S S Mundra: Strong financial services sector - imperative for sustainable
growth
Keynote address by Mr S S Mundra, Deputy Governor of the Reserve Bank of India, at the
ICAI International Conference "Accountancy Profession: Spearheading Excellence", Indore,
9 August 2015.
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Assistance provided by Shri Sanjeev Prakash is gratefully acknowledged.
Good Morning to you all!
1. I am pleased to be here this morning to speak to the delegates of this International
Conference and I thank ICAI for providing me this opportunity. As you all know, the theme of
this morning's session is "Financial Services Sector- Agenda for Sustainable Growth" and as
somebody who has spent his entire professional life in the banking sector - first as a
commercial banker and now as a Central banker, I would speak with a particular emphasis
on banking sector.
Introduction
2. Let me begin by taking you back to South Korea of the year 1997. The "grey-haired"
amongst you would recall that in the period leading up to 1997, the Korean economy as also
the other "tiger" economies in the South East Asian Region had expanded by 6% to 10% on
an annual basis. Buoyed by expectations of rapid growth and expansion, the chaebols
(family-owned business conglomerates) in Korea had raised significant amounts of foreign
funds for investment in building industrial capacity. However, as the economic growth slowed
down, the debt problem started to accentuate and one of the chaebols, Hanbo collapsed
under a $6 billion debt load. The company had decided in 1993 to build the world's fifth
largest steel plant and there was cost escalation of the project from Won 2,700 bn to Won
5,700 bn while the steel demand had turned sluggish. The situation deteriorated further in
July 1997 when Kia, Korea's third largest car company asked for an emergency bank loan to
avoid bankruptcy. These events prompted international credit agencies to downgrade the
ratings of Korean banks with heavy exposure to the chaebols and thus, began the financial
meltdown in Korea.
3. Of course what is widely known as the "Asian Financial Crisis" had begun earlier on
February 5th, 1997 in Thailand when a Thai property developer failed to make a scheduled
interest payment on its eurobond loan. The business model of financial institutions in
Thailand was built around issuing eurobonds denominated in US dollars to benefit from the
interest rate differential between dollar denominated debt and Thai debt and using the
proceeds to fund property development. By January 1998, the stock markets in many of
these economies had lost over 70% of their value, currencies also depreciated by a similar
extent and many had to seek IMF assistance.
4. My purpose in beginning the address by narrating these events is to highlight
typically how problems unfold in a crisis. The problem often begins with banks taking
excessive exposure (concentration) to a particular sector or sectors, the corporate increasing
their leverage manifold and investing in creating excess capacities. Unraveling of the risks
could perhaps still be managed if the banks' capital positions were strong, but if that is not
the case, risk manifests itself in all its dimensions. Leveraged positions created out of
borrowed money from abroad for funding growth in domestic markets add another twist to
the tale. Once home currency depreciates, debt servicing becomes a challenge for
corporates holding large unhedged positions. If there are large scale borrowings by various
corporates, this debt crisis could easily degenerate into a full-blown currency crisis.
5. The Financial Crises typically take the form of currency, debt or banking crisis and
have severe consequences for the economy. A question that begs an answer at this stage is
why financial crises happen? There are, of course, many reasons - some economic, some
social and some political. While we would leave a detailed discussion on this issue for
another day, suffice to say at this stage that the origin of all crises can be traced to a
weakness in the underlying structure and an all-round failure to exercise self-restraint and
lack of adherence to the established framework. In fact, the ground for the 2008 Financial
Crisis was created by a prolonged period of easy monetary policy, consequent mispricing of
risks, a search for yield by the market intermediaries and an inadequate supervision over
market behavior.
India today
6. Looking at the Indian scenario today, one can't avoid some comparison with the
events in the South East Asian economies of 1997-98, though the degree of severity differs
widely. Let me take the example of the steel sector. Bank loan to the steel sector in India has
witnessed a 21% CAGR over the past five years and broadly ranges between 4 to 9 % of
individual bank's loan book. Banks' total exposure to the steel sector stands at Rs. 3 lakh
crore while the net sales for the companies within the sector also stands at around Rs. 3 lakh
crore with an EBIDTA of Rs. 37000 crore. The level of stressed assets in the sector exceeds
27%. Large capacities are lying idle as global/domestic demand conditions have weakened.
Further the capacity expansion has been done using excessive leverage. These pointers
definitely raise concerns.
