Shyamala Gopinath: Addressing the regulatory perimeter issues - Indian
experience
Remarks by Ms Shyamala Gopinath, Deputy Governor of the Reserve Bank of India, at the
Ninth Annual International Seminar on Policy Challenges for the Financial Sector, co-hosted
by The Board of Governors of the Federal Reserve System, The IMF, and The World Bank
on "Emerging from the Crisis - Building a Stronger International Financial System",
Washington DC, 3-5 June 2009.
* * *
The regulatory perimeter or boundary issue has been engaging the attention of policy
makers internationally for quite some time but it was not a central issue associated with the
current crisis. Paradoxically the origins as well the severity of impact of the crisis were
concentrated in the most heavily regulated institutions. However, in my view, the real issue
lay in not recognizing and addressing the dynamic inter-connectedness between entities
across regulated, unregulated and lightly regulated domains perpetuated through high
leverage. It was a systemic crisis and attributing it to any single component of the system
would only be an incomplete assessment.
Borrowing from the field of natural ecosystems, sustainability of a complex flow system
depends on the optimal balance between efficiency and resilience of its network. While the
financial system was considered to be very efficient, the inherent elements for ensuring
resilience were obviously inadequate. At the heart of this self-feeding financial ecosystem
were entities which had access to liquidity, the banks, which acted as the fulcrum around
which the system moved. It is therefore not surprising that the system collapsed once this
fulcrum became vulnerable. The peripheral entities, though, were as much an integral part of
the system and need to be recognized as such.
The basic premise that I will be elaborating upon in my remarks today is that as far as
systemic stability is concerned, it is more important to focus on the interconnected linkages
amongst all major entities within the system, whether regulated or unregulated. Extending
regulatory boundary is a very valid issue to be examined for its own sake, to address the
specific contextual concerns. But once having decided the perimeter, it is extremely
important to have a framework for hardwiring the perimeter. This is important as regulation
creates incentives for certain activities to move beyond the boundary.
One of the issues with just focusing on extending the perimeter, apart from issues clearly
enunciated in the literature, relates to heterogeneity of regulatory foci across various
segments. The boundary itself varies for different regulatory clusters - the focus of a banking
regulator would be entirely different from that of a securities regulator, from that of an
insurance regulator etc. and all of which may be different from the focus required for
regulation of markets. If the entire financial system is looked as a single ecosystem, then
inspite of the inherent differences between the various market players, it should be possible
to identify the macro drivers of the whole system, the network flows. Using this perspective, it
becomes evident that just focusing only on the perimeter would be missing an integral
component that may need regulatory attention.
Current crisis - perimeter issues
As mentioned earlier, the origins of the current crisis lay within the heavily regulated
institutions. The impact of the crisis, however, was exacerbated by dynamic
interconnectedness between entities across regulated, unregulated and lightly regulated
sectors. As some of the recent reports have pointed out, the two concerns relating to "outside
perimeter" entities that contributed to the current crisis were: (i) maturity transformation being
undertaken by these entities, which traditionally used to be a function of banks; and (ii) the
systemic leverage resulting out of the hugely leveraged positions of these entities, either
through direct borrowing from banks or through the funding markets.
The central issue in both the above is the interaction between the unregulated entities and
the formal regulated funding channels, essentially banks and money markets. The maturity
transformation primarily entailed heavy reliance by these entities on short term funds for
funding long term assets. The prudential framework for banks placed a significant reliance on
management of these ALM mismatches but the unregulated entities, such as SIVs didn't
have any oversight and as a business model, ran huge ALM mismatches. The model just
broke down when the funding markets started seizing.
Many of the entities, like hedge funds, were consciously left unregulated because of the fact
that they managed only private capital pools where the issue of investor protection was not
relevant. However, what was not appreciated was the systemic risks these entities were
posing on account of the huge leverage positions these were carrying through either the
formal banking channel or the funding markets, particularly repo markets. The seamless
efficiency thought to be provided by close integration of the underlying asset markets and
repo markets proved to be just a chimera. The disaggregated exposures of the regulated
clusters at any point of time to the unregulated entities were not available and as the markets
collapsed, such exposures became evident.
