Duvvuri Subbarao: Financial stability - issues and challenges
Valedictory address by Dr Duvvuri Subbarao, Governor of the Reserve Bank of India, at the
FICCI-IBA Annual Conference on "Global Banking: Paradigm Shift", organised jointly by
FICCI and IBA, Mumbai, 10 September 2009.
* * *
I. Global banking - paradigm shift
Thank you for inviting me to participate in this FICCI-IBA conference on "Global Banking:
Paradigm Shift". I understand this is one of the important banking conferences in the annual
calendar, and so I struggled through what I should say at this valedictory that is central to the
theme of the conference.
Quite understandably, public discourse over the last one year has been dominated by the
global financial crisis; and the future of global banking has clearly been one of the important
facets of this discourse. How the regulatory architecture around the world is reinvented will
be a critical determinant of the paradigm shift in global banking. In his 1962 book, "Structure
of Scientific Revolutions", Thomas Kuhn argues that when evidence against a prevailing
scientific theory piles up, that theory is jettisoned and a new one is adopted signalling a
paradigm shift. As we contemplate the lessons of the crisis, the questions that arise are what
is the evidence against the old model of central banking and regulation, and what is the new
model. What is the paradigm shift required? I will position my speech this afternoon on some
of the issues in this paradigm shift.
II. Financial stability - key lesson of the crisis
Breakdown of trust
There appears to be broad agreement around the world that the worst of the crisis is behind
us. The risk of a descent into a second Great Depression - which seemed to be a threat as
recently as March - has greatly diminished, if not disappeared. Nevertheless there is a
furious debate on the pace and shape of global recovery. Regardless of one's position on
this debate, everyone is agreed on one thing which is that restoration of trust in the financial
system is central to the pace and shape of recovery. What this crisis has witnessed is a
massive break down of trust across the entire financial system - trust in banks and
nonbanks, trust in central banks and other regulators, trust in credit rating agencies and
investment advisers, trust in brokers, dealers and traders, and trust in the financial markets, if
not in the market system itself.
Anatomy of financial instability
It was the abrupt breakdown of trust following the collapse of Lehman Brothers in
midSeptember 2008 that caused financial markets in advanced economies to go into seizure.
Suddenly, there was a great deal of uncertainty not only about the extent of losses and the
ability of banks to withstand those losses, but about the extent of risk in the system, where it
lay and how it might explode. This uncertainty triggered unprecedented panic and almost
totally paralyzed the entire chain of financial intermediation. Banks hoarded liquidity. Credit,
bond and equity markets nearly froze. Signalling a massive flight to safety, yields on
government securities plunged while spreads over risk free government securities shot up
across market segments. Several venerable financial institutions came to the brink of
collapse. Massive deleveraging drove down asset prices setting off a vicious cycle. Trust
totally dried up.
The epicentre of the crisis lay in the advanced economies, but it soon spread in two
directions. First, in the advanced economies, it spread from the financial sector to the real
sector severely hurting consumption, investment, export and import. Second, it spread
geographically from the advanced economies to the emerging market economies and soon
engulfed almost the entire world through trade, finance and confidence channels. In short,
financial stability that we had grown to take for granted got impaired.
Financial stability comes centre stage
That indeed is one of the many lessons of the crisis - that financial stability cannot be taken
for granted. We have learnt that financial stability can be jeopardized even if there is price
stability and macroeconomic stability. We have learnt that a threat to financial stability
anywhere in the world is potentially a threat to financial stability everywhere. We have learnt
that financial stability has to shift from being an implicit variable to an explicit variable of
economic policy.
Financial instability, as we have seen, can hurt even the most advanced economies, but the
damage it can cause in poor and developing economies can be particularly severe. People
with low levels of income have no headroom to bear downside risks, and their livelihoods can
be disrupted by financial instability. It is therefore even more important that countries such as
ours pay particular attention to preserving financial stability even as we deepen and broaden
our financial sector at home and integrate with the rest of the world.