7. Excessive leverage by the borrowing corporates is not limited to the steel sector
alone. The Global Financial Stability Report released by IMF recently has noted that 36.9 per
cent of India's total debt is at risk, which is among the highest in the emerging economies,
while India's banks have only 7.9 per cent loss absorbing buffer, which is among the lowest.
An analysis of a sample of 3,700 companies by Credit Suisse has highlighted that 37% of the
debt held by these companies is with companies having Interest Coverage less than 1.There
may be valid questions around the assumptions made in deriving these conclusions, but the
underlying direction cannot be ignored.
What are the consequences of a weak financial sector?
8. Let me answer it differently. Financial sector facilitates risk-sharing by reducing
information and transactions costs. A strong financial sectors characterized by strong
financial intermediaries and wider and deeper financial markets. In a strong financial sector,
the liquidity and maturity transformation amongst the borrowers and savers happens in the
most efficient manner. In such a market, savers are confident in handing over their surplus
funds to the financial intermediaries which can then be borrowed and invested for creation of
productive assets at the least cost. This can create multiplier effect and generate wealth and
prosperity for both savers and borrowers and for the economy as a whole. Particularly in
case of EMEs, where credit market is typically bank-led, an efficient resource allocation
framework is central to Governments' efforts towards employment generation and poverty
eradication. On the contrary, a weak financial sector consisting of weaker intermediaries and
shallow financial markets would invariably be prone to crisis resulting from inefficient
resource allocation and disproportionate risk-taking behavior. So, typically, a weak financial
sector would have highly leveraged corporates and/or over indebted individuals. Absence of
a strong financial sector also drives individuals towards dissaving or moving into physical
assets which retards investment and consequently growth besides building up asset price
bubbles.
9. A weak financial system can have deleterious consequences for the economy and
the country. Dallas Federal Reserve researchers Tyler Atkinson, David Luttrell and Harvey
Rosenblum in their paper "How Bad Was It? The Costs and Consequences of the 2007-09
Financial Crisis" observe that the crisis was associated with a huge loss of economic output
and financial wealth, psychological consequences and skill atrophy from extended
unemployment, an increase in government intervention, and other significant costs. Their
estimate of total loss for the US economy alone is nearly $ 14 trillion, which is nearly 7 times
India's GDP.
10. The quarterly report of March 2012 of the Special Inspector General for Troubled
Assets Relief Program (TARP) in the US puts the cost of Gross US Government Bailout
Outlays from the 2008 Financial Crisis at $4.6 trillion, while the guarantees from US
Treasury, Federal Reserve and other US government agencies totalled $16.9 trillion.
Likewise figures released by the National Audit Office in the UK, put the cost of bailouts for
the UK taxpayer due to the 2008 Financial Crisis alone at a peak of £955bn.
11. The above numbers, thus, give a sense of the economic loss arising out of financial
crisis. These numbers are staggering and hence, scary. As the old adage goes, "prevention
is better than cure" and hence, it is the endeavor of the regulatory reform process to
strengthen the financial system and prepare it to withstand the force of any impending crisis.
12. So, what all is being done to make the financial sector and the banking sector
healthy? Before I get into the steps taken to strengthen the banking sector post crisis, I must
highlight the monetary stimulus infused by various Governments/ Central banks across the
developed world. The monetary policy makers in the US, Europe, UK and Japan have all
followed an expansionary monetary policy to wriggle their way out of recession. But the
efforts have not quite borne fruit as many of these countries have not yet reached anywhere
close to pre-crisis growth rate. Japan has, in fact, entered its third "lost decade" and is still
stuttering to find growth. Moreover, as is being proven now, loose monetary policy is like
"Chakravyuha", the famous battle formation in the epic "Mahabharata" where it was easy to
enter, but difficult to exit.
13. Let me now turn to the reforms aimed at the banking sector.
Global reforms
14. The banks in Europe and the USA entered the financial crisis with highly -leveraged
balance sheets. They were too thin on equity and the balance sheet was too precariously
placed to withstand write-down on their investments in complex derivate instruments. The
situation was somewhat better in the developing world, but even the banks in these markets
got impacted as the pains of the real economy slowly started to inflict the financial economy.
