Shyamala Gopinath: Emerging blueprint for prudential regulation -
assessment and challenges
Address by Ms Shyamala Gopinath, Deputy Governor of the Reserve Bank of India, at
"Confluence 2009", organized by the Indian Institute of Management Ahmedabad,
Ahmedabad, 27 November 2009.
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It is a pleasure to participate in the Confluence 2009 at one of the premier management
institutes of the world. It has largely been the symbiotic relationship between the academia
and financial sector that has spurred the revolution in finance over the past few decades.
Starting from 1973, when the Black Scholes option formula moved almost immediately from
paper to practice (the seminal paper was published in the same year, followed by the
opening of the world's first modern options market, the Chicago Board Options Exchange) it
has been a series of discrete jumps from one innovation after another in the financial sector
aided primarily by the highly technical support provided by multidisciplinary research.
Somewhere along the way, however, the real marketplace got misaligned with the
assumptive world of financial theory.
What the present crisis has done is to put a serious poser to the "legitimatory" cloak around
the way financial markets function and are regulated. The real problem with the reigning
doctrinaire was that it institutionalized a certain market philosophy which never in the past
came for a mid-course correction in spite of opportunities provided by crises of relatively
smaller intensity. More importantly, it greatly influenced the philosophy of regulation of
financial markets and put market prices at the centre of the prudential regimes. Even the field
of accounting over the years has gradually gravitated towards a market-based system
instead of a prudence based system. With both the prudential regimes and accounting
regimes reinforcing the primacy of market based frameworks, there was actually no systemic
mechanism to appreciate and address the underlying infirmities. The downsides of such an
approach were clearly evident during the crisis - a clear illustration being that of international
banks during the crisis accounting for large gains on fair valuation of liabilities due to
widening of credit spreads. I do not know if this crisis will prove to be an inflexion point but it
has certainly succeeded in pushing the policy makers to at least attempt to address some of
the fundamental issues.
In the aftermath of the crisis, policy makers around the world are contending with five major
challenges - known commonly as the five Rs, i.e. "Recovery" (from recession or slowdown),
"Rescue" (of failing or vulnerable banks and financial institutions), "Retreat" (or exit at some
stage from the large policy stimulus delivered so far), "Regulation" (to strengthen crisis
prevention) and "Restructuring" (particularly international architecture to preserve and
promote financial stability in a globalised world). Today I will focus on one of the five "Rs",
i.e., "regulation" as a catalyst to minimize the probability and intensity of systemic crises in
future, and also share with you the Indian experience and approach to regulation.
Regulation and crisis
The high impact and unprecedented complexity of the crisis has opened several issues on
the regulation of financial entities and markets to vigorous debate and diverse perspectives.
In particular, "Soft Touch" regulation, widely perceived as a key factor that allowed excesses
to grow in financial systems is now considered ineffective and one that needs to be
approached with considerable caution. In the post-crisis scenario, a counter viewpoint is
emerging, which though not in favour of excessive regulation does emphasise that regulation
needs to be more encompassing and should include a macro perspective. Going forward,
regulation has to balance the focus on systemic aspects with promoting efficient and
competitive financial systems and healthy institutions to support growth and economic
development.
In the pre-crisis framework for financial stability - the three pillars of Basel-II, namely capital
adequacy, supervisory review and market discipline were generally seen as adequate and
appropriate. However, the crisis revealed that many international banks needed higher and
better quality capital, because there was pervasive underestimation of risk, which created the
impression that banking systems around the world were adequately capitalized before the
crisis. The supervisory review process for assessing capital adequacy, and the overall
supervisory frameworks for early identification of vulnerabilities also failed because of
complex interconnectedness between financial institutions and markets which was difficult to
understand without robust macro-prudential supervision. The disclosures envisaged in Pillar
3 also proved to be insufficient in the light of the complexity of financial instruments and the
information asymmetries generated. It is not surprising therefore that in the post-crisis period,
the emerging global consensus is increasingly supporting regulatory actions that will
strengthen prudential regulation both at the macro and micro level that will need to be
integrated appropriately into the national regulatory regimes over time. Today, I will touch
upon some important international initiatives underway that aim to develop a macro
prudential orientation towards regulation while strengthening the micro prudential aspect. I
will then also talk about some aspects of the regulatory framework in India.