All of us in the financial sector have a role in managing financial stability. Given the centrality
of this topic to our mandate, I would like to focus my comments this afternoon on financial
stability. I will start by examining how and why central banks let financial stability fall through
the cracks, and then review the international initiatives under way to remedy the system. I will
then explain the Indian approach to financial stability, in particular highlighting the stability
enhancing features of our policy and regulatory framework. Finally, I will look ahead to some
issues and challenges on the way forward.
III. Central banks and financial stability
Central bankers around the world are clearly in the forefront battling the crisis. While they are
clearly part of the solution, questions are being asked about whether they were, in fact, part
of the problem. In particular, did they fail to see the crisis coming? Were they behind the
curve in preventing excesses from building up? Did they neglect financial stability in their
zealous pursuit of price stability? More importantly, did they behave like this because the
accountability mechanisms were weak? To address these questions, let me refer to three
egregious failures attributed to central banks.
First failure - exclusive focus on price stability
The years before the crisis saw a powerful intellectual consensus building around inflation
targeting. A growing number of central banks, starting with New Zealand in the late 1980s
and currently numbering over 20, geared monetary policy almost exclusively to stabilizing
inflation. Even where central banks did not target a precise inflation rate, their policy
objectives were informed, if not dominated, by price stability. This approach seemed
successful. There was an extended period of price stability accompanied by stable growth
and low unemployment. The presumption that price stability would deliver financial stability
too seemed to have been validated. Having beaten the nasty bouts of stagflation of the
1970s and tamed business cycles, central banks declared victory. They had discovered the
holy grail.
The crisis has blunted that sense of triumph. It has called into question the wisdom of
exclusive inflation targeting and even challenged the notion of price stability being the only
objective of monetary policy. It has underscored the importance of acknowledging financial
stability as an explicit variable in the policy matrix of central banks.
Second failure - failure to prevent asset price bubbles
A second and related feature of central banking that led to the crisis was the benign neglect
of the build up of asset bubbles and financial imbalances. In particular, the monetary policy
stance of studied indifference to asset price inflation stemmed from the now notoriously
famous Greenspan orthodoxy which can be summarized as follows. First, asset price
bubbles are hard to identify on a real time basis, and the fundamental factors that drive asset
prices are not directly observable. Second, monetary policy is too blunt an instrument to
counteract asset price booms. And third, a central bank cannot presume to know more than
the market. After all financial markets are efficient, rational and self-correcting. Any central
bank action to correct the market is not only uncalled for, but is bound to be sub-optimal. The
surmise therefore was that the cost-benefit calculus of a more activist monetary stance of
"leaning against the wind" was clearly negative. It was considered more cost effective for
monetary policy to wait for the bubble to burst and clean up afterwards rather than prick the
bubble in advance.
Third failure - lightness of regulation
A third lapse attributed to central banks, and to financial sector regulators where they are
separate from central banks, was the lightness of regulation. A host of factors - innovation of
complex products by slicing and dicing, the originate and distribute mode of lending, misuse
of derivative products, securitization that encouraged aggressive off-balance sheet activity,
loose supervision and regulation - all culminated in the build up of systemic risks, and this
despite the growing sophistication of risk management systems. Regulation typically
focussed on individual institutions, not recognizing the fallacy of composition - that systemic
stability could be threatened even if individual institutions within the system are stable. A
whole network of bank-like institutions - now called the "shadow banking system" - grew and
flourished outside the regulatory regime of banks. Regulatory arbitrage became common
practice as banks shifted risk to affiliated entities in the shadow system and evaded capital
requirements.
Warnings ignored
It is not as if the risks to financial stability were brewing silently. Several international fora
were discussing growing threats from macro economic imbalances, asset price build up,
credit expansion and depressed risk premia, and some had even issued alerts and warnings
about the impending crisis. But central banks largely refrained from strong corrective action
for a variety of reasons - the perceived inefficiency of monetary policy to redress asset price
bubbles, separation of monetary and regulatory policies and misplaced faith in the
selfcorrecting forces of financial markets. At least some of the central banks actually believed
that the Great Moderation permanently changed the macroeconomic dynamics and that the
good times will roll on for ever. The net result of all this was financial stability failed to receive
central bank attention it warranted.