It was in this background that the regulatory reform process was set in motion by the
multilateral Standard Setting Bodies to undo the excesses of the pre-crisis era. The major
elements of the reform process that have been implemented/ currently under negotiation are
as under:
• Basel-III capital prescriptions including capital conservation and countercyclical
buffers
• Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR)
• Leverage Ratio
• Total Loss Absorbing Capacity (TLAC), a work-in-progress, which aims at a
higherloss absorbency requirements and resolution framework for
G-SIBs/G-SIIIs/GNBNIs
• Regulation of the shadow banking sector
• Reforms of the OTC derivatives market and resolution of CCPs
• A standardized, non-modeled approach for calculating regulatory capital to resolve
the problem of excessive variability in banks' regulatory capital ratios (A thought)
• Compensation- Alignment with prudent risk taking, Claw back provisions
Transparency in benchmark setting
•
15. The underlying objective of these reform measures is to avoid the dependence on
taxpayers' money to bailout financial institutions in the event of stress.
Indian position
16. Being a bank dominated economy, a healthy banking sector is imperative for India's
economic growth. RBI has been proactively working towards development of a strong and
efficient banking system through its regulations. As member of the international Standard
Setting Bodies, we are not only implementing the globally agreed regulatory reforms now, but
have also been proactive in introducing macro-prudential measures like higher risk weights
for real estate exposures of banks, measures for dealing with risks emanating from
derivatives and securitization transactions and spiraling unhedged forex exposure of
corporates, much before the global attention was drawn to such risks. At RBI, we have
always been conscious of the need for the regulation to evolve quickly for addressing
incipient risks and it is in this spirit that many of the recent reform measures have been set in
motion.
Recent measures taken by RBI
17. An important pre-condition for banks to be able to meet their lending obligations to
current and prospective borrowers is that they remain profitable and solvent. It is in this
context that following regulatory actions have been launched in recent past which are a fair
mix of both, prudent regulation and right incentives to support growth with proper risk
management:
• Guidelines on "Early Recognition of Financial Distress, Prompt Steps for Resolution
and Fair Recovery for Lenders: Framework for Revitalizing Distressed Assets in the
Economy covering formation of Joint Lenders' Forum (JLF), Corrective Action Plan
(CAP), "Refinancing of Project Loans", "Sale of NPAs by Banks" to facilitate early
recognition/resolution of financial distress
• Banks permitted to grant an extended debt repayment period to their borrowers in
long-gestation projects ("5/25" scheme)
• Enabled banks to take steps for Strategic Debt Conversion (SDR) giving them right
to convert their outstanding loans into a majority equity stake if the borrower fails to
meet conditions stipulated under the restructuring package
• Enhanced fraud monitoring framework
• Issuance of long term infrastructure bonds to facilitate financing of long term infra
projects
• Revoking forbearance on restructuring
Certain other regulatory measures like revision of the single/group borrower exposure limits
and identification of D-SIBs, etc. have also been initiated.
Role of the auditor community in promoting sustainable growth
18. Let me now turn to some messages that I would like to give the auditor community
present here. First of all let me compliment you for the very critical role that you play in
keeping the banking sector healthy by auditing the balance sheets of banks and that of the
borrowers to whom the banks lend. I would, however, begin on a light-hearted note. I quote
former AIG Vice Chairman Jacob Frenkel, who, in the aftermath of the Financial Crisis, once
quipped, "The left side of the balance sheet has nothing right and the right side of the
balance sheet has nothing left. But they are equal to each other. So accounting-wise,
we are fine." I am sure we don't want our accounting system to be fine like this.
19. External auditors play a vital role in maintaining market confidence in audited
financial statements. In the case of the banking industry, this role is particularly relevant to
financial stability given banks' financial intermediation function within the economy as a
whole. Core Principle 27 of the Basel Committee's Core Principles for Effective Banking
Supervision (September 2012) states that "the supervisor determines that banks and banking
groups maintain adequate and reliable records, prepare financial statements in accordance
with accounting policies and practices that are widely accepted internationally and annually
publish information that fairly reflects their financial condition and performance and bears an
independent external auditor's opinion".
20. Over the years, we have observed several accounting scandals unfold, latest in line
being the one at Toshiba. It is understood that Toshiba would have to revise its pre-tax profit
figures by ¥152bn ($1.2bn) over a seven-year period dating back to 2008. The amount
involved accounts for nearly 30 per cent of the total pre-tax profit during the period. The initial
findings have showed top executives' involvement in accounting malpractices where the
inflated figures were made possible by delaying the reporting of losses and underestimating
project costs. A sustained failure of this kind most definitely points to gaps in the audit
process.