Macro-prudential regulation
Financial regulation was founded on the assumption that making each bank safe makes the
system safe. This fallacy of composition probably explains lack of regulatory action even
while the risks of underpricing, high systemic leverage and rapid credit expansion were
evident. In recognition of the fact that the costs of systemic crisis can become excessive,
significant work is ongoing at the international level in making prudential regulation more
macro oriented and system focused. In this current context, the deliberations at various fora
are taking on board a specific connotation of macro-prudential regulation - buffering the
system from the vagaries of the boom-bust cycles through countercyclical tools. The tools
being examined are broadly two: first, reducing the risk of system wide spillovers and
second, addressing the negative feedback loops induced by pro-cyclical interactions
between individual institutions and the system as a whole.
Addressing systemic risk
Systemic risk is defined as a risk of disruption in the financial system that is caused by an
impairment of all parts of the financial system and has the potential to have serious negative
consequences for the real economy. The objective of the overlay of the macroprudential
framework is to contain the risk of systemic contagion.
Systemically important entities: The identification of systemically important institutions can
be on the basis of their size, connectedness to the system or even the business model
followed. The objective is to identify the negative externalities such institutions might
generate. Both qualitative and quantitative criteria will be relevant; whether the bank is
largely a domestic focused bank or multinational, complex or a constellation of subsidiaries
and interconnectedness with the system. On interconnectedness, an institution is clearly
systemic if it is a dominant player in the inter-bank market or other funding and derivatives
markets.
Systemic capital surcharge: On account of the interconnected nature of the financial
system, supervision of individual institutions may not help in proper assessment of risk at the
system level. System-wide risks may be much larger than the sum total of risks identified at
individual institution levels, which could be on account of institutions that are systemically
important and that generate negative externalities or risks for the system. There is therefore
a proposal to levy a "systemic capital charge" on banks and institutions which pose potential
systemic risks. This would, however, require identification of systemically important
institutions and an assessment of the contribution of a systemically important institution to
overall systemic risk.
There is also another issue - that of determining the extent of the systemic risk surcharge.
This is as yet an issue of debate though there are calls to measure in a rigorous and
scientific way relating it to the downside risk of the financial system. The systemic risk
assessment would require macro-prudential analysis to examine the dynamically changing
interactions between financial institutions, the financial markets and the real economy, as
well as risks from unregulated or less regulated entities for the banking systems. Regulated
entities may have tendency to escape or circumvent regulation by using structures and
subsidiaries, which could be alternative sources of extra return during normal times but could
as well be potential sources of risk. If a special "capital charge" has to be imposed in
proportion to the risk posed by a systemically important financial institution to the entire
financial system, then developing the matrix for institution specific capital charge would be a
real challenge for the regulators.
Orderly Bank Resolution: Existing legal and regulatory arrangements across jurisdictions
are not generally designed to resolve problems in a financial group operating through
multiple, separate legal entities. This is true of both cross-border and domestic financial
groups. While the regulatory framework has been harmonized across jurisdictions, the
resolution framework has remained jurisdiction specific. There is no international insolvency
framework for financial firms and a limited prospect of one being created in the near future.
To prevent weakness in one institution affecting the entire financial system, a pre-planned
resolution mechanism should ensure winding down of the problem in an orderly manner, only
affecting the shareholders or at best the creditors, but not tax payers in general. Different
proposals in this regard include "living wills" prepared by institution, particularly large and
systemically important institutions during normal times approved by their respective boards,
or resorting to "narrow banking" that could limit the activities of a bank once its problems
exceed some threshold. Another suggestion, that I referred to earlier in the context of
systemic institutions is to segregate "utility banking" from "casino banking", thereby making
access to lender of last resort support only to "utility banking" and allowing "casino banking"
to fail without any support from the authorities. While these suggestions are being discussed
and debated, the Basel Committee is working on developing a bank resolution framework
that would facilitate the orderly resolution of cross-border banks. This of course would involve
significant cross-border cooperation and information sharing between home and host country
supervisors.
Leverage ratio: Excessive leverage particularly in off balance sheet transactions could go
unnoticed because of the emphasis on risk weighted capital adequacy requirement. Assets
created through leverage may not appear risky during a boom phase, and bubbles could be
fuelled by growing leverage without the need for higher capital. Recognising the risks in over
leverage and in view of the fact that risk models cannot capture risks with absolute precision,
the risk based capital adequacy is proposed to be underpinned by an internationally
harmonized leverage ratio. The design of a leverage ratio requires a definition of capital (the
capital measure) and a definition of total exposure (the total exposure or assets measure).
The specification of both the numerator and the denominator is a complex issue and it will be
a challenge to arrive at an internationally homogeneous definition. The capital measure
should ideally be the pure loss absorbing component. The exposure must include all
onbalance sheet items, with some arguing for exclusion of cash and cash like instruments. For
off balance sheet items, there could be several options based on conversion factors, notional
principal values etc. Currently all options are being examined. In normal times it may not be
binding - the acid test is whether a bank otherwise complying with Basel II will be limited by
this ratio in good times, so that it does not leverage excessively and result in shortage of
capital in bad times. It would put a floor under the build up of excessive leverage.