IV. Global action towards financial stability
Expectedly, the crisis has triggered a vigorous debate on how financial stability should be
safeguarded. Even as the crisis is not fully behind us, several lessons are clear. First, the
received wisdom is that prevention is better than cure and that central banks should take
countercyclical policy actions to prevent build up of imbalances. Second, a consensus is
emerging around the view that central bank purview should explicitly include financial
stability. Third, there is growing acknowledgement that financial stability needs to be
understood and addressed both from the micro and macro perspectives. At the micro level,
we need to ensure that individual institutions are healthy, safe and sound; we need in
addition, to safeguard financial stability at the macro level.
Some of the significant actions already taken to bolster the resilience of the international
financial system include the enhancement of the Basel II capital framework, particularly with
regard to trading and off-balance sheet securitisation activities of banks, setting strong risk
management standards for banks and financial institutions on governance, management and
disclosure of liquidity risk and stress testing, integrating sound compensation principles in the
Basel capital framework, introducing central counterparties for derivatives trading, developing
new accounting standards to enhance the consolidation of special purpose vehicles, making
transparent banks' relationships with such entities and the issue of internationally agreed
principles for the oversight of hedge funds.
Beyond actions already taken, work is under progress on several initiatives to strengthen
stability and I want to highlight some of the more important ones.
•
Strengthening the regulatory capital framework: Recognising that the banking sector
entered the crisis with an insufficient level and quality of capital, the Basel Committee
on Banking Supervision is developing concrete proposals to strengthen the quality,
consistency and transparency of the capital base of banks.
•
Developing a global liquidity standard: Recognizing that illiquidity of banks can
threaten its solvency as much as inadequate capital and also adversely impact the
stability of the financial system, work is under way to develop an international
framework for liquidity risk regulation and supervision.
•
Strengthening the supervision of cross-border entities: Given the growing number of
cross-border financial conglomerates and their role in transmitting risk, arrangements
are being put in place for cross-border cooperation among regulators and for
establishing supervisory colleges.
•
Strengthening the macroprudential framework: Regulation has typically focussed on
individual institutions, which as has become evident now is necessary but not
sufficient. It is equally important to monitor systemic stability. The Basel Committee is
now developing macroprudential regulations to address procyclicality and systemic
risk issues.
•
Reviewing international accounting standards: There is a view that some of the
current accounting standards have contributed to market volatility. The Financial
Stability Board and the accounting standard bodies are consulting on revising
standards, in particular those relating to financial instruments and their valuation.
•
Extending the perimeter of regulation: Work is under way to develop a global
framework governing the registration, regulatory disclosure and reporting
requirements to be imposed on non-banks. The principle being put forward is that if
an institution looks and behaves like a bank, then it should be regulated like a bank,
regardless of its legal form.
•
Strengthening the oversight of credit rating agencies: The crisis has questioned the
integrity, conduct and business model of credit rating agencies. Corrective initiatives
under way include stronger regulation of credit rating agencies, measures to address
conflicts of interest, differentiation between ratings of structured and other products,
and strengthening the integrity of the rating process.
•
Rationalising compensation structures: It is agreed that compensation structures in
large financial institutions have given rise to perverse incentives for staff to maximize
profits at the cost of long-term sustainability. A key objective of the proposed changes
is to promote compensation schemes that reflect the underlying risks taken that
include back loading payoffs and claw back clauses that retrospectively adjust
bonuses on the basis of future position losses.
As a member of G20, the expanded Financial Stability Board (FSB) and the Basel
Committee on Banking Supervision (BCBS), India is actively engaged in several of these
international initiatives. The task for us will be to draw the lessons of the crisis, understand
international best practices and adapt them to our context.
V. Financial stability - Indian approach
Financial stability in India during the crisis
Even in the midst of such a cataclysmic crisis, our financial sector remained safe and sound,
and our financial markets continued to function normally. Sure, we have been hurt by the
crisis, but much less than most others. It will be a folly though to let that lull us into
complacency and to believe that there is something inevitable about India's financial stability.
As India further integrates with the rest of the world, as it inevitably will, we will increasingly
be exposed to the forces of globalization. We cannot be globalizing, and at the same time
expect to remain "decoupled". Indeed, this crisis has shown that "decoupling" is a God that
failed. If financial stability anywhere in the world is jeopardized, our financial stability will
become vulnerable too.
