Anand Sinha: Approach to regulation and supervision in the post crisis
world
Keynote address by Mr Anand Sinha, Deputy Governor of the Reserve Bank of India, at the
program "Supervisory effectiveness in the post crisis world", organized by the Centre for
Advanced Financial Research and Learning (CAFRAL), Mumbai, 4 February 2013.
* * *
Inputs provided by Ajay Kumar Choudhary, Ms. Anupam Sonal Rajnish Kumar and Jayakumar Yarasi are
gratefully acknowledged.
Ms. Usha Thorat, Director, Centre for Advanced Financial Research and Learning
(CAFRAL), Mr. Aristobulo de Juan, a veteran supervisor and an international consultant,
Mr. Pierre Yves Thoraval, former Deputy Secretary General of the French Banking
Commission, Mr. Chris Cardoza, Program Director at the Toronto Centre, Ms. Shyamala
Gopinath, former Deputy Governor, Reserve Bank of India and all the esteemed delegates of
the conference. It is my privilege to address you all in this conference today.
Effectiveness in the Post Crisis
The Conference is quite aptly themed "Supervisory World".
The policy makers and supervisors are trying to grapple with the havoc the crisis has
wreaked. So much ink has been spilt and so many reams of papers have been used in
describing the what, why and how of the crisis. New regulations have replaced old ones and
new theories have come to the forefront debunking the old and crisis-battered beliefs. But
one question still remains. Have we really come out of the crisis and entered the post-crisis
world? Is the crisis now a thing of the past and is it firmly behind us? It does not appear to be
so. If one looks at the latest IMF update on World Economic Outlook (WEO-Jan 2013), the
growth rates have been revised downwards, though marginally, to 3.5% for 2013 and 4.1%
for 2014 and it specifically notes that the Euro area continues to pose a large downside risk
to the world economy.
If we look at the history of financial crises, they have never been far away. The earliest
recorded crisis dates back to 13th century when there was a default by England. We have
had so many crises in the more recent past such as, Great Depression of 1929, stock market
crash of 1987, Asian crisis of 1997, banking crises in several countries in 80s and 90s and
the dot com bubble of 2000, etc., the latest being the global financial crisis of 2007 and the
very recent and continuing sovereign debt crisis. However, all these crises (other than the
global financial crisis) have been of smaller magnitude in comparison to the great depression
of 1929. The global financial crisis of 2007, certainly, is of a very large magnitude and has
had a devastating impact on the global economy. As it is said of peace that it is an interlude
between two wars, perhaps, looking at the regularity of crises in the recent times, one would
say, a calm period is an interlude between two crises. Such has been the history of financial
crises in the past.
How was the global financial crisis different?
If the financial history is checkered with crises, then why is it that the current global financial
crisis has assumed such a gigantic proportion in terms of coverage and impact? The very
famous book "This time is Different - Eight centuries of financial folly", suggests that all
crises have, more or less, similar origins and only that we do not take cognizance of them.
However, looking at the significantly large and unparalleled dimension of the current crisis,
one will have to assume that there must have been other serious contributory factors. In fact,
if you recollect, the crisis originated in a small segment of the US financial system - the
subprime market - and many were generally sanguine and had even dismissed the crisis
initially as a small and localized one which did not have enough potential to spread to, and
impact other segments. However, the crisis soon exploded into a major crisis impacting not
just the US financial system but the entire globe. Therefore, one could surely agree that there
were very many fundamental weaknesses in the system which exacerbated the crisis.
Let me give you some details regarding the magnitude of the crisis. I am quoting from
Andrew Sheng's book "From Asian to Global Financial Crisis" where he refers to a text
message which made rounds in December 2008. "1 year ago RBS paid USD 100 billion for
ABN AMRO. Today that same amount would buy: Citibank USD 22.5 billion, Morgan Stanley
USD 10.5 billion, Goldman Sachs USD 21 billion, Merrill Lynch USD 12.3 billion, Deutsche
Bank USD 13 billion, Barclays USD 12.7 billion, and still have USD 8 billion change ... with
which you would be able to pick up GM, Ford, Chrysler and the Honda F1 Team.".
This was
the dimension of the crisis which shows how the valuation of banks and financial institutions
plunged at the height of the crisis.