Another critical aspect which was again brought forth during this crisis was the market
behaviour and impact of entities, some of them unregulated, having huge trading books and
dynamically hedging their huge portfolios. The market makers in the derivative and
structured product markets need to normally hedge their portfolio risks, which has a direct
impact on the underlying markets. In normal times, such individual action does not have a
systemic impact. However, in times of crisis when the views become absolutely
unidimensional, a large number of such big players tend to hit the market on the same side and
the resultant impact on the underlying market is huge. It could, thus, be argued that the
efficient markets enabled the unregulated cluster to acquire systemic proportions and
reinforced its connectedness with the regulated cluster.
The Indian experience
India is unique in this regard as it has a formalized structure for generic non bank finance
sector with heterogeneous sub-segments. There some 13000 non banking finance
companies (NBFCs) whose assets comprise around one-tenth of the banking sector. The
NBFCs in India comprises heterogenous types of financial institutions including All-India
financial institutions, development finance institutions, non banking finance companies, etc,
with each one of them having its roots at a particular stage of development of the financial
sector. All-India financial institutions (AIFIs), and development finance institutions (DFIs),
which were largely an offshoot of development planning in India, were created for long-term
financing with some of them having sectoral/regional focus. Non-banking financial companies
(NBFCs), on the other hand, are mostly private sector institutions, which have carved their
niche in the Indian financial system.
The basic regulatory framework
The Indian financial system is a predominantly bank intermediated system and accordingly
regulation over banks has worked as the basic systemic lever. The non-banking space
comprises of heterogeneous entities but not all are regulated by the RBI. Broadly speaking,
the RBI regulates all such companies taking public deposits and those non-deposit taking
entities involved in asset financing, providing loans and investments. Other non-banking
entities such as housing finance companies, mutual funds, insurance companies, stock
broking companies, merchant banking companies, venture capital funds etc. are regulated by
the respective sectoral regulator and are exempted from the NBFC regulations.
Regulation of Non-Banking Finance Companies in India was considered necessary as far
back as the sixties as an adjunct to the monetary and credit policy of the country and
protection of depositors' interest. The emphasis of regulation was on protection of the interest
of depositors and as such directions issued by RBI dealt with acceptance of deposits and
matters relating thereto. The unfettered growth of deposits and institutions accepting them
outside banking system in the nineties was a matter of concern. Further in the absence of
any prudential norms or ceilings, several non-bank finance companies made poor investment
choices, leading to high level of NPAs, liquidity crunch and consequent significant default in
repayment of deposits. Therefore, some further regulatory action was taken including
registration of these companies, for which the statutory powers were given to the RBI
through the RBI (Amendment) Act in January 1997. The Act provided for registration of all
NBFCs; nevertheless the RBI focused mainly on depositor protection and put in place
stringent regulatory requirements for these entities.
With the growth of the financial system, it gradually came to be realized that even
nondeposit taking entities, which were mostly in asset financing and loan business, could pose
systemic risks on account of their interactions with the formal banking system and market
based financing. Moreover, many such entities in this lightly regulated segment were
essentially indulging in regulatory arbitrage - what was not permitted for banks was
happening through this channel. It was therefore decided in 2006 to put in place an elaborate
prudential framework for such identified entities having systemic implications.
A gradually calibrated regulatory framework was created to address the issue of systemic
risk, which included prudential capital requirements, exposure norms, liquidity management,
asset liability management, creation of entity profile and reporting requirements, corporate
governance and disclosure norms for non banking finance companies defined as
systemically important.
It was recognized early on that mere acceptance of public deposits would not capture the
systemic importance of the entities and hence the focus was shifted to acceptance of public
funds in any form. So, any entity that is accessing public funds, whether through deposits,
inter corporate deposits, debt instruments such as NCDs or CPs, or bank loans, was
considered interconnected entity and hence treated as a source of potential risk. The
ultimate objective was that such interconnectedness should not result in transmission of risk
to banks or the payment and settlement system.