India's approach to financial stability
In contrast to the minimalist formula of "single objective, single instrument", the conduct of
monetary policy by the Reserve Bank has been guided by multiple objectives and multiple
instruments. In general, our three main objectives have been price stability, growth and
financial stability, with the inter se priority among the objectives shifting from time to time
depending on the macroeconomic circumstances.
What have been the key features of our approach to safeguarding financial stability? On
financial globalization, our stance has been gradualist - of making haste slowly. We view
capital account liberalisation as a process and not an event. The extent of opening is
contingent upon progress in other sectors. The policy framework encourages equity flows,
especially direct investment flows but debt flows are subject to restrictions which are
reviewed and fine-tuned periodically. The exchange rate is largely market-determined and
we intervene in the foreign exchange market in times of excessive volatility.
Our approach to financial sector regulation has been informed by the fact that our system is
dominated by commercial banks. Thus, as early as mid-1990s, the Reserve Bank instituted
the prudential framework governing banks, especially commercial banks, as a part of the
overall structural reforms. As of April 2009, all our commercial banks are Basel II compliant.
We established a Board for Financial Supervision for focussed regulation and supervision of
banks and other financial institutions under RBI's jurisdiction. We widened and deepened the
financial markets in terms of instruments, products and participant, while continuing with a
cautious approach towards exotic products.
India - important measures towards financial stability
It may be relevant to highlight some of the specific features of our system that have
contributed to financial stability:
•
Banks are required to hold a minimum percentage of their liabilities in risk free
government securities under the statutory liquidity ratio (SLR) system. This stipulation
ensures that banks are buffered by liquidity in times of stress.
•
We managed the capital account actively. In the face of large capital inflows during
2006-08, we sterilised the resultant excess liquidity through calibrated hikes in the
cash reserve ratio (CRR) and issue of market stabilisation scheme (MSS) securities.
When the flows reversed during the last quarter of 2008, we reversed the measures
too. We cut the CRR and bought back the MSS securities to inject liquidity into the
banking system.
•
Through pre-emptive countercyclical provisioning and a differentiated risk weight
stipulation for "sensitive sectors", we were able to contain the adverse impact of high
credit growth in some sectors and asset price fluctuations on banks' balance sheets.
•
To ensure that securitization is value adding, we insist on "true sale", and credit
enhancements and liquidity support are subject to capital regulations. We also require
profit from sale of assets to SPVs to be amortised over the life of the securities
issued.
•
Access to overnight unsecured call market is restricted to banks and primary dealers.
Other entities can access the overnight market only through collateralised instruments
which are cleared and settled on a guaranteed basis through a central counterparty.
• Regulation and oversight have been extended to systemically important non-deposit
taking, non-banking finance companies, and this has limited leverage and space for
regulatory arbitrage.
•
Systemic interconnectedness has been addressed by bringing banks' exposures to
non-bank finance companies within the prudential framework.
•
Central counterparty (CCP) clearing and guaranteed settlement is currently operative
for government securities transactions and inter-bank rupee-USD forex transactions.
CCP guaranteed arrangements for forex forwards and OTC rupee interest rate swaps
are underway.
Financial stability unit in RBI
As you will note from the above listing, we have used both monetary and regulatory
measures to maintain financial stability. This synergistic approach has been possible
because the Reserve Bank is both the monetary authority and the regulator of banks,
nonbanks and a large segment of the financial markets. On the way forward, our financial
markets will deepen and broaden further and we will also be increasingly exposed to the
forces of globalization. All this will have implications for our financial stability. The Reserve
Bank is conscious of the need to pay increasing attention to financial stability and to improve
our skills in this area. As a beginning in this direction, we have set up a multi-disciplinary
Financial Stability Unit in the Reserve Bank and are planning to put out a regular Financial
Stability Report. The first report is planned in the next few months. These reports will present
an overall unified assessment of the health of the financial system with a focus on
identification and analysis of potential risks to systemic stability.
VI. Financial stability: challenges on the way forward
Like all other policy measures, maintenance of financial stability involves trade-offs and
throws up a number of challenges. I want to highlight five important challenges that we will
need to address on the way forward. In doing so, I will draw from global experience.