Economies go through business cycles, i.e. upturns and downturns, or booms and
recessions, and come out rather quickly but when they are hit with financial crises, they take
longer to come out. History suggests that recessions following financial crises are bigger
than normal recessions with output losses being 2-3 times larger and recovery from
recession following financial crises being slower, as we are witnessing now. The core reason
for this is the leverage that gets built up in the run-up to the crisis which acts as a drag on the
economy and slows down the recovery. It is for this reason that, despite massive quantitative
easing by central banks and fiscal stimuli by sovereigns, the global economy is yet to recover
significantly from the global crisis.
The crisis has impacted the world in a major way, both financially and non-financially. While
the financial impact is recorded in terms of huge output losses, increase in unemployment
and erosion in wealth, the non-financial impact is no less. Crisis has shaken the very roots of
long held beliefs and convictions. Just when we thought we knew all the answers, the crisis
posed new questions forcing us to find out new answers. That reminds me of physics, in
which I graduated and which remains my favourite subject. During the turn of the last
century, physicists came to the conclusion that they had found out all that they needed to
know about the laws of nature. All that remained was to apply these rules to find out answers
to some of the questions. Then there were two major experiments which changed the entire
scenario resulting in the development of radically different theories to explain the
phenomena. Similar things have happened in the financial world - may not be of similar
magnitude - that have shaken the intellectual foundations and left us groping for answers to
new questions. There has been a paradigm shift in the thinking on regulatory philosophy and
approach, especially in areas of systemic risk and efficient market hypothesis; on several
aspects of macroeconomic thought, for example, role of monetary policy in ensuring financial
stability, incorporation of banking and financial system dynamics in macroeconomic models
and realising that macroeconomic stability is a necessary but not a sufficient condition for
ensuring financial stability.
A lot of work was initiated in the aftermath of the crisis to address risks that were identified to
have caused or exacerbated the crisis. The approach to regulation and supervision has
changed in a significant way drawing lessons from the crisis. Before I expound on the
revamped approach to regulation and supervision in the post crisis world, let me step back a
little and briefly touch upon the genesis of crisis. This not only helps in putting things in
perspective, but as we deliberate on the reasons underlying the crisis, the solutions would
automatically flow.
The genesis
Several factors were responsible for the crisis. However, at the core of the crisis was the
inadequate understanding and measurement of risks and funding of assets with shorter term
liabilities on a large scale. There was aggressive easing of monetary policy in the US after
the bursting of dotcom bubble leading to very low interest rates. The long term yields in the
US were also depressed on the back of global imbalances as the huge reserves built by
countries, specifically China, found their way back to the US treasuries. An era of Great
Moderation followed: there was steady growth in advanced economies and accelerated
growth in emerging market economies along with low and stable inflation. This resulted in
policy makers believing that they had found the holy grail of high growth with low inflation.
Underlying this belief was the notion that markets had become mature and sophisticated and
had the wherewithal to distribute risks and provide efficient hedging instruments to those who
needed. Low interest rates triggered a massive search for yield which led to financial
innovation that was socially suboptimal. The innovation was aided by the progress in
quantitative finance and modelling and technological developments. While we cannot
disregard the utility of financial models - they are certainly very useful - overreliance on such
models proved to be disastrous. The financial models, in contrast with the models used in
physics, are not governed by immutable laws of nature but by the human behaviour - the
herd mentality, irrational exuberance and pessimism, greed and fear, which cannot be
modelled with any accuracy. Hence, these limitations need to be factored in while using the
models.
Low interest rates prior to the crisis enabled build up of leverage. In fact, if we observe
closely, leverage happens to be the major contributing factor to most crises. Let me explain
in brief. When times are good, there is a feel good factor, there is plenty of liquidity which is
cheap, the asset values and collateral values are high and the banking system losses are
low, leading to lower provisioning and lower capital requirements. These factors lead to
higher demand for credit from the households and corporates. From banks' perspective, as
the provisioning and capital requirements are lower, they have surplus capital and raising of
capital is also easy. This leads to a greater incentive to lend and expand the balance sheet.