There is a move to transfer all standardized OTC
Regulation of OTC derivatives market:
derivatives particularly credit default swaps onto trading platforms/exchanges or a clearing
house. However the specific proposals being discussed in various countries do envisage
continuance of non-standardised OTC contracts albeit with a stricter bilateral collateralisation
requirement and higher capital charge. Also, the end-users that use derivatives to hedge
commercial risks are proposed to be exempt from the clearing requirement. This was one of
the major concerns expressed against the move to transfer all OTC transactions onto
exchanges that it will increase the cost of hedging for the real sector. The issues going
forward would be: (i) balance the trade-off between bringing all major market participants
onto exchanges and giving relief for hedging by end-users; (ii) identifying the specific
contracts that can be traded on the exchange (iii) strengthening prudential framework for
residual non-standardised OTC contracts.
It would be imperative for the CCPs to be treated as "too big to fail" systemic entities and
regulated/supervised within a globally harmonized set of standards.
Containing pro-cyclicality
Both prudential regulations and accounting standards have increased pro-cyclical behavior
among banks. Regulators need to recognize pro-cyclicality as a very natural unavoidable
behavior. As noted by Kindleberger (2005), "...the cycle of manias and panics results from
the pro-cyclical changes in the supply of credit; the credit supply increases rapidly in good
times, and then when economic growth slackens, the rate of growth of credit has often
declined sharply... Minsky believed that pro-cyclical increases in the supply of credit in good
times and the decline in the supply of credit in less buoyant economic times led to fragility in
financial arrangements and increased the likelihood of financial crisis."
The Basel Committee broadly defines pro-cyclicality as the adverse feedback mechanisms
through which the financial system can amplify business fluctuations and possibly cause or
exacerbate financial instability. The Committee is working on various proposals intended to
contain procyclical elements in regulation.
Building countercyclical capital buffers: Given the fact that pro-cyclicality is unavoidable,
building capital buffers during good times over and above the risk weighted capital levels is
necessary. Such counter-cyclical capital prescription could theoretically be influenced
through any of the elements of the capital equation: the percentage number which could
oscillate between a point measure and a range measure, the risk weights applicable to
different asset classes, individual constituents of capital etc. There is a consensus on the
establishment of a capital buffer above the minimum that is met or exceeded in good times.
There are several technical issues to be addressed including whether these should be linked
to broad measure of credit aggregates or earnings.
Dynamic provisioning: The fundamental principle underpinning dynamic provisioning is that
provisions are made against all outstanding loans based on an estimate of forward looking
expected loss instead of incurred losses. The benefit is that such provisioning would make
the balance sheets less vulnerable to cyclical fluctuations. The foremost critique of the above
approach has come from the accounting fraternity which interprets this as an instrument
which can be potentially misused for profit smoothing. However, post crisis there is greater
appreciation of the prudential benefits of dynamic provisioning even from accounting
standard setters. It should be possible to have inbuilt checks and balances to ensure that the
potential misuse is minimized.
Additional technical work in necessary for studying business cycle patterns, and determining
adequacy of provisions considering experience over the economic cycle. This would involve
factoring in historical loss experience and qualitative factors such as underwriting standards
and economic conditions.
Micro prudential regulation
From the micro perspective, the focus is on strengthening the resilience of individual
institutions. I will discuss some important initiatives being debated in this regard.
Improvements in capital - level and quality: Before the global crisis, based on quantitative
impact analyses, it was perceived that many global banks may require lower capital after the
migration to Basel-II. The crisis though revealed the deficiency of capital, which precipitated
a severe global credit squeeze. In addition to increasing the minimum level of capital, the
regulatory capital requirement would now also emphasise: (a) extending the coverage to
include securitization activities and complex financial instruments, all off-balance sheet
activities and trading book exposures -thereby making the coverage as comprehensive as
possible, (b) enhancing the quality of capital buffer by including only common equity and
reserves under Tier 1 capital.
Given the current policy emphasis on economic recovery, however, any actual
implementation of stronger capital requirement may have to wait till the recovery becomes
durable, since a tighter capital requirement in the midst of economic slowdown could impede
recovery.