In the Indian context, what has provided a huge systemic advantage is the fact that the
regulation of key financial markets - money market, Government securities market, forex
market and credit market - vests with the banking regulator i.e. the RBI. Thus the channels
of interconnectedness between banks and other financial sector entities are not beyond the
regulatory purview. From a financial stability perspective, the above framework has proved to
be a sound model.
Some of the specific provisions which illustrate the effectiveness of the above framework in
addressing the inter-connected linkages are briefly mentioned below:
•
Prudential limits on bank exposures (funded and non-funded) to non-bank finance
companies - individual as well as aggregate;
•
Restrictions on bank financing to non-bank finance companies against collateral of
shares or for on-lending to capital market intermediaries;
•
Prudential limits on bank exposures to equity markets includes exposure to capital
market intermediaries such as brokers;
•
Prudential regulations on inter-bank exposures of banks to reduce systemic risk;
•
Participation in the overnight unsecured money market limited to banks and primary
dealers;
•
Lending/borrowing by non-banks in the overnight market allowed only through repos
or against collateral of government bonds;
•
Securitisation guidelines issued to banks in 2006 which provided for, inter alia, credit
enhancements to be deducted from capital, profit/premium from sale to be amortised
over the life of the securities issued, liquidity support to attract 100 per cent risk
weight.
Addressing the inter-connectedness - few pipeline issues
The securities firms/investment banks are regulated by the securities regulator, the
Securities and Exchange Board of India (SEBI) but such regulation primarily focuses on
transparency and discipline in market practices. As these entities are normally not doing fund
based business which would require prudential regulation, a decision had been taken that
entities registered with SEBI need not normally be registered with RBI. While these entities
form part of a separate regulatory cluster, their inter-linkages with the other regulated
clusters or other unregulated entities may need to be examined particularly if such entities
also undertake fund based business. Therefore a constant evaluation is required of the
functioning of institutions under different regulators to address regulatory gaps.
While mutual funds are regulated from investor protection angle by the securities regulator,
the systemic implications of the inert-linkages became apparent in the post-Lehman scenario
of severe risk aversion and liquidity crunch. RBI had to announce a special 14 day repo at for
a notified amount of Rs.20,000 crore to enable banks to meet the liquidity requirements of
Mutual Funds. The real issue was the over reliance of the money market mutual funds on
short term funds placed by the large corporates and banks with redemption facilities on par
with current accounts of banks. It has now been decided to jointly work with the securities
regulator to identify and address the macro-prudential concerns arising from the current
framework.
Private Equity/venture capital activity is not a regulated activity per se. However, the issue of
bank involvement with such funds has come into focus recently in India. The G30
recommends the large systemically important banking institutions should be restricted in
undertaking proprietary activities that present high risks and serious conflicts of interest.
Sponsorship and management of co-mingled private pools of capital should ordinarily be
prohibited and large proprietary trading should be limited by strict capital and liquidity
requirements. Keeping in view the reputational risk involved in such activities, the Reserve
Bank had mandated maintenance of certain level of economic capital in some of the cases
approved in the recent past. Importantly, all exposures of a bank to a venture capital fund are
treated as capital market exposure and counted for the regulatory limit.
A revised regulatory framework - key considerations
The broad features of a possible framework to capture the above inter-linkages are outlined
below.
(i) Specification of the nature of connectedness between entities that may be considered
inducing vulnerabilities in the system;
(ii) Identification, from the haze of the unregulated cluster, the class of entities
considered to be either having significant direct connectedness with the regulated
clusters or having a significant presence in any market segment where regulated
entities are also present;
(iii) Putting in place a reporting system to capture the interconnected flows within the
identified sub-system - the regulated clusters and the unregulated entities on a
regular basis;
(iv) Prescription of a prudential framework - and this is the key - for the regulated
clusters to contain the risks arising from this connectedness.
