Usha Thorat: Global agenda for regulatory and supervisory reforms - the
stock taking and way forward
Opening remarks by Ms Usha Thorat, Deputy Governor of the Reserve Bank of India, at the
Panel Session on "Strengthening financial regulation and supervision" of the FICCI - IBA
Conference on "Global Banking: Paradigm Shift", Mumbai, 8 September 2009.
Assistance of Shri Tulasi Gopinath in preparing the speech is acknowledged.
* * *
I thank the organisers of the FICCI - IBA Conference on Global Banking: Paradigm Shift for
having invited me to chair the panel session this afternoon on Strengthening Financial
Regulation and Supervision.
Macro-economic scenario
The massive derailment of the financial sector in the advanced economies has had a knock
on effect on the world economy. The world output is expected to contract by 1.4 per cent in
2009, GDP in the advanced economies is projected to decline by 3.8 per cent in 2009 before
growing by a meagre 0.6 per cent in 2010. The GDP of US and the UK is forecast to witness
a fall of 2.6 per cent and 4.2 per cent in 2009 before an anaemic recovery to 0.8 per cent and
0.2 in 2010, respectively. Euro area, on the other hand, is expected to shrink by 4.8 per cent
and 0.3 per cent both in 2009 and 2010, respectively (WEO, 2009a). Unemployment in
advanced countries is projected to scale higher from 5.8 per cent in 2008 to 8.1 per cent in
2009 and further to 9.2 per cent in 2010 (WEO, 2009). The unemployment in the US is
expected to almost double from 5.8 per cent in 2008 to 10.1 per cent in 2010. Spain is
forecast to suffer the highest unemployment within the euro area with 19.3 per cent
unemployment in 2010. The fiscal stimuli that have been put together in these countries in
response led to worsening fiscal positions. In the OECD countries, the fiscal position is set to
deteriorate from -3.2 per cent in 2008 to -7.7 per cent in 2009 and further to -8.8 per cent in
2010. The fiscal deficit is poised to more than double in the US, Japan and the Euro area in
2009 and further deteriorate in 2010. By the end of 2010, the ratio of gross government debt
to GDP is estimated to reach 98 per cent for the US, 87 per cent for Germany, 80 per cent
for France and 73 per cent for UK. Financial stabilization in the world has come at a huge
cost. Financial stabilization cost1 is highest for the US at 12.7 per cent of GDP and lowest for
Italy at 0.9 per cent of GDP. For the UK, it is 9.1 per cent, 4.4 per cent for Canada, 3.1 per
cent for Germany, and 1.8 per cent for France (GFSR, 2009).
Collapsing growth in advanced economies led to a sharp contraction in economic activity in
EMEs, due, inter alia, to an unprecedented drop in export demand that coincided, with a
significant reversal in international bank lending and foreign portfolio investment. Emerging
and developing economies are projected to post a much subdued growth of 1.5 per cent in
2009, notwithstanding an expected pick up in growth momentum during the second half of
2009. Emerging Asia is estimated to grow by 5.5 percent in 2009 and 7.0 percent in 2010,
owing to improving prospects in China (7.5 per cent and 8.5 per cent) and India (5.4 per cent
and 6.5 per cent). African countries are forecast to register much lower growth of 1.8 per cent
in 2009 and recover to 4.1 per cent in 2010. On the contrary, Latin America is projected to
contract by 2.6 per cent in 2009, before a recovery to 2.3 per cent in 2010. Badly affected by
the reversal of capital flows and sharp contraction in commodity exports, countries in central
and eastern Europe and in Commonwealth of Independent States are expected to suffer
more severe shrinkage of 5.0 per cent and 5.8 per cent respectively in 2009 (WEO, 2009a).
These countries are highly dependent on western European banks, which own the majority
of banking systems in these countries. Cross-border bank funding has been disrupted as the
banking crisis in western Europe intensified. This real sector weakness has been adversely
affecting the banking sector in these countries through the negative feedback loop.
Global response by sovereigns and regulators
It is not therefore surprising that there has been so much soul searching, especially in the
advanced economies, of what went so seriously wrong with the international financial system
leading to the worst crisis since the great depression. The various factors that led to and
precipitated the crisis are now well known and documented and I do not want to go over
these. What I would like to do, is to discuss the actions taken so far by Governments, central
bankers and regulators over the last one year. Just last week, we have had two very
important statements - one issued by the G20 Finance Ministers and Governors and the
other by the Basel oversight body - the Group of Governors and Heads of supervision.