Therefore, the increased credit demand from the borrowers and the increased incentive to
banks to lend, results in the build up of leverage. When the cycle turns, pessimism sets in,
losses increase, value of assets and collaterals diminish and liquidity dries up and becomes
costlier. These erode the financial health of banks, households and corporates who become
risk averse. The demand for credit by households and corporates as also the supply of credit
by banks slows down. Banks also deleverage to preserve their capital. All these exacerbate
the downturn. Leverage is an amplifier in as much as it amplifies the profits during upturn and
exacerbates losses during the downturn: higher the leverage, more severe is the downturn.
This amplification is also called procyclicality. Prior to the crisis, the regulatory policies did
not effectively address the systemic risks arising out of procyclicality and
interconnectedness.
Lack of appreciation for systemic risks and the absence of suitable regulatory framework to
address such risks was one of the major reasons for exacerbation of the crisis. The thinking
prevailing prior to the crisis was that strong individual institutions make a strong system,
which did not turn out to be true. The crisis brought home the fact that even when the
institutions are individually strong, when each one of them tries to pursue and preserve their
own self interest, their actions could lead to instability of the system.
The credit risk transfer mechanism was also highly flawed. Securitisation, which was once
considered to be a very useful financial innovation in enabling efficient transfer of risk - and I
still think it is a very useful tool - was not handled properly as perverse incentives took over.
There were also serious gaps in the regulatory and supervisory framework and philosophy.
Let me quickly go through some of the regulatory and supervisory gaps that contributed to
the crisis. Most importantly, the capital maintained by banks, was inadequate both in terms of
quantity as well as quality. Liquidity buffers were also insufficient as financial institutions
operated on the assumption that markets would continue to provide liquidity at all times and
hence they financed their long term assets with much shorter term liabilities. The outstanding
Repurchase Agreements (repos) tripled between 2001 and 2007 with particularly rapid
growth of overnight repos. The financial firms were also excessively leveraged, with the
leverage for many commercial and investment banks significantly going up from 2003
onwards. High leverage could be built up by financial institutions while being compliant with
the capital adequacy requirement, pointing to serious deficiencies in risk measurement
methodologies and models. For example, two large Swiss banks, which were among the
best capitalised, also came under stress during the crisis.
Lack of transparency in the OTC markets was another major factor which led to build up of
risks in the system. Information about the position building was not available even with the
regulators, leave alone the counterparties. The insurance giant, AIG wrote huge credit
protection (to the tune of USD 400 billion) collecting huge premium in return, believing that it
would not be required to settle claims of protection buyers. The quantum of protection sold
by AIG was not known to the market participants due to which they went on buying credit
protection from AIG. When the system came under severe stress and AIG was required to
post higher margins, it found itself in deep trouble and had to be eventually bailed out by the
Federal Reserve.
Burgeoning under/unregulated shadow banking system added to the forces which
exacerbated the crisis. In the run up to the crisis, there was rapid growth in the shadow
banking system. In the US, at the peak of credit boom, financing from this sector was much
larger than that from the regulated banks. In many advanced economies including the US,
the shadow banking system is still larger than the regular banking system. The hands-off
approach to the shadow banking system from a regulatory perspective was based on a few
assumptions and beliefs. One, the touching faith in market discipline and self regulation, - It
was believed that shadow banks would be constrained by market discipline i.e. discipline
imposed by banks and other market participants, and also by their own self regulation. Two,
it was believed that only banks were important from the financial stability perspective as they
held deposits and were at the core of the payment and settlement systems. Three, it was
assumed that if banks' exposure to shadow banking system was regulated, it was easy to
contain risks in the shadow banking system. Four, it was also believed that regulation of
shadow banking system would be very costly, reduce innovation and impede risk transfer.
The compensation structure in financial institutions was also seriously flawed as it
encouraged perverse incentives and, therefore, was another major reason attributed for the
outbreak of the crisis. Participants were paid large bonuses on the basis of short term
performance even though the embedded risks could be high which would crystallise later.
The compensation structure encouraged private sharing of profits while socializing the losses
by taxing the exchequer.
The entire regulatory approach in the pre-crisis period was veering towards light touch
regulation. There was a touching faith in the efficient market hypothesis which made many
believe that markets are self correcting. This belief ignored the well known herd and irrational
behaviour of the financial markets. If we look at any risk distribution, there are always fat tails
which are on account of irrationality. The negative fat tails are due to excessive pessimism
while the positive fat tails are due to exuberance.