First challenge: how to define and measure financial stability
It came to light in several countries during the crisis that the responsibility for financial
stability fell through the cracks as no agency or regulator was definitively mandated with it.
Now, there are moves to explicitly indicate which agency/agencies will be responsible for
financial stability as also to specify a protocol for addressing threats to financial stability,
much like the ones we have developed for managing natural disasters. But this requires, in
the first place, for financial stability to be precisely defined.
Despite widespread usage, financial stability is difficult to define let alone measure. This is in
contrast to price stability which can be defined and quantified. Some define financial stability
as the absence of financial instability which, of course, is tautological. From a
macroprudential perspective, financial stability can be defined as a situation where the financial
sector functions without any discontinuity. This definition is conceptually neat but is not useful
for policy purposes unless it can be quantified for measurement purposes. Policy makers and
analysts at international fora are actively engaged in fleshing out the definition so that it is
precise, measurable and comprehensive. Some critical elements of any financial stability
framework, aspects that need to inform the definition of financial stability, are the following:
•
Excessive volatility of macro-variables such as interest rates and exchange rates
which have direct impact on the real economy;
•
Build-up of significant leverage in financial, corporate and household sector balance
sheets;
•
The moral hazard risks posed by institutions that have become "too-big-to-fail" or too
interconnected or complex to resolve;
•
Internal systemic buffers within the financial sector, both at the institution and
systemic levels, to counter potential shocks to the economy;
•
Strong policy and institutional mechanisms to lean against the wind even as "the
music is playing";
•
Prevalence of unregulated nodes in the financial sector which, through their
interconnectedness with the formal regulated system, can breed systemic
vulnerabilities.
Second challenge: financial stability - exclusive or shared responsibility?
The crisis has triggered an active discussion on an appropriate regulatory structure that is
best suited to safeguard financial stability. There are several regulatory models around
including those where the central bank is a pure monetary authority with bank regulation and
supervision vested with another agency. Post-crisis, the emerging view is that the crisis was
caused, at least in part, by the lack of coordination and communication between the separate
bodies and that it is optimal, in the interest of financial stability, to entrust the function of
regulation of banks and non-banks also to central banks. The argument is that only the
monetary authority, as the lender of last resort, can provide emergency liquidity support.
Also, being the regulator, the monetary authority gets a better sense of the market conditions
and can therefore manage liquidity more efficiently.
But this model raises fresh questions. In particular, can the central bank have exclusive
responsibility for financial stability? Conversely, can the government completely delegate this
responsibility to the central bank under a principal-agent model?
Consider, for example, a situation where the banking system is under threat of instability.
Decisions have to be made on which banks to bail out and how much support to extend. In
all this, fiscal support may need to be extended. Would a government, especially if it is
democratically elected and accountable to a legislature, not want to have a say in this
regard? This calls for the following question to be resolved. How should the responsibility for
financial stability be shared between the government and the central bank? What should be
the protocol for decision making? Who should prevail, and under what circumstances, in the
event of a deadlock?
Third challenge: growth and financial stability - managing the trade-offs
In order to safeguard financial stability, we have traditionally used a variety of prudential
measures such as specifying exposure norms and pre emptive tightening of risk weights and
provisioning requirements. But these measures are not always costless. For instance,
tightening of risk weights arguably tempers the flow of credit to certain sectors, but
excessive, premature or unnecessary tightening could blunt growth. Similarly, exposure
norms offer protection against concentration risks; however, such limits could restrict the
availability of credit for important growth sectors. This is a live issue in our country in the
context of the immense needs of infrastructure financing. Thus, as in the case of price
stability, central banks face the challenge of managing the trade off between financial
stability and growth.
It needs to be recognized that after a crisis, with the benefit of hindsight, all conservative
policies appear safe. But excessive conservatism in order to be prepared to ride out a
potential crisis could thwart growth and financial innovation. The question is what price are
we willing to pay, in other words, what potential benefits are we willing to give up, in order to
prevent a black swan event? Experience shows that managing this challenge, that is to
determine how much to tighten and when, is more a question of good judgement rather than
analytical skill. This judgement skill is the one that central banks, especially in developing
countries such as India, need to hone as they simultaneously pursue the objectives of growth
and financial stability.