These statements reflect the consensus arrived at, so far, for strengthening financial
regulation and supervision and outline what remains to be done. It is therefore very timely
that we are having this seminar today to debate and discuss the implications of the changing
international framework for emerging countries like India.
Let me start with the Basel Committee. In July this year, the Committee issued a series of
standards for higher capital for the trading book as it was recognised that the Basel II
framework seriously underestimated the capital needs for the trading book. Therefore, the
Basel Committee has introduced new trading book capital rules that substantially raise
trading book capital requirements. It prescribes higher capital requirements for
resecuritisations and exposures to off-balance sheet vehicles. It has evolved principles for
stress testing and valuation of complex products, as also for supervision and management of
funding liquidity risk. It has incorporated the FSB compensation standards into the Pillar 2
supervisory review process and has enhanced Pillar 3 disclosures focusing on trading
activities, securitisations and exposures to off-balance sheet vehicles. Yesterday, i.e. on 7th
Sep 2009, following a meeting of the Governors and Heads of Supervision, the oversight
body of the Basel Committee on Banking Supervision representing 27 important jurisdictions,
issued a press release on a comprehensive set of measures to strengthen regulation,
supervision and risk management of the banking sector. These measures include:
•
Raising the quality, consistency and transparency of the Tier 1 capital base. The
predominant form of Tier 1 capital must be common shares and retained earnings.
Deductions and prudential filters will be harmonised internationally and generally
applied at the level of common equity.
•
Introduction of a Leverage ratio which will be initially a supplementary measure to the
Basel II risk-based framework with a view to migrating to a Pillar 1 treatment based
on appropriate review and calibration. To ensure comparability, the details of the
leverage ratio will be harmonised internationally, fully adjusting for differences in
accounting.
•
Introduction of a minimum global standard for funding liquidity that will include a
stressed liquidity coverage ratio requirement, underpinned by a longer-term structural
liquidity ratio.
•
Prescribe a framework for countercyclical capital buffers above the minimum
requirement. The framework will include capital conservation measures such as
constraints on capital distributions. An appropriate set of indicators, such as earnings
and credit-based variables, will be used as a way to condition the build up and
release of capital buffers.
•
Provisioning requirements on a forward looking basis using the principle of expected
losses.
•
Recommendations to reduce the systemic risk associated with the resolution of
crossborder banks.
•
Assess the need for a capital surcharge to mitigate the risk of systemic banks.
In order to ensure transition to a higher level and quality of capital, supervisors will be
encouraged to take actions to limit excessive dividend payments, share buybacks and
compensation.
The G20 Finance Ministers and Central Bank Governors issued a statement on 5th
September reaffirming their commitment to strengthen the financial system to prevent the
build-up of excessive risk and future crises and support sustainable growth. The Group took
note of the actions taken so far by FSB including introduction of CCPs to clear most credit
default swaps, stronger oversight regimes for credit rating agencies, internationally agreed
principles for the oversight of hedge funds, good practices for due diligence by asset
managers when investing in structured finance products, and issuance of internationally
agreed principles for regulation of short selling. More action has been called for by the Group
in the following areas:
• Compensation practices.
•
Stronger regulation and oversight for systemically important firms and strengthening
the legal framework for crisis intervention and winding down firms.
•
Delivering an effective programme of peer review, capacity building and
countermeasures to tackle non-cooperative jurisdictions that fail to meet regulatory
standards, AML/CFT and tax information exchange standards.
•
Consistent and coordinated implementation of international standards, including
Basel II, to prevent the emergence of new risks and regulatory arbitrage, particularly
with regard to Central Counterparties for credit derivatives, oversight of credit ratings
agencies and hedge funds, and quantitative retention requirements for
securitisations.
•
Convergence towards a single set of high-quality, global, independent accounting
standards on financial instruments, loan-loss provisioning, off-balance sheet
exposures and the impairment and valuation of financial assets.
The Indian position
In India, strengthening and developing financial sector has been subservient to the needs of
the real sector. Endeavour has always been to ensure harmonised development of all the
sectors of the Indian economy. A number of measures based on the principles that are now
accepted internationally were already brought into practice even before the crisis. These
included restrictions on leverage for banking and non banking institutions, stringent liquidity
requirements, counter cyclical prudential measures, not recognising in Tier I capital many
items that are now sought to be deducted internationally, recognising profits from sale of
securitised assets to SPVs over the life of the securities issued, not reckoning unrealised
gains in earnings or in Tier I capital. The challenge for us is to facilitate the growth of the real
sector through financial products and innovations subject to adequate safeguards and
adoption of sound risk management policies. For further strengthening financial regulation
and supervision, the following measures are under the consideration of RBI:
•
Based on July 2009 final documents from BCBS on enhancements to Basel II
framework, further guidelines relevant to standardized method are being issued.
