Shyamala Gopinath: Macroprudential approach to regulation - scope
and issues
Paper presented by Ms Shyamala Gopinath, Deputy Governor of the Reserve Bank of India,
at the Asian Development Bank Institute (ADBI) - Central Bank of Malaysia (Bank Negara
Malaysia/BNM) Conference on Macroeconomic and Financial Stability in Asian Emerging
Markets, Kuala Lumpur, 4 August 2010.
* * *
1. Explicit pursuit of macroeconomic and financial stability can be said to be the single
most significant take away from the recent crisis. More than the specifics, the importance of
this mandate lies in decisively effecting a course correction with regard to the approach and
philosophy for regulation of the financial system. It is being acknowledged that a macro
prudential perspective is critical in designing and pursuing micro prudential regulation of
institutions and markets. Two distinct but highly inter-related constructs have come to
epitomize this post-crisis framework: macro prudential regulation and systemic risk
management. Both these concepts are philosophically appealing and conceptually sound,
but operationally quite challenging. Understanding the nuanced interplay between these
would be crucial in designing an efficient operative framework for financial stability.
Systemic risk management
2. Systemic risk is a much broader concept implying probability of sudden disruption to a
large part of the financial system, reflected in failure of multiple institutions and freezing of
markets, triggered by a common shock and propagated through interconnected exposures
and correlated positions. Any framework for containing systemic risks would need to involve
the following elements:
 Strengthening the financial system's resilience to economic downturns and other
adverse aggregate shocks
 Sound monitoring of common, correlated exposures among financial institutions
arising out of network linkages and developing measures to quantify the contribution
of individual institutions to systemic risk

Minimising the moral hazard associated with failure of systemically important
institutions and finding mechanisms to restrict the contagion impact of failing
institutions during crisis
3. It is in the above context that the role of macro prudential approach in financial sector
policies becomes critical. Macro prudential regulation can be considered as one of the tools
of this larger policy framework.
Analytics of macro prudential regulation
4. Macro-prudential regulation, as it has come to be generally interpreted, essentially
envisages that the key instruments of prudential regulation viz. capital, liquidity and
provisioning vary dynamically according to macroeconomic circumstances. The macroeconomic
triggers could arise either from the changes in the normal economic cycle or sharp asset
price movements. Conceptually, this is supposed to be in addition to stricter prudential
standards for capital, liquidity and leverage across the board.
5. The dynamics of macroprudential regulation is evident when seen in terms of the broad
objectives:
(i) the basic idea is that
To address procyclical elements in the financial system:
cushions should be built up in upswings so as to be relied upon when the rough
times arrive - the counter-cyclical approach. The key measures under consideration,
which have countercyclical characteristics and could act as "automatic stabilizers"
are the following:
 Building buffers through capital conservation based on simple capital
conservation rules. The objective is to ensure that banks which have depleted
capital buffers rebuild them by reducing discretionary distribution of earnings.
A buffer range will be established above the regulatory minimum capital
requirement and distribution constraints will be imposed on the bank when
capital level falls within this range.

A countercyclical capital buffer that will sit on top of the conservation buffer
established as a range to take account of the macro financial environment in
which banks operate. The buffer will be triggered only when excessive credit
growth compared to the long-term trend is judged to be associated with the
buildup of systemwide risk. In order to make this buffer effective it has to be
combined with jurisdictional reciprocity. The upside of this will be that capital
will not be a constraint to maintain flow of credit to the economy during a
period of stress

Promoting forward looking provisions through a change in accounting
standards towards an expected loss approach. Current standards do not
permit credit losses based on events that are expected to occur in the future to
be included in provisions.
(ii)
To provide a mechanism to correct the inherently skewed pricing of credit risk
by financial institutions through the cycle. One of the major causes of the recent
crisis was that in the pre-crisis boom period there was general euphoria and the
financial sector was severely underpricing the risks. In a risk-based capital regime,
during booms this directly implied lesser capital for risky activities and hence
increased lending to risky sectors and increased trading volumes in riskier
instruments. In was only after the crisis had set in that the true extent of risk
underpricing became evident. The situation swung to the other extreme after the
crisis. The macro prudential tools including the leverage ratio are meant to address
situations like this by effectively influencing the costs of credit exposures
dynamically.