Fourth challenge: reforming regulatory architecture
As the lessons of the crisis emerge, central banks are vigorously reinventing themselves and
almost all countries are reviewing their regulatory architectures. Two key lessons are driving
this change: first that the responsibility for financial stability cannot be fragmented across
several regulators; it has to rest unambiguously with a single regulator, and that single
regulator optimally is the central bank. And second, that there is need for coordination across
regulators on a regular basis and for developing a protocol for responding to a crisis
situation. I want to address three issues in the broad area of regulatory architecture.
The first issue has to do with regulatory coordination. In India, we have a host of regulators in
the financial sector - RBI, SEBI, IRDA and PFRDA. In order to facilitate coordination
between them, there is a High Level Coordination Committee on Financial Markets
(HLCC-FM) comprising all the regulators and the Finance Secretary. While the Governor of
the Reserve Bank chairs the HLCC-FM, the Ministry of Finance provides the secretariat. The
hallmark of the HLCC meetings, and one that adds most value to them, is that the meetings
are informal and there is free exchange of positions, views and opinions. There is a view that
the HLCC-FM should be given a formal structure. While a formal structure will have the merit
of enforcing accountability, the flip side is that it may make the forum excessively
bureaucratic and detract from its other value adding features. This is an issue that we must
debate further. One area where the HLCCFM could have a more defined role relates to
oversight of large financial conglomerates.
The second issue relating to regulatory architecture with relevance for financial stability has
to do with changes, if any, warranted in the regulation of financial markets. Two recent
reports, both influential, one by Percy Mistry on Mumbai as an International Financial Centre
and the other by Raghuram Rajan on Financial Sector Reforms, have recommended that
regulation of all trading of financial products and instruments be brought under SEBI. We
need to seriously debate the advisability of such a unification.
Currently, the arrangement for regulation of financial markets is as follows. Apart from banks,
NBFCs and other financial institutions, RBI regulates the money market, the government
securities market, the credit market and the foreign exchange market and the derivatives
thereon. In respect of OTC derivatives, only those derivatives where one party to the
transaction is an RBI regulated entity have legal validity. In respect of products traded on the
exchanges, procedures for trade execution fall within the regulatory purview of SEBI.
Therefore, unlike many countries, India has had established procedures for regulation of
OTC derivatives.
By far the most important reason why the present arrangement should continue has to do
with preserving financial stability. Unlike equity prices, interest rates and exchange rate are
key macroeconomic variables with implications for monetary policy and overall
macroeconomic stability. In addition, banks dominate the interest and exchange rate
markets. By also being the regulator of these markets, the Reserve Bank is in a position to
exercise oversight of institutions, markets and products, to monitor market developments,
sense impending developments, take advance action, prevent excessive volatility and
maintain financial stability at the systemic level. This is an arrangement that has stood to the
test of time, has protected our financial stability even in the face of some severe onslaughts.
This is an arrangement that we should not jettison lightly in quest of a unified market
regulator.
The third issue in the reform of regulatory architecture is about whether a central bank should
also be a banking regulator. Pre-crisis, there was a dominant argument for separation of the
monetary and regulatory functions premised on a possible conflict of interest. According to
this view, if financial stability becomes the dominant concern of a central bank, it could result
in a moral hazard for banks. Banks will likely take excessive risks in the full confidence that
the central bank, being also the regulator, will ease policy and extend regulatory forbearance
to bail them out in a crisis. Paradoxically, the aggressive pursuit of financial stability can itself
threaten financial stability over the long horizon.
The crisis has clearly weakened this argument. The concern over regulatory forbearance is
exaggerated. It is worth noting that some advanced economies where regulation and
supervision are with an agency other than the central bank are themselves revisiting their
regulatory structures and contemplating some unification. The crisis has also shown that
there are clear synergies between monetary policy management and financial sector
regulation. In particular, the central bank can perform its lender of last resort function more
effectively if it has a clear view of the institution's current and prospective balance sheet and
its liquidity and solvency position.
The jury of course is still out on which model is the best as the crisis has discredited almost
a