21. Another piece of accounting manipulation was observed in case of Rosneft, the
Russian state controlled energy group, which, in a bid to mitigate the effects of the rouble's
fall on its results, changed the way it accounted for foreign currency swings. The company
shifted to recording the impact of such fluctuations when they materialized, rather than
calculating the temporary effect every quarter. I am not sure how the audit community views
this but analysts would definitely find it intriguing and not presenting a true and fair picture of
the company's financials.
22. Auditors are expected to maintain highest standards of professional ethics and
ensure that the financial statements of the enterprises they audit, present a true and fair
picture of the prevailing state of affairs on an ongoing basis. As professionals, you must
remain rather vigilant when auditing areas that: (a) involve significant management estimates
and judgments, especially those measurements involving a wide range of measurement
uncertainty; (b) involve significant non-recurring or unusual transactions; or (c) are more
susceptible to fraud and errors being perpetuated due to weak internal controls1.
23. As I said earlier, the lending business and the loan appraisals depend almost
entirely on the balance sheets submitted by the borrowers and hence, fabricated account
statements can lead to erroneous conclusions and unwarranted financing of enterprises.
Banks increasingly lean on the auditors for undertaking stock and asset audit, concurrent
audit and forensic audit. While looking at corporate balance sheet and to understand the
level of leverage, it is important to look through the corporate structure and gearing of capital
in downstream subsidiaries.If these tasks are accomplished proficiently, that would not only
strengthen the banks' financials but also help create a stronger financial sector.
24. Many contend that accounting rules fueled the recent global financial crisis. While
there is broad consensus that accounting rules are an important determinant of bank
behavior, it would be imprudent to blame a single factor for the crisis as the specific
mechanisms and their interaction with regulatory requirements are less well understood. The
implications of the use of fair value accounting and the incurred loss approach of loss
provisioning under International Financial Reporting Standards (IFRS) are cases in point.
Both have been criticized as contributing to a pro-cyclical behavior in banks' decision
making, i.e. adding exuberance and fueling investments in the up-turn and triggering
downward spirals and throttling investments in the down-turn of the credit cycle2. Regulation,
on the contrary, are framed to last "through the cycle." I am, however, not going to delve
deeper into this debate and would only focus on some of the imponderables which
implementation of IFRS would throw up, especially in the Indian context.
IFRS Implementation and the imponderables
25. What IFRS implementation would entail for the banking system? The question is
how prudential regulation would exist alongside IFRS? Proposed impairment calculations
under IFRS, accounting for interest income on Effective Interest Rate basis and presence of
multiple systems for operation and accounting of different portfolios would mean that IT
systems would have to be upgraded/realigned for IFRS migration. Banks would also need to
overcome challenges around converging policies for financial accounting and tax accounting
for preparation of financial statements.
26. As the IFRS implementation date draws near, there are several pressing questions
for which answers would need to be found.
i) How would the consolidation of accounts happen in situations where the parent
entity is covered under Ind AS but the downstream subsidiaries are not?
ii) What would be the position when an account of one of the subsidiaries has to be
drawn up under Ind AS but that is not the case for the parent entity (say an NBFC
holding company)?
iii) How do you deal with equity with a "put" option?
iv) How the firms' account can be made comparable across periods?
27. It is quite possible that initially adoption of fair value accounting may lead to negative
implications for the revenue of firms and consequently, could impact the balance sheet of
both - firms as well as that of the banks.
Conclusion
28. I am reminded of a quote by Jim Peterson, a former lawyer for Arthur Andersen, the
now-defunct accounting firm that audited Enron. He said "An auditor's opinion really says,
"This financial information is more or less OK, in general, so far as we can tell, most of
the time"," I trust the accounting community present here does a much more meaningful and
methodical job than what Mr. Peterson suggests.
29. Let me conclude by reiterating that a strong financial sector is a sine qua non for
sustainable growth. Financial Sector and in specific, the banking sector, derives its strength
from a healthy credit portfolio, both corporate and retail as well as a healthy investment
portfolio. Accounting standards and the auditors have a pivotal role in enabling the banks to
develop such portfolios. There are, of course, complex but essential interplay between
regulations, accounting standards and credit ratings.
30. I am sure that the Conference would be able to guide the various stakeholders in
finding appropriate answers to many of the issues which I have just referred to. I once again
thank ICAI for inviting me to share my thoughts on this occasion and wish the Conference all
success.