(iii) To attempt pre-empting asset price bubbles in the economy and limit the
build-up of financial risks in the system. Asset price booms have invariably been
identified with a pre-crisis economic configuration as both symptomic as well as
causative factors. Earlier, though, the policy frameworks adopted an approach of
benign neglect of asset prices as they saw little role either for the monetary policy or
prudential policy in addressing these. The recent crisis however has forced a rethink
in this regard. There is now a broad consensus on the need to use credit channel as
a macroprudential instrument.
6. The Group of Governors and Heads of Supervision (GOHS), the oversight body of the
BCBS have recently announced1
broad agreement on the overall design of the capital and
liquidity reform package, though much of the work in regard to countercyclical buffers and
forward looking provisions is still work in progress.
7. The recent BCBS consultative document2 lays out a broad framework in regard to
countercyclical capital buffers, conceptually based on deviation of credit to GDP ratio from its
long term trend. Recognising the different contexts in each jurisdiction, each national
supervisory is expected to apply judgment in the setting of the buffer after using the best
information available to gauge the build-up of system-wide risk. However, it does not
envisage addressing sectoral credit issues through such countercyclical measures.
8. The challenge, particularly in growing emerging market economies, would be to
reconcile this approach with the risk of credit constraints given the supply side issues which
are qualitatively very different from advanced economies. Generalized credit increase higher
than the trend may not, in itself, be a matter of systemic concern in view of the changing
structure of economies. The framework in these countries would therefore necessarily have
to adopt a more nuanced, sectoral focus. There are challenges in trying to influence asset
prices through the credit channel. First, it is really difficult to set an optimum level of asset
prices as a target. Second, only bank financed exposures to asset markets can be influenced
through macro prudential tools which may not generally be the dominant funding source.
There have been instances where asset prices build-up is due to leverage outside the
banking sector. Third sectoral approach will inevitably involve an element of regulatory
judgement and discretion.
9. In this context, it would be pertinent to recount the Indian experience in applying
macro-prudential elements in view of apparently excessive credit to certain sectors,
particularly commercial real estate (CRE) which has been the cause of most banking crisis.
The Indian experience
10. During the expansionary phase since 2004, the Reserve Bank had taken various
measures to counter pro-cyclical trends. The potential adverse impact of high credit growth in
some sectors and asset price fluctuations on banks' balance sheets at various points in time
were contained through pre-emptive countercyclical provisioning and differentiated risk
weights for certain sensitive sectors. It was for the first time in October 2004 that the rapid
growth in housing and consumer credit was flagged as a concern and as a temporary
counter cyclical measure, the risk weight applicable to these loans was increased by
25 basis points. In the context of continuing high credit growth, the limitations of the
prudential framework in capturing the ex-ante risks of pro-cyclical nature of bank credit were
explicitly recognized in October 2005 which triggered an across the board increase in
provisioning requirement for standard assets.
11. To counter the possibility of an asset bubble in addition to concerns about credit quality
led to risk weight on banks' exposure to the commercial real estate (CRE) and capital market
being increased from 100 per cent to 125 per cent in July 2005. Given the continued rapid
expansion in credit to the commercial real estate sector, the risk weight on exposure to this
sector was increased to 150 per cent in May 2006. Further, the general provisioning
requirement on standard advances in specific sectors, i.e., personal loans, loans and
advances qualifying as capital market exposures, residential housing loans beyond
Rs.20 lakh and commercial real estate loans was increased from 0.40 per cent to one per
cent in April 2006 and further to two per cent on January 31, 2007.
Year/Month CRE Risk CRE Provisions on
Weight (%) Standard Assets (%)
December 2004 100 0.25
July 2005 125 0.25
March 2006 125 0.40
May 2006 150 1.00
January 2007 150 2.00
The backdrop of our countercyclical actions
12. While contemplating the measures, we did not have any disaggregated statistical data
or evidence to support our concerns on the potential risks of rising bank exposures to real
estate, among other sensitive sectors based on the incurred loss method. However, what we
did have was a clear trend in significant year-to-year increase in aggregate bank credit. The
Indian financial system is still largely a bank-intermediated system and for this reason, the
bank credit channel becomes a key monetary policy transmission instrument. Thus the
aggregate bank credit growth has always formed an important variable in the conduct of
monetary policy. The credit-deposit ratio, particularly on an incremental basis, has been an
important indicator.
