Financial regulation and economic policies for avoiding the next crisis
(Urjit R. Patel, Governor, 32nd Annual G30 International Banking Seminar,
October 15, 2017, Inter-American Development Bank, Washington, D.C.)
1. Let me start by reminding ourselves of some numbers that are a key
backdrop for today's panel discussion. Total global external liabilities have grown
from 30 per cent to 190 per cent of global GDP between 1980 and 2015, far
outpacing the growth in global trade (from 19 per cent to 28 per cent of GDP over
the same period). The main vehicle of this new globalisation has been cross-
border banking flows, which constituted a third of global capital flows in the decade
prior to the financial crisis. In parallel, the global trade network has become
increasingly interconnected through supply chains that transcend national borders,
and by the advent of new players, especially from the developing world. China
now accounts for about 11 per cent of global trade and emerging market and
developing countries (EMDCs) taken together contribute 37 per cent (up by about
15 percentage points since 2000).
2. During the global financial crisis, the explicit pre-crisis assignment of policy
instruments to objectives became blurred. The experience demonstrated that
macroeconomic policymaking is expected to do a fine balancing act to achieve
multiple and, at times, conflicting objectives of monetary stability, fiscal stability
and financial stability. Within these trade-offs, financial stability has assumed some
seniority, entailing for national authorities the constant need to monitor, identify
and minimise the build-up of systemic risks in financial systems and reduce spill
overs in the most efficient and effective way. This involves a fine dovetailing of the
objectives of market efficiency into consumer protection and the management -
even pre-emption - of systemic risks.
3. In my remarks today, I would focus on the following issues in the role of
financial regulation in averting the next crisis:
• -
Globalisation and adherence to global rules/standards synergies and
challenges.
• -
Financial regulation and suddenness of crisis incidence regulatory
intervention needs to be more anticipatory and data-based.
• -
Backward-looking versus forward-looking risk-based supervision need for
global systemically important banks to disclose their internal rating models.
•
Too-big-to-fail and moral hazard.
•
Adequacy of global financial safety nets (GFSNs) in the context of the size
-
and speed of crises gaps and discriminatory practices in the international
financial architecture.
(i) Globalisation and global rules/standards.
4. Emerging market economies (EMEs) have undoubtedly benefited from
globalisation, but they are also more exposed than before to vulnerabilities that
come with globalisation. As we access markets abroad and spread our activities
on a global scale, our financial systems are also required to embrace global
norms, especially on capital, risk recognition and accounting standards; monetary
policy based on some rule relating to a nominal anchor such as inflation; fiscal
policy based on a budget or expenditure rule; and market-based exchange rate
regimes, complemented by strong and effective financial sector regulation and
supervision, corporate governance and enforcement rules, and bankruptcy and
resolution architecture.
5. Markets inherently impose these exacting standards of discipline when they
allow access to banks and corporates. For example, international capital tends to
punish monetary and fiscal indiscipline severely. Even as some shocks tend to be
impervious to fundamentals, economies with sound, prudent, transparent and
accountable macro-policy frameworks have demonstrated success in containing
negative externalities as well as in restoring normalcy faster. In this context,
prudent policy frameworks tie down policy actions to final goals. Some of us may
think that rules are a cost imposed on us in the form of sacrifice of independence
and sovereignty. While all rules may not best fit us, the ones that I will highlight,
specifically, monetary, fiscal and accounting, are widely accepted by reasonable
people as a basic minimum.
First, fiscal rules are institutionalised or legally binding rules that credibly commit
authorities to fiscal discipline. By restraining expenditure or overall deficits, they
enhance the credibility of macroeconomic policies, by keeping public debt within
sustainable levels improving thereby the credibility of the fiscal authority as a
participant in financial markets.
Second, a transparent and predictable monetary policy framework is, almost by
definition, rule-based.
Third, while regulation is imposed from outside, corporate governance is internal
to firms and is more in the nature of self-regulation with safeguards that principles
and rules laid down by the regulations are followed conscientiously. Nevertheless,
regulation and corporate governance have to complement each other.
with globalisation, operations of large firms have become transnational,
Fourth,
and massive cross-border movement of capital requires adoption of uniform
accounting standards, such as the International Financial Reporting Standards
(IFRS). When these standards are applied rigorously and consistently, investors,
regulators and other stakeholders all benefit with higher quality information to
make decisions.