•
A draft circular detailing the modalities for adopting the integrated liquidity risk
management system as also the guidance note on "Liquidity Risk Management"
based on Basel Committee's "Principles for sound liquidity risk management and
supervision" brought out in September 2008 as well as other international best
practices will be put up on the Reserve Bank website by October 31, 2009.
•
As part of developing financial market infrastructure, recently, capital adequacy norms
for CCPs have been laid down. CCIL's role is being gradually extended to the OTC
interest rate and forex derivatives segment, initially as a reporting platform and
thereafter, covering the settlement aspect.
•
Additional guidance on securitisation focusing on a minimum lock-in-period and
minimum retention criteria for securitising the loans originated and purchased by
banks is proposed to be issued shortly.
•
Recently, regulatory and supervisory framework for financial conglomerates has been
reviewed for enhancing the regime. The enhancements would be put in operation
shortly.
•
RBI would shortly be issuing a draft Discussion Paper on prudential issues in banks'
floating and managing private pools of capital in order to sensitize banks about risks
inherent in such activities and limit such exposures commensurate with their risk
management and available capital.
•
As indicated in the Annual Policy Statement announced in April 2009, the Reserve
Bank would recommend the implementation of the sound procedures/principles being
developed by the FSB for financial institutions regarding the compensation packages.
•
There has been significant progress in the area of convergence of accounting
standards. The Indian accounting standards are expected to be fully convergent with
IFRSs with effect from April 1, 2011. Reserve Bank of India is actively working with
the Government, accounting standard bodies and banks for ensuring preparedness
for smooth convergence by the banking system.
Way forward
The agenda that is being developed for strengthening of financial sector regulation and
supervision is ambitious. Contentious issues will arise both at national and at the
international levels on regulatory cooperation. Whereas the principles underlying this
regulatory overhaul are being increasingly accepted, many challenges will arise on their
practicality and modes of implementation:
•
Firstly, there is a need to ensure that regulators and supervisors remain firm in their
resolve to ensure that there is no build-up of risk in the system and that the principles
and framework articulated are adhered to in letter and spirit.
• Second, the interconnectedness of the institutions and markets requires central
banks, banking and securities regulators to work in close coordination with full
exchange of information and frequent interaction to assess the systemic risks at any
point of time.
•
Third, several of the countercyclical proposals are dependent on the assessment of
economic and banking conditions in national jurisdictions which will determine the
capital buffer requirements - these will obviously vary from one jurisdiction to another
as cycles would also vary. With banks operating across the globe, this will imply that
capital requirement could vary across jurisdiction - parking the transaction in a more
favourable jurisdiction cannot be ruled out. Coupled with complex structures and
differential tax regimes, minimising regulatory and tax arbitrage will continue to be a
huge challenge.
•
Fourth, cross border resolution issues will continue to be daunting especially as
national regulators will seek to protect domestic depositors and stake holders.
•
Fifth, convergence toward international accounting standards will be a huge
challenge in terms of not only bringing in the changes in standards that are
appropriate for the country but also for putting in place systems and capabilities to
facilitate convergence. Issues such as putting in place prudential filters for not
distributing unrealised gains would also arise.
•
Sixth, while there are discernible signs of recovery in the global financial markets, the
real test of the resilience of the financial system will be its performance through the
exit process. For the emerging market economies such as ours, the challenge will be
to manage the impact of this process of global stabilisation.
•
Seventh, in emerging markets such as India, without sufficient historical data of credit
and default cycles, there are difficulties in putting in place many of the advanced
methodologies under the regulatory framework such as expected loss provisioning,
additional capital buffers linked to PDs.
•
Eighth, an additional challenge for the EMEs is that they are exposed to the volatile
international capital flows necessitating suitable regulatory policies depending on the
macro economic conditions for ensuring financial stability.
•
Finally, for countries like India, the advantages of coming in late is that while
introducing new products and instruments one can have the benefit of the global
experience so that the pitfalls can be avoided while reaping the gains of innovation.
Thank you.
References
World Economic Outlook, (2009): International Monetary Fund, April.
World Economic Outlook (2009a): International Monetary Fund, Update, July.
Global Financial Stability Report (2009): International Monetary Fund, April.