13. In view of the rapid credit expansion in the period 2003-2006, in addition to the
countercyclical measures being taken, it was explicitly indicated by the RBI in April 2006 that
growth of non-food bank credit, including investments in bonds/debentures/shares of public
sector undertakings and private corporate sector and commercial paper, will be calibrated to
decelerate to around 20 per cent during 2006-07 from a growth of above 30 per cent.
Inflationary expectations had also started firming up and as part of monetary management,
the repo rate was increased by 175 basis points in stages to 7.75 per cent by April 14, 2007
from its level of 6.0 per cent in September 2004. Further, the CRR was raised by 200 basis
points in stages from 4.5 per cent in September 2004 to 6.5 per cent.
Specific case of real estate
14. From a regulatory perspective, the key observable features that tilted the balance in
favour of some kind of pre-emptive sectoral action, aimed primarily at preparing the banking
sector to better manage the potential downsides, were the following:
(i) The onsite inspections of banks had started giving indications of the negative
fallouts of the euphoria evident in lax underwriting standards and a few frauds that
came to light;
(ii) There were emerging signs of underpricing of risks as the real estate prices were
spiralling fuelled by ample liquidity and the dominant wealth effect transmittal from
the stock market boom. There were clear tax incentives at work here which made
utilisation of stock market gains into real estate an extremely tax-efficient
arrangement.
(iii) A new factor in the housing credit market that was emerging was the mortgages for
investment purposes - the trend for second homes, particularly in metros having a
rising population of young, skilled job owners with salaries. Real estate, so to say,
had crossed the rubicon to emerge as a true investment asset.
(iv) There was increasing anecdotal evidence of the inventory buildups of completed
commercial as well as residential units. These were clearly signs of real estate
having crossed the basic demand-supply equation to an investment asset.
(v) There was a visible steep increase in land prices coming from auction results. Large
real estate companies could monetise the huge land banks on the back of the then
booming stock market valuations with a simultaneous increase in bank lending for
commercial real estate.
15. It was in the above backdrop that it was decided to make it costlier for banks to finance
loans backed by real estate. It was felt that the usual sector-neutral monetary policy
instruments would not be effective without posing significant costs to the economy generally.
So while the monetary policy instruments were indeed used, the objective of this generalised,
gradual tightening was quite different from the requisite stronger action in respect of bank
exposures to sectors such as real estate.
16. It needs to be appreciated that in the Indian context, the sharp rise in bank credit to the
real estate was per se not a clear indicator of any asset price bubble given the inherent
demand-supply dynamics in the economy and the genuine needs of an economy on a high
growth path. There was a confluence of positive factors contributing to the development
including a decline in inflation and stable inflationary expectations, resulting in decline in both
nominal and real interest rates and availability of ample systemic liquidity, contributed no less
by the rising tide of capital flows. Concomitantly, there was a shift in funding by the
corporates to non-bank sources, including external borrowing, which forced banks to look at
diversifying their lending portfolios. This shift also helped in meeting the increasing genuine
demands on the commercial real estate front, including the office space largely accounted for
by the IT boom and gradual expansion of organised retail to Tier II cities.
17. The objective, I must underline, was not to address the asset price bubble per se and
not to curtail genuine credit needs of the economy but to prepare the banking sector to better
manage the potential downsides related to selective sectors. In other words we adopted what
is now called the "expected" as well as "unexpected" loss approaches.
18. What are the key inferences? First, that harmonisation of the monetary policy objectives
and prudential objectives can give a more complete picture, which may not be possible if
banking supervision is separate from central banks; second that macro prudential policy is no
substitute for monetary tightening but should rather act as complement to monetary policy
and third, that supervisors need to have the necessary independence and flexibility to act
timely on the basis of available information, which may albeit be incomplete.
Going beyond macro prudential regulation
19. As with all ideas which gain currency and wide acceptance in a short period of time,
macro prudential regulation runs the risk of being over applied. However, there is an equally
strong risk of making it too narrow in focus. It must be reiterated that macro prudential
regulation is just one element of a broader macro prudential approach and needs to be
supplemented with other tools to address systemic risk issues. Such tools could be in the
form of additional prudential measures applied to all institutions with a systemic objective.