Liquidity: The original notion that high capital strengthens confidence in the bank and thus
reduces liquidity risk as also that a single capital ratio is an adequate measure of financial
soundness has been dispelled. Adequate capital cannot save a bank from illiquidity spirals in
the markets. Illiquidity could also lead to insolvency if markets abruptly stop supplying
funding liquidity and some of the apparently liquid assets in the banks' portfolios turn out to
be illiquid (i.e. could be sold at significant loss only) under a condition of generalized market
stress. Banking by nature depends on liquid funds and deposits to create assets which are
less liquid, and if assured access to liquidity under a condition of market stress is not planned
as part of the liquidity management strategy, then banks would remain vulnerable to illiquidity
shocks in the markets.
The Basel Committee's Principles of Sound Liquidity Risk Management and Supervision
(September 2008) provides a robust liquidity risk measurement, management and
supervision approach, which needs to be effectively implemented. The Committee is
currently engaged in developing a global liquidity standard comprising of: i) a short-term core
funding ratio to address liquidity needs in a one month acute stress scenario. For this, banks
will need to maintain on an ongoing basis a stock of truly high quality liquid assets that
should be no less than the cumulative net cash outflows over the one month period. ii) a
longer term structural liquidity ratio, which intends to address structural liquidity issues and
core funding over longer-term horizons.
Accounting standards
The Pittsburg communique issued by the G20 Leaders has exhorted the "international
accounting bodies to redouble their efforts to achieve a single set of high quality, global
accounting standards..... and complete their convergence project by June 9, 2011." The
IASB and FASB have since issued a joint statement reaffirming their commitment to work
towards convergence to a single set of high quality global standards.
As things stand, there are multiple areas where the approaches of IASB and FASB differ
fundamentally.
•
Financial instruments accounting: FASB is more inclined towards continuing fair
value measurement for most financial instruments, which would be proposed by
early 2010, while the IASB has proposed a mixed model of historical cost and fair
value, to be available for use in 2009 year-end financial statements. The November
5th Joint Statement however mentions that the boards agreed to a goal of making
US GAAP and IFRS fair value measurement requirements the same other than
minor necessary differences in wording or style
•
Provisioning and impairment: The IASB published on 5 November 2009 a proposed
impairment model for those financial assets measured at amortised cost, based on
the expected cash flows approach. The FASB is developing a model for accounting
for credit losses for financial assets that the FASB has tentatively decided should be
measured at fair value through other comprehensive income. This has been an area
of contention between accountants and prudential regulators and some agreement
here would be critical for using provisioning requirements as a tool to address
balance sheet procyclicality.
•
Accounting requirements of the IASB and FASB for netting/offsetting of assets and
liabilities, particularly derivatives, results in significant differences in banks' total
assets, posing problems for framing an international leverage ratio: while the US
GAAP allows derivatives to be offset against each other, the IFRS only allows
offsetting if the institution has both the ability and the intention to net settle. This
results in significant differences between the size of balance sheet assets prepared
as per the two standards. From a prudential perspective, this poses a challenge for
prescribing a uniform method to calculate leverage.
The IASB has recently issued the IFRS 9 Financial Instruments pertaining to classification
and measurement of financial assets in replacement of IAS 39. Essentially, the number of
classification and measurement categories has been reduced along with the removal of the
tainting clause. The objective is to measure, on the basis of this classification, at fair value
those instruments for which current values are more informative and at amortised cost those
instruments for which contractual flows are more informative.
Indian experience
The Indian financial system avoided any major stress on account of contagion from the
global financial crisis, even though the real economy later exhibited slowdown in activity as
the synchronised global recession affected all countries around the world. Our overall
regulatory framework and the specific regulatory measures played an important role in
preventing instability in the Indian banking system during the global financial crisis in
particular, and in avoiding any banking crisis in general in the past.
Macroprudential framework
Macro variables such as aggregate credit growth, sectoral credit growth and incremental
credit-deposit ratio of banks have historically been integral components of macro policy
framework. Much before the crisis, these variables were dovetailed into the prudential
regulatory framework for banks. Counter cyclical measures in respect of capital and
provisioning were first taken on board in 2005 when risk weights and provisioning on certain
segments were increased on account of rapid credit growth in these segments leading to
concerns about potential impact of asset price bubbles and impact on credit quality.
However, the important difference was that Indian approach entailed sector-specific
prescriptions. In the Indian context it was imperative to ensure that flow of credit to
productive sectors was not affected since the rapid credit growth was a matter of concern
only in certain sectors.
In India, we have identified about a few financial conglomerates perceived as being
systemically significant based primarily on size. There is a mechanism in place involving all
regulators for monitoring intra-group transactions and exposures, and large exposures of the
groups to outside counterparties. The challenge going forward will be to ensure that the
monitoring mechanism and regulatory coordination is strengthened further in the interest of
financial stability, in particular with regard to any recommendations made by standard setters
and keeping in view the Indian context.