6. With globalisation, it is imperative for banks in EMEs to adhere to standards
emanating from the global standard setting bodies. While challenges remain in
adopting standards like IFRS in EMEs, we welcome the forward looking
provisioning framework. Banks generally tend to delay provisioning for bad loans
until cyclical downturns have already set in and it is too late, possibly magnifying
the impact of the economic cycle on banks' income and capital. In such
circumstances, providing for and recognising actual and potential loan losses at an
earlier stage in the credit cycle could potentially reduce procyclicality and foster
financial stability.
(ii) Financial regulation and suddenness of crisis incidence: Need for
regulatory intervention to be more anticipatory and data-based.
7. In the context of financial stability, acceptable regulation should have three
broad characteristics: Firstly, regulation ought to be predictable. A regulation
susceptible to forbearing instincts carries the concomitant chance of risk inducing
behaviour by stakeholders. Second, regulation should aim to shoehorn internal
governance mechanisms of the regulated entities in an incentive compatible way.
Finally, it should aim to address information asymmetry between the key
stakeholders since the lack of information often leads to herd behaviour, thus
precipitating crises.
8. Backward looking regulation attempts to address gaps in regulation in one
sector, region, and nation; but given the complexity and inter-connectedness of the
financial system, activity swiftly shifts to another sector, region or nation and builds
financial excesses. However, the next threat to financial stability may come from
quarters that regulators are completely unaware of. Thus, forward-looking
regulations are required to tackle such unforeseen risks. With the advent of big
data analytics, cloud computing and artificial intelligence, we are at a stage where
data can be used to model future events with certain confidence intervals, and our
regulations can potentially be structured to deal with such events. The recent
thrust on two areas - cybersecurity and FinTech - is a case in point. A decade
back, few bankers or policymakers talked about this threat. Today these are
identified as major risks to the financial system.
9. The allergy to intrusive regulation pre-crisis has been overturned into a
necessity in the post-crisis period across advanced economies (AEs) and EMEs.
In the post-crisis hyper-active regulatory environment, it is possible to develop
detailed dos and don'ts to potentially avert a crisis. In such a milieu, certain basic
characteristics of a regulatory framework, coupled with a supervisory regime that
is responsive to investors' and other stakeholders' concerns, has the best chance
of inducing prudential behaviour among regulatees. Regulators have been
slapping record fines on major banks and financial institutions for making undue
profits or masking their problems by fraudulently rigging rates. A lot of mis-selling
of products by banks in certain jurisdictions has also raised serious concerns
among regulators, which is attracting more intrusive regulation with a significant
bearing on banks' compliance costs.
(iii) Reliance on internal rating-based risk assessment by global banks:
Black-box requires reasonable disclosure and transparency.
10. The last financial crisis has prompted doubts that the internal ratings based
(IRB) approach may have been used opportunistically to minimize capital
requirements, thus helping banks to disguise credit bubbles by keeping their risk
weighted assets (RWAs) artificially low. The evidence suggests that internal risk
estimates employed for regulatory purposes systematically under-predict actual
default rates. Supervisory confidence in risk weights is critical to the success of the
regulatory framework. The BCBS's work on the implementation of the Basel
capital framework has gathered evidence that significant variations in capital
outcomes generated by internal models (with respect to portfolios with similar risk
profiles) may be unwarranted. Thus, there is a need to improve transparency and
comparability across internal models to ensure that internal ratings are built and
validated on the basis of a set of common standards. A reasonable degree of
transparency and disclosure will help establish the credibility of the risk
assessment models used currently by many large global banks. "Sunlight is said to
be the best of disinfectants".
(iv) Too-big-to-fail (TBTF) and moral hazard.
11. There are concerns related to the implicit government guarantee for TBTF
institutions. These concerns derive from the belief that the TBTF status gives large
banks a competitive edge and incentives to take on additional risks. If investors
believe that the largest banks are too big to fail, they will be willing to offer them
funding at a discount. Together with expectations of rescues, this discount gives
the TBTF banks incentives to engage in riskier activities. This, in turn, could drive
smaller banks that compete with them to take on further risks, exacerbating the
riskiness of the entire financial system.
12. Regulatory labelling of systemically important financial institutions/banks
(SIFIs/SIBs) may convey the promise of implicit taxpayer-sponsored bailouts for
uninsured deposits in case of insolvency. While they also bring in additional
regulatory capital prescriptions to act as a loss absorbent, in a competitive capital
market, the possibility of SIFIs/SIBs taking additional risks to earn the additional
returns on capital and thereby negating the role of additional capital can never be
ruled out. Hence, the nature of supervisory oversight of SIFIs/SIBs ought to be a
lot more intrusive relative to other financial institutions. The bank bailouts
experience in Europe shows that political economy of bailouts is more important
than regulatory labelling.
