structure for the financial sector, in different jurisdictions, has therefore been
suggested so as to ensure, through appropriate intervention, that none of the market players
"fall between the cracks" and remain unregulated in the regulatory dispensation in any
jurisdiction.
The Indian scenario
17. With rapidly increasing financial globalisation, it is difficult to assume that a country can
remain totally insulated from the fallout of global turmoil of this dimension, though the degree
of impact could certainly vary as per the county-specific conditions. Thus, India too was
exposed to the impact of this global crisis though to a much lesser extent. A detailed study
undertaken by the RBI recently in regard to the impact of the sub-prime episode on the select
banks had revealed that none of them had any direct exposure to the sub-prime markets in
the USA or other markets. However, a few Indian banks had invested in the collateralised
debt obligations (CDOs)/bonds which had a few underlying entities with sub-prime
exposures. Thus, no direct impact on account of direct exposure to the sub-prime market
was in evidence though a few of these banks had to record the mark-to-market losses
caused by the widening of the credit spreads due to adverse impact of the sub-prime episode
on the term liquidity in the market.
Measures taken by the RBI
18. The RBI has taken several measures over the years for strengthening the risk
management systems in the banking sector and wide-ranging measures at the systemic level
in the recent past in the light of the global and domestic developments. Let me make a brief
mention of some of these.
Risk management in banks
19. The management of liquidity risk by the market participants has emerged as a very
crucial factor in the recent crisis. The RBI has been alive to the importance of liquidity risk
management in the Indian banking system. We had issued the guidelines on Asset-Liability
Management (ALM) system to the banks as far back as in February, 1999, which stipulated a
simple maturity ladder approach to the ALM along with certain regulatory gap limits for
negative mismatches in the first two time buckets. In October, 2007, we modified the
guidelines with a view to adopt a more granular approach to measurement of liquidity risk. In
terms of the revised guidelines, the banks are required to capture liquidity risk in time
buckets consisting of the next one day, the next 2-7 days, the next 8-14 days and so on.
Banks have been urged to make concerted efforts to capture 100 per cent data, including
offbalance sheet items, from all their branches in a timely manner. While the banks are required
to prepare the "Statement of Structural Liquidity" on a daily basis for their MIS, for monitoring
by the RBI, the statement needs to be sent to the RBI at monthly intervals.
20. Besides the ALM Guidelines, RBI has also issued the Guidance Notes to the banks on
management of credit risk, market risk and operational risk. The banks are also required to
adopt formal risk management architecture for effective management of different types of
risks, with appropriate high-level risk management committees guiding the risk management
function in the banks. Such a holistic risk management architecture coupled with the
inculcation of a robust risk management culture in the banks is expected to adequately
address the risk management imperatives in the Indian context.
Management of systemic liquidity
21. On account of liquidity crunch in the western world, there has been wide-ranging
deleveraging in evidence as the global investors were constrained to liquidate their investments
in the financial markets. This has also resulted in significant FII divestments in the Indian
equity markets and the capital outflows from India. This, in turn, impacted the systemic
liquidity and also exerted pressure on the exchange rate of the rupee. The RBI intervention in
the forex markets also added to the pressures on the rupee liquidity. In this background, the
RBI initiated a variety of policy measures to infuse liquidity into the system to enable the
uninterrupted flow of credit to the productive sectors of the economy.
22. The RBI has acted pro-actively and promptly and taken multi-directional measures to
infuse liquidity into the Indian system so as to ensure availability of credit to the productive
sectors of the economy and thereby, maintaining financial stability. While the package of
measures has had some positive effect, the challenges still remain as the global
uncertainties continue to persist. The Reserve Bank will continue to closely monitor the
developments in the global and domestic financial markets and will take swift and effective
action as appropriate. The bankers too, on their part, mindful of the needs of their customers,
have recently reduced their lending rates and it is expected to have a salutary effect on the
credit off take in the system.
Conclusion
23. These are challenging times for all of us and we need to be watchful of the unfolding
developments. While the temporary counter-cyclical measures taken by the RBI are as per
the need of the hour, it has to be borne in mind that the measures are ad hoc in nature in
response to a particular situation. The banks would, therefore be well advised to ensure that
their business strategies and decisions are guided by the longer-term perspective of the
systemic and macroeconomic developments and are not unduly influenced by the current
episode of the exceptional events. Since the banks would have a key role in successfully
countering the adverse impact of the recent developments, their continued safety &
soundness and financial health would be of utmost importance - for the banks, for their
customers as well as for the public policy authorities from a systemic perspective. I am sure,
the banking community would rise to the occasion and measure equal to the task in
effectively responding to the challenges ahead, through prompt action underpinned by robust
pragmatism.
24. I wish the reactivated Bankers Club of Kolkata become a vibrant platform for exchange of
information and will come out with innovative ideas for taking safe banking to every nook and
corner of the country.
Thank you for the attention.