The issue of regulatory perimeter being raised internationally in the post crisis scenario had
also confronted us in the context of growing systemic significance of non-deposit taking
nonbanking financial companies. The focus of regulation in India used to be on deposit taking
non-bank institutions. Since the non-deposit taking financial institutions were growing rapidly
in view of regulatory arbitrage and the liability side dynamics was closely linked to the public
funding markets, the systemically important non-bank financial institutions were brought
within the regulatory framework. This included capital adequacy and exposure norms. Banks
exposures to these entities are also subject to prudential regulation.
To address liquidity risks at the very short-end for individual banks and also for the system as
a whole, there is a well laid down framework in place. The overnight unsecured
(uncollateralised) market for funds is restricted to banks and primary dealers (PDs), with
specified limits. There are prudential limits on banks on their purchased inter-bank liabilities
as a proportion of their net worth to encourage greater reliance on stable sources of funding.
The SLR regime is now viewed by some as a potential solvency as well as liquidity buffer.
For short-term liquidity requirements, only the excess over SLR is considered.
We already have a CCP mechanism for clearing and settling all interbank spot forex
transactions and all outright and repo transactions in government securities. Non-guaranteed
settlement of OTC trades in interest rate swaps has also commenced in 2008. Guaranteed
settlement of IRS and forex forwards is a work in progress at advanced stage.
Few random concluding thoughts
A real concern going forward is that the urgency and momentum for reform of the financial
system is gradually waning. The easing conditions have provided the comfort and space for
dissenting voices. There are now much more vociferous voices from the market participants,
having been bailed out either implicitly through system wide guarantees and liquidity or
specific bailouts against some of the crucial reform measures. As in the past, there are two
key levers being employed by this group: first, the risk of short term economic growth being
adversely impacted and second, the fear of an unlevel playing field among major financial
centres resulting in loss of business opportunities and competitiveness for the first movers. In
conclusion I would like to flag a few challenges on the road ahead for both national and
international policy makers:
i. Increasing minimum capital and liquidity requirements will bring out a balance
between financial innovation efficiency and growth. The BCBS will carry out a
comprehensive impact assessment to calibrate the new capital and liquidity
standards to ensure that they are proportionate to the risks. They will assess the
overall effect of the package and there will be no piecemeal layering of the
requirements. Moreover these will be introduced over a time frame that does not
impact eco recovery. The G20 Principals have in the November 7, 2009
communique emphasized "the need for the Basel Committee to develop stronger
standards by end-2010 to be phased in as financial conditions improve and the
economic recovery is assured, with the aim of implementation by end-2012".
ii. From a financial stability perspective it would be useful not to restrict the scope of
macroprudential regulation and interpret it as an institutionalized mechanism for
aligning the regulatory framework for institutions and markets with a systemic
perspective. For instance, the systemic problems faced by many countries on
account of excessive foreign currency liabilities need to be effectively addressed
through the use of prudential tools or other instruments, though from an individual
institution's perspective no action may be warranted.
iii. Excessive dependence of entities on wholesale funding markets such as repo is an
issue of systemic concern since one, it accentuates systemic procyclicality through
haircuts/margins and two, the leverage loop that builds through these markets in
high liquidity periods induces rigidity and gets entrenched into funding models of
entities. It is therefore imperative to bring the repo markets within the regulatory
perimeter, particularly since many entities participating in these markets are
unregulated/lightly regulated. There is need for a cautious approach when the
securities that are repoed carry credit risk and are illiquid. The RBI guidelines on
repo of corporate bonds, which will be issued shortly, will take the above issues on
board.
iv. One issue with the macro-prudential approach being pursued would be to find the
appropriate balance between a rule-based, formulaic approach and the regulatory
discretion for determining the course of action. It is quite possible that the sense
coming out of the macro analysis or stress tests will be in the nature of potential
leads without any conclusive evidence and therefore not amenable to rule based
approach. However, this should not lead to inaction if there are overriding
considerations of financial stability.
Assuming that the above work program unfolds as intended and is fully implemented, would
it be sufficient to prevent the next crisis? Perhaps not. But what it will undoubtedly achieve is
to give sufficient room for regulators to act. The origins of next crisis may come from as yet
unidentified exogenous sources or the macroeconomic framework or macro-imbalances but
the emerging blueprint for prudential regulation is aimed at preparing the system to adjust
itself in a non-disruptive manner. This will need timely judgement and effective action by the
regulators even as the music continues to play.