As far as supervision is concerned, it had its own share of flaws in the pre-crisis period. The
role of supervision is to ask questions, when things are going very well. When the financial
system or individual entities are not doing well, supervisors will obviously intervene. But
supervisors need to be proactive and ask questions when the going is good. It must be
confessed, however, that asking questions during good times is difficult as you will be seen
as a spoilsport. It is a difficult task. Supervisors have unenviable job on hand. With
commercial banks having some smart people, regulators need to be smarter to question
them and that is where the issues of skills and technology come in. In the run-up to the crisis,
it was observed that the supervisors were staying on the sidelines and not intruding
sufficiently into the affairs of participants. They were not being proactive in dealing with the
emerging risks and in adapting to changing environment. There was a lack of capacity to
identify, or to act on identification. For example, supervisors could not see the risks building
up when banks started dealing in very complex products or when banks started relying
excessively on short term funding sources for their operations. Supervision was not
comprehensive and even when supervisors found some anomaly, it was not taken to
conclusion.
The effect of crisis on India was, however, relatively muted, as there was no direct exposure
to sub-prime assets and the indirect exposure to failed institutions and stressed assets was
very small. The Indian growth was largely driven from within based on domestic demand
and, more importantly, some of the features of macroprudential regulations were already in
place. We have been alert to dealing with systemic risks, both procyclicality and
interconnectedness, at least 4-5 years prior to the global crisis. We had also put in place
robust OTC market infrastructure and central counterparty mechanisms. We were lucky to
have put in place some of the regulations, based on our own perception, that have now been
designed internationally. The approach to these issues today is, however, much more
structured.
Review of regulatory framework
After giving you a background of what caused the crisis, let me now turn to the reforms in
regulation put in place globally, drawing lessons from the crisis. Every weakness and flaw
that I have mentioned has been tried to be corrected. The Basel III regulations stipulate
enhanced quality and quantity of capital. The component of tier I capital as part of total
capital has been raised to 6% (out of total 8% CRAR), requirement of equity capital has been
raised very substantially to 7 % (including 2.5% of capital conservation buffer) from the
earlier 2%. There was no concept of capital conservation buffer earlier, though there is
something similar in pillar II of Basel II. Pillar II deals with two kinds of risks: (a) the pillar I
risks which are not covered under pillar I such as concentration risk and interest rate risk in
the banking book, and (b) the impact of a stress situation on banks and estimation of
additional capital required for banks to withstand the stress.
During the crisis, it was observed that the losses in the trading books of banks were several
times the losses as computed by the VaR models. As regards the counter party credit risk, it
was found that most losses arose from the mark to market losses due to deterioration in the
credit quality of the counterparties rather than due to outright default. The Basel III
regulations have, therefore, expanded the risk coverage, specially, in the trading book and of
risks relating to counterparties.
As regards liquidity, a global framework has been built for the first time in several years, both
in terms of the requirement for banks to have adequate high quality liquid assets to withstand
a stress situation over a 30 day horizon and also from the perspective of avoiding asset
liability mismatch by requiring banks to fund long term assets with stable funds.
In my view, the most important lesson from the crisis is the recognition of systemic risks and
the development of a framework to deal with that. I would touch upon these issues briefly, as
there is a full session on systemic risk during the course of your conference. Systemic risk
has two dimensions - procyclicality that I have explained a little earlier, and
interconnectedness. One interesting feature of interconnectedness which is different from
knockout effect (impact from one interconnected institution to others in the system), is that it
can play simultaneously, or near simultaneously on a large number of institutions through
common exposures to an asset or an asset class. For example, if multiple institutions have
exposure to an asset and if one of the institutions begins a fire sale of the asset, say, due to
a temporary liquidity stress, the consequent fall in the asset prices would force other
participants, who are otherwise liquid and solvent, to sell that asset to avoid mark to market
losses. This would lead to further erosion in the value of that asset resulting in further losses
and more fire sales. Therefore, the rational actions of individual institutions to preserve their
self interest could turn out to be a collectively irrational action.
As regards procyclicality, since banks face large losses which crystallize during downturn,
they have to make larger provisions and provide additional capital. This would constrain their
lending activities which in turn would have an adverse impact on economic recovery. Basel
committee has, therefore, prescribed building up of countercyclical capital buffers. Banks are
expected to build capital buffers during the upturn which could be used during downturn so
as to maintain their lending activities which would cushion the impact of a downturn on the
economy.