(v) For the unregulated entities, the most significant aspect would be to contain their
leveraging capability in general across major market segments, particularly the
funding markets. A simple quantitative limit would be the best suited.
(vi) Some systemically significant entities, though, may still need a formal prudential
regulatory structure, including capital adequacy requirement.
From a policy perspective, the critical points would be the last two - having effective
regulation over the regulated entities, while restraining leverage capabilities of the
unregulated/lightly regulated entities. In our case, it proved to be an effective combination
since banks' exposure to such entities could be regulated through absolute exposure norms
or even tweaking the risk weights applicable to such exposures.
I realize the problem would be much more involved in predominantly market based financial
systems where direct bank linkages are not very obvious. But even in such regimes, as has
been clearly demonstrated, the indirect linkages of banks were enmeshed in the maze. That
is why it would be important to ensure that the markets too should not provide leverage
capabilities to such entities beyond a limit.
Contingency liquidity provision
The recent crisis has again brought to the fore the role of a lender of last resort (LOLR), the
extent of central bank intervention and the entities to which such intervention can be
extended. The question as to under what circumstances and to what extent should safety
nets be extended to non-deposit taking institutions has been widely debated.
The basic underpinning of the LOLR philosophy internationally has been that any institution
whose failure is conclusively decided to cause broader systemic instability needs to be
supported in the interregnum. As long as banks were the only institutions fulfilling this
criterion, the case was straightforward. However, with the development of global financial
markets and growth on non-banks as alternate media of financial intermediation, the
decisions were not so simple as the recent experience has clearly shown.
In India, while there is no provision for the Reserve Bank of India to lend directly to any
nonbank entities, except a few specified ones, there have been specific instances of workable
arrangements being devised in the interest of broader stability to provide liquidity support to
some institutions/sectors indirectly. In respect of non-banking finance companies, in the
postLehman fallout there was severe systemic liquidity crunch and even the non-banking finance
sector were stressed. It was apprehended that in a scenario of asymmetrical information and
general risk aversion of banks, the strains in non-banking finance sector could eventually
pose a systemic risk. It was then decided to provide liquidity to those systemically important
NBFCs facing temporary liquidity mismatches through an SPV. The key part was that the
liquidity was provided to the SPV by the RBI through purchase of fully government
guaranteed bonds. Further, this facility was only meant to tide over temporary liquidity
mismatches and not for balance sheet expansion. The aggregate quantum for the facility was
around Rs. 200 billion (USD 4 billion) and the interest rate was the LOLR rate for banks.
Similarly in case of mutual funds, who were faced with severe redemption pressures, it was
decided to have a facility for lending to banks through a 14-day repo to enable the banks to
meet the temporary liquidity needs of mutual funds.
As regards protection of depositor interests, a comprehensive prudential framework is
already in place for all deposit taking companies. Stringent capital adequacy and leverage
requirements, exposure norms, and disclosure have been prescribed as part of a structured
regulatory framework. Statutorily, such companies are required to invest at least 10 per cent
of their outstanding deposits in unencumbered Government bonds. Further, NBFCs have to
ensure that at all times there is full cover for public deposits maintained by them. All such
companies accepting/ holding public deposits are required to create a floating charge on their
statutory liquid assets in favour of their depositors through the mechanism of "Trust Deed".
Conclusion
The issue of extending the regulatory perimeter has to be a balancing act and it needs to be
carefully nuanced in terms of intended objectives. The thrust of regulation may need to be
borne by the regulated clusters - particularly deposit taking institutions. However, for the
unregulated cluster, the key issues would be to contain their ability for systemic leverage -
both directly through banks or indirectly through funding markets and to subject them to an
effective reporting arrangement for their inter-linkages with the regulated clusters. From a
systemic stability perspective, it would be equally, if not more, important to focus on the
interconnectedness of the regulated and unregulated/lightly regulated entities.