20. Frankly it would be difficult to make a binary distinction between micro prudential and
macro prudential policies - ultimately all macro risks translate into micro risks for financial
institutions. The critical thing is incorporation of systemic perspective while designing
policies.
21. A recent survey conducted by the CGFS3 on macro prudential frameworks in various
countries found that though conceptions of macro prudential policy aims and objectives were
fuzzy, many countries had used various instruments keeping the broad systemic perspective
in mind. The survey also found far more extensive use of macro prudential policies by policy
makers in emerging market economies as opposed to their counterparts in the more
advanced nations. It has helped enhance financial system resilience.
22. The survey clearly shows that the emerging markets were also open to target specific
sectors. The most widely used instruments have been measures to limit credit supply to
specific sectors that are seen as prone to excessive credit growth. These included limits
calibrated to borrower risk characteristics (caps on LTV ratios or debt/income ratios) as well
aggregate or sectoral credit growth ceilings and limits on exposures by instruments. Many
emerging economies, given their specific context already had placed measures to address
specific risks - loan-to-deposit limits, core funding ratios, reserve requirements for liquidity
risk and limits on open currency positions or on derivatives transactions for forex risk.
23. In the Indian context, I can say that this perspective was writ large on most of the
elements of the prudential framework. I would like to briefly mention about the key areas:

Addressing interconnectedness
- In regard to wholesale funding markets, prudential limits are in place on
aggregate inter-bank liabilities for banks as a proportion of their net worth.
The overnight un-collateralised funding market is restricted only to banks and
-
primary dealers and there are ceilings for both lending as well as borrowing by
these entities.
Investment by banks in subordinated debt of other banks is assigned 100%
-
risk weight for capital adequacy purpose. Also, the bank's aggregate
investment in Tier II bonds issued by other banks and financial institutions is
limited to 10 percent of the investing bank's total capital.
- Exposure limits apply to exposures between banks and non-bank finance
companies.

Forex liabilities: There are limits on the proportion of wholesale foreign currency
liabilities intermediated through the banking system, other than for lending for
exports. Retail foreign currency deposits from non-residents are subject to minimum
maturity requirements and interest rate caps.

Banks are required to hold a minimum of 25 percent of their liabilities in the form of
liquid domestic sovereign securities. This stipulation has worked both as a solvency
as well as a liquidity buffer.

The credit conversion factors (CCF) used for calculating the potential future credit
exposure for off-balance sheet interest rate as well as exchange rate contracts were
doubled across all maturities in 2008. This was done since it was felt that the CCFs
as per the Basel norms did not fully capture the volatility in the interest rate and
forex markets in the Indian context.

Profits on sale of assets to an SPV under securitisation are not allowed to be
recognised immediately on sale but over the life of the pass through certificates
issued by the SPV. Any liquidity facility by the originator or a third party is to be
treated as an off-balance sheet item and attracts 100% credit conversion factor as
well as 100% risk weight.
24. The nature and sources of systemic risks are different in emerging market economies.
This part of the world has seen many systemic crises over the past two decades and each of
these crises have demonstrated the importance of prudential policy to minimize risks to
financial stability and to reduce the impact from disturbances domestically and globally.
Financial markets in emerging markets tend to be less well developed and resilient than such
markets in advanced economies. This makes the system more vulnerable to even small
disturbances and increases the criticality of macro prudential safeguards. It therefore
becomes imperative for the systemic stability perspective to guide other realms of economic
policy framework as well.
25. I can highlight two specific areas of perceived systemic risk in our context where a
macro prudential approach has been used and found useful.
(i) Volatile capital flows: Excessive volatility of capital flows could impose significant
costs to the economy beyond the obvious exchange rate impact. There are
implications for financial stability in the form of induced risks of asset price bubbles
and excessive foreign currency exposures in the financial system and external debt
in general. Experience shows that the most volatile components of capital flows
have been portfolio flows. These flows as well as debt flows are also procyclical.
While capital account regime in India has accorded substantially large freedom to equity
flows - both FDI as well as portfolio flows, debt flows have been attempted to be modulated
contextually through a regulatory framework with a combination of quantitative and price
based measures. Calibration of the debt flows into sovereign as well as corporate debt has
been the most actively used instrument for this purpose.