(v) Inadequacy of global financial safety nets (GFSNs) and discriminatory
central bank swap lines force EMEs to self-insurance.
13. Monetary policy stances of systemic central banks, geo-political
developments and uncertainty surrounding the direction of macroeconomic
policies in AEs have been the main push factors driving the influx of capital flows
to EMEs. For these recipient economies, this has translated into heightened
financial market volatility with adverse implications for their growth prospects and
for macroeconomic and financial stability. By and large, EMEs have absorbed the
shocks by maintaining fairly open capital accounts and by strengthening their
macro fundamentals through prudent policies. Yet, as high intensity events starting
with the taper tantrum have shown, macroeconomic fundamentals do not matter in
the face of these large and sudden movements of capital, and their economies
remain vulnerable to rapid materialization of risks.
So far, our quest for a robust, equitable and quickly deployable global
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financial safety net (GFSN) has remained elusive. As a consequence, EMEs have
had to buffer themselves by maintaining reserves and managing financial volatility
through a combination of policy instruments, including a macro-prudential/capital
flow management toolkit, which are essentially pre-emptive in nature. Given the
"stigma" attached to the IMF facilities and their quest for "self-insurance", EMEs
have resorted to building foreign exchange reserves as the "first line of defence" to
calm volatility in financial markets and to provide adequate liquidity buffers for
"sudden stop" and reversals. Second, regional financial safety nets have emerged
to complement the agenda of financial stability.
In the post global financial crisis era, the GFSN has grown significantly with
15.
increased accumulation of reserves by countries, and increase in various bilateral
and multilateral swap arrangements. Global reserves grew from about US$2 trillion
in 2000 to about US$12 trillion by the end of Q2 of 2017 about 60 per cent of
which are held by EMEs. However, according to the Fund's Assessing Reserves
Adequacy (ARA) metric, many EMEs (especially in Eastern Europe and Latin
America) fall short of the range of 100-150 per cent of the composite metrics that
are considered adequate for precautionary purposes. Bilateral swap lines between
central banks expanded dramatically during the crisis and have further increased
since then. The bilateral swaps are dominated by China's extensive network of
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renminbi swap lines 30 swap lines in place at end-2015 valued at US$500
billion. BRICS countries have established a US$100 billion multilateral currency
swap arrangement aiming to provide regional short-term liquidity and to address
balance of payments difficulties. Other regional financing arrangements (RFAs)
that have emerged are Eurasian Fund for Stabilization and Development (EFSD)
with contributions of US$8.5 billion, Arab Monetary Fund (AMF) and the Latin
American Reserve Fund (FLAR).
16. With every new tail event, however, the churn becomes larger, the volatility
ever higher, threatening to overwhelm the modest defences that EMEs are able to
muster. It is in this context that I would draw your attention to the stark asymmetry
prevailing in the provision of swap lines by systemic central banks. In fact, I would
go as far as describing the situation as a virtual "apartheid" by which systemic
central banks protect themselves and their self-interest. Meanwhile, EMEs that are
at the receiving end of global financial turbulence are systematically denied
access. The time has come to end this sectarian approach and the access to swap
lines be equally available. While EMEs have shown a degree of resilience to the
turmoil of recent years, they are vulnerable to liquidity and bridge financing gaps
that are transitory but debilitating. Access to swap lines will help them manage
these risks better and prevent them from assuming systemic proportions, thereby
threatening global financial stability. We must learn from the lessons of the global
financial crisis and act expeditiously and comprehensively to establish a broader
swap network. In its absence, the macroeconomic environment of each country
will inform the choice of policy instruments. In such a milieu, there cannot be any
common code or uniform approach to capital account liberalization.
17. There has been considerable focus on macro-prudential measures (MPMs)
in the recent period. However, while legitimacy of MPMs has been well
established, the same legitimacy for capital flow measures (CFMs) has not been
universally accepted despite an explicit endorsement by the IMF for selective use
of CFMs. It is important to recognize that amid global financial cycles and the
inexorability of the trilemma, corner solutions are not feasible. So soft capital
account management becomes a necessity - keeping external debt within
practicable limits and prudence regarding the external sector help strengthen
financial and macroeconomic stability.
The challenge before us is to identify what is going to strike us next? Hence,
18.
any regulation of the financial system should take a pre-emptive approach, and
consider the potential fragility of banks alongside all other elements of the financial
ex ante
system. This would prevent regulatory arbitrage and help to determine the
supervisory "guide rails/rules of the game" for the system.