Basel Committee has suggested "credit to GDP" ratio as a metric to calibrate countercyclical
capital buffers. The model assumes that deviation from the trend is cyclical and hence should
trigger build up (or release) of buffers. While this model could work for advanced economies,
it may not work effectively for emerging market economies like India since, in our context, the
deviation in the "credit to GDP" ratio may not only be cyclical but may have large structural
components. EMEs have large segments of population which are still financially excluded.
Financial inclusion initiatives which are being taken in these economies would bring a large
segment of such populace into formal banking fold, which would result in a sharp jump in the
credit to GDP ratio, which could be misinterpreted as cyclical deviation. Further, especially in
India, we had taken a big leap in transforming from an agrarian economy to a service
oriented economy. With the current initiatives to invigorate manufacturing and infrastructure
sectors which are highly credit intensive and are employment generating, the credit to GDP
ratio would show a sharp spurt, not necessarily indicating any cyclical trend. We have been,
therefore, following a sectoral approach, as a countercyclical policy, modulating risk weights
and provisioning requirements for certain sensitive sectors which show signs of overheating.
Our approach has been fairly successful, though not equally well in all the sectors that we
targeted. While the Basel Committee has not considered the sectoral approach, the Bank of
England has considered it as one of the tools in formulation of its macroprudential policies. In
the foreseeable future, the Reserve Bank, in all likelihood, would continue to follow the
sectoral approach for dealing with procyclicality. This deviation from the prescribed
methodology would be permissible within the Basel Committee's "comply or explain"
framework. However, the downside here is that the deviation from the laid down
methodology may be interpreted by markets as non-compliance. To guard against this, we
will have to improve and sharpen our communication.
Building up of provisioning buffer during good times based on expected loss methodology to
deal with procyclicality is another important regulatory construct under Basel III. However,
the progress in this area has been very slow and it is still work in progress. As an interim
measure, we propose to implement a provisioning methodology similar to the Spanish
"dynamic provisioning", shortly.
The countercyclical policies assume a lot of importance, more so for developing countries
like India because of the economic conditions of these countries. While the gains from
growth take longer time to percolate to all strata of the society, the pains of instability
permeate and percolate immediately. Also, costs, in terms of increase in poverty are higher if
output falls, than the gains from reduction in poverty for an equivalent rise in output. Financial
stability, therefore, assumes great importance for emerging markets. Perhaps this is the
reason why macroprudential policies have been practiced in EMEs well before the advent of
crisis while the advanced economies have only now begun to practice these policies in the
wake of Basel III regulations. I would also like to mention here that while the Reserve Bank is
complimented for steering the country safely out of the crisis, it is also, often considered to
be very cautious. I believe that we cannot afford to be less cautious as we do not have the
wherewithal to sustain or absorb the high costs of misadventure. That is the reason why we
became alert and started implementing countercyclical policies much before the onset of the
crisis and do not encourage use of exotic financial products.
To deal with the cross sectional dimension of systemic risk i.e. the issue of
interconnectedness, the Systemically Important Financial Institutions (SIFIs) have been
brought into focus. Global Systemically Important Financial Institutions (G-SIFIs) and
Domestic Systemically Important Financial Institutions (D-SIFIs) are the entities that could
potentially create larger negative externalities to the financial system if they were to get into
trouble and fail. Therefore, it is necessary to stipulate greater loss absorbency for these
entities, subject them to more intense supervision and put in place stronger resolution
regime. SIFIs are identified based on a metric which takes into account factors such as their
global activity, their size, interconnectedness with other segments of the system, their
substitutability and the complexity of their operations. G-SIFIs have to maintain additional
capital in a range of 1% to 2.5% depending upon their systemiticity. The reason for
stipulating higher capital is twofold. One, the higher loss absorption capacity would reduce
the probability of G-SIFI's failure and in the event of their failure, reduce the impact of their
failure. Second, higher capital requirements would act as an inbuilt incentive for G-SIFIs to
reduce their systemiticity. The framework for D-SIFIs is similar but less structured and with
larger national discretion.