(ii) Management of sovereign borrowings - since the stop to automatic monetization of
Government debt in the nineties, market borrowing by the Government has been a
critical variable in the macroeconomic framework. The stipulation of Statutory
Liquidity Ratio (SLR) for banks needs to be seen in this context. Banks have been
permitted to hold this mandated investment as "held to maturity".
Another critical factor, which buffered sovereign balance sheet from vicissitudes of global
crisis is that India does not have foreign currency market borrowing and only a limited
dependence on foreign investors in respect of domestic currency debt. There is a strong
domestic investor base, apart from banks, in the form of insurance and pension/provident
funds which has enabled India to elongate the maturity of its domestic debt. The experience
in general of emerging market countries has been that foreign investors in sovereign debt
prefer short-term investments.
Issue of systemically important financial institutions (SIFI)
25. The universally accepted post-crisis approach with regard to management of systemic
risks in the financial system accords primacy to addressing the issue of "too big to fail"
(TBTF). The view is that resolution of systemically important financial institutions (SIFI), short
of a public-funded bailout, is at the heart of the TBTF issue. SIFIs exaggerate the negative
externalities and correlated exposures within the financial system. Their scale, complexity
and interconnectedness also implies that their resolvability becomes extremely difficult and
hence the "too big to fail" conundrum.
The real challenge will be to have a non-discretionary framework for quantitatively defining
the SIFIs. In November 2009, G20 finance ministers agreed on the criteria for identifying
institutions and markets of systemic importance4, based on the joint proposals of the
International Monetary Fund, Bank for International Settlements and Financial Stability
Board. Three main criteria are proposed:
 measuring the volume of financial services provided by an institution or group.
size:
Size - for the purposes of systemic risk identification - is an exhaustive notion
covering the exposures, or balance sheet and off-balance sheet risks of the entity in
question.

the lack of substitutability: assessing the financial system's relative dependence
on the financial services provided by a single entity to measure the system's
immunity to the disappearance of said entity.
 looking at the direct and indirect links between financial
interconnectedness:
institutions that will contribute to the spread of systemic risk and its contagion to the
real economy.
28. The efforts at the FSB have since proceeded towards addressing three specific issues:
(i) reducing the probability and impact of failure via higher prudential requirements, better
supervisory practices, potential limitation on the size, breadth and intra-group connectivity;
(ii) improving resolution capacity; and (iii) strengthening the core financial infrastructures and
markets to address interconnectedness and lessen the risk of contagion in case of
resolution.
29. The specifics of the broad template are still under preparation and it will indeed be a
huge challenge for global regulators to arrive at an agreed framework. Given the
heterogenous country situations in respect of banks that are not internationally active, a
"constrained discretion" approach is being discussed which will help country jurisdictions to
design a suitable framework for SIFIs. The authorities' choice of a particular measure or
combination of measures from the agreed range of policy options will depend on conditions
in each financial system and be targeted to the specific risks posed by SIFI institutions in
each jurisdiction while agreeing to the broad, internationally accepted principles.
30. Pre-crisis, the twin instruments of effective
Reducing the probability of failure:
supervision and market discipline were expected to address the factors endogenous to the
firms that increased their probability of failure - essentially the risk it took on its books. These
instruments were found insufficient in doing so. Further, in the new systemically oriented
regulatory philosophy, it was believed that apart from being a risk to themselves, many large
institutions posed risk to the system at large through significant negative externalities. It
therefore became a sort of public good cause to contain the riskiness of these large
institutions. The exact mechanism for doing this would be contingent on multiple factors,
including size, interconnectedness, complexity, business model and industry structure etc.
31. Alternate resolution mechanism: In spite of the above regime, if an institution fails on
account of systemic stresses, the objective must be to minimise the cost for the taxpayers.
Different models have been proposed with the objective to allow the orderly resolution of a
systemically important nonbank financial firm, including a mechanism to cover the costs of
the resolution. Various approaches that have gained traction in policy deliberations for
improving resolution capacity include limits to complexity of internal structures - preference
for standalone subsidiaries, recovery and resolution planning, use of contingent capital and
other instrument to absorb losses as a going concern, a special resolution regime for SIFIs
which makes the shareholders and creditors share losses; and a bailout fund, contributed by
the same entities expected to be bailed out. In the US, the Dodd-Frank Wall Street Reform
and Consumer Protection Act envisages a resolution regime which allows the government to
impose losses on shareholders and creditors, unlike the normal bankruptcy provisions for
other firms where the aim is to reorganise or liquidate a failing firm "for the benefit of its
creditors".
32. Strengthening markets and market infrastructure: The singular area of attention in
this regard has been to move much of the OTC derivatives market to a central clearing
model. There is broad agreement in this regard though few important concomitant issues
arising out of risk concentration in CCPs will need be addressed carefully, including cross
margining across CCPs or across different products.
33. There is also the issue of implicit or explicit liquidity support by the banking system to
the CCPs in the form of lines of credit or to intermediaries such as brokers and market
participants in the form of margins for trades, payment commitments or other forms of
guarantees. It is likely that the risk of transactions undertaken through CCP sit in
banks/regulated financial entities books either directly or indirectly and if so it needs to be
ensured that they are subject to all the prudential norms and risks are captured appropriately.
Ideally, regulators of CCPs should prefer collaterals in the form of liquid securities rather than
bank deposits or guarantees.
34. However, besides the issue of CCPs, there are equally important issues relating to
market practices which have bearing on the financial stability. One fundamental issue is the
undisputable faith in the benefits of ever increasing volumes and liquidity in all markets.
Shifting to CCPs is only shifting the risks. There is need to regulate all derivatives markets in
interest rate, credit and forex products from a systemic perspective - the concept of "market
regulation" as practiced by many emerging countries may perhaps not be so anachronistic.
35. The regime for credit rating agencies is another such area. In spite of the systemic risk
inherent to ratings, current efforts to regulate rating agencies focus mainly on
microprudential issues and typically aim at reducing conflicts of interest and cliff effects by
lowering use in regulatory and supervisory framework. A moral hazard created by rating
agencies is the use of support ratings wherein implicit sovereign support available to
systemically important institutions is taken into account to upgrade ratings. It may be
necessary to require agencies to provide ratings without assumption of support. Addressing
financial stability issues relating to potential procyclicality and systemic risk stemming from
rating agencies is, an agenda for future work.
36. The other important issue I would like to flag, which is going to get accentuated by the
move towards CCPs and collateral support arrangements, is the increasing collateralization
of bank balance sheets. Leverage is one part of this aspect - a recent IMF paper5
clearly
brings out the risks inherent in widespread re-hypothecation of collaterals in many of the
developed markets. The other part is the impact on bank balance sheets of the pro-cyclical
collateralization regimes. If a large part of the good quality collateral on banks' books is
locked up for their trading operations, what does it do to the resolvability issues in times of
crisis and burden sharing? Both regulation of markets and close monitoring of interconnected
exposures would be required to address the underlying risks.
Existing framework in India for monitoring large financial conglomerates
37. The financial system in India is largely bank dominated and the banks are the parents
of most of the large Financial Conglomerates. Incidentally, those FCs are not owned by any
Holding Companies. Since 2004 there is a framework in place to closely monitor certain large
financial conglomerates aimed at reducing the probability of failure of these institutions.
considered to be systemically important in view of concerns relating to the moral hazard
associated with the "Too-Big-To-Fail" proposition and the contagion or reputation effects on
account of the "holding out" phenomenon.
38. The current practices being followed in supervision of these conglomerates include
offsite surveillance through quarterly Returns, regular interactions with the CEOs of the Parent
Companies and other entities in the Group, periodic reviews by a Technical Committee
having members from sectoral financial market regulators.
39. The two-pronged structured processes in the nature of off-site surveillance and the
periodic interface with the conglomerates has proved quite robust in assessing the risks
faced by these systemically important financial institutions. From time to time these groups
have been advised to improve their corporate governance processes and risk management
systems especially with respect to the management of credit concentration risks and liquidity
risks on a group wide basis.
40. Recently other initiatives have also been launched for further strengthening of the
regulatory/supervisory approaches for the identified conglomerates. Discussion with the main
auditor of the Group by the lead regulator is being contemplated. Steps are already
underway to tighten the capital adequacy norms for these conglomerates so as to ensure
that the amount of capital that the group possesses on a consolidated basis i