For any regulatory regime to be effective, robust supervisory framework is absolutely
necessary. Increasing the intensity and effectiveness of supervision for SIFIs in particular is a
key component for reducing the moral hazard and negative externalities posed by these
institutions. Towards this, the Basel Core Principles (BCPs) on Effective Supervision - the
global standards against which supervisors are assessed as part of the IMF-World Bank
Financial Sector Assessment Program (FSAP) - have been recently revamped. The Joint
Forum has published Principles for supervision of financial conglomerates. Several other
issues i.e. model risk, management, enhanced scrutiny of Boards and senior management,
more emphasis on adoption of strong controls by SIFIs, horizontal review, stress testing,
supervisory colleges, macroprudential surveillance and examination of risks associated with
business models are being addressed.
Resolution framework for SIFIs is another critical aspect that is under development. A robust
resolution framework needs to be put in place with a view not to burden the Government with
the task of bailing out large and systemically important institutions, if they were to fail. A well
defined resolution regime enables separation and continuation of core activities from
noncore activities followed by an orderly resolution. In this context you must have heard of living
wills. FSB is also consulting on guidance on recovery and resolution planning for making
operational the "Key attributes of effective resolution regimes for financial institutions" which
it has published earlier. In the US, under the Dodd-Frank Act, an orderly resolution
framework has been put in place.
There is also a serious debate on revamping the banking models especially in the context of
concerns regarding systemically important and complex institutions. There is an increasing
realization that the retail part of the banking system, which offers core services to the people
in terms of deposits and retail credit, should remain safe. There are three well known reports
in this regard; Vickers' report in the UK proposes ring fencing the retail business from the
investment banking activities. The Volker rule under the Dodd-Frank Act in the US proposes
restrictions on proprietary trading with some exceptions and puts limitations on banks
sponsoring Hedge funds, Venture Capital funds and Private Equity funds. A recent addition is
the Liikanen report for the Euro zone which is on somewhat similar lines.
The need to provide oversight to the shadow banking system is another major lesson from
the crisis. The shadow banking system grew phenomenally in the run-up to the crisis and
overshadowed the regular banking system in many jurisdictions. The risks originated in the
lightly, or unregulated shadow banking system, spread to the regular banking system and
exacerbated the crisis. Oversight/regulation of shadow banking system was, however, not
immediately taken up by the Basel committee as the Committee was preoccupied with the
work related to banking regulation which itself was very onerous. With the work regarding
revamping of banking regulations largely complete, the FSB and the Basel committee have
now focused on putting in place a robust framework for oversight/regulation of the shadow
banking system. Improving the oversight/ regulation of the shadow banking system assumes
all the more importance with the tightening of banking regulations as the widened regulatory
gap between the two systems would lend a scope to increased regulatory arbitrage with risks
flowing from the more regulated banking system to the less regulated shadow banking
system.
Regulating shadow banks poses a dilemma. It may not be appropriate to impose bank like
regulation on them as it may stifle flexibility and innovation which the sector is known for. At
the same time, having widely divergent approach towards this sector which performs bank
like credit intermediation would create huge arbitrage opportunities and give rise to systemic
risks. There is a two pronged approach that is recommended in this regard: casting the net
wide to gather data on all non-bank credit intermediation activities and then narrowing the
focus on those non-bank credit intermediaries that have the capacity to pose systemic risk on
account of maturity/liquidity transformation and leverage. There are broadly four graded
approaches for oversight/regulation of credit intermediaries. One, indirect approach which
involves regulating banks' exposure to shadow banking system. Second, a direct approach
where macroprudential measures are taken to address risks in securities lending and repo
transactions. The third approach is regulation of shadow banking activities through disclosure
obligations and restrictions on activities and the fourth approach is the regulation of shadow
banking entities, i.e. imposing bank like regulation on these entities, limiting maturity
Integrated set of
transformation and leverage. FSB has published the "Initial
recommendations to strengthen oversight and regulation of shadow banking" and the related
responses received. When the final standards are brought out, which is likely in the near
future, countries will have to take cognizance of that and build their systems for dealing with
shadow banks.
In India, about 50 per cent of the shadow banking system consists of Non-Banking Financial
Companies (NBFC) which is regulated by the Reserve Bank. The other components largely
include insurance and mutual fund participants which are regulated by other regulators i.e.
IRDA and SEBI respectively