Anand Sinha: Financial stability: 2007 to 2012 - five years on
Special address by Mr Anand Sinha, Deputy Governor of the Reserve Bank of India, at the
FIBAC 2012 on "Sustainable excellence through customer engagement, employee
engagement and right use of technology", organized by the Federation of Indian Chambers
of Commerce and Industry (FICCI) and the Indian Banks' Association (IBA), Mumbai,
6 September 2012.
* * *
Inputs provided by Ms. Dimple Bhandia are gratefully acknowledged.
Mr. D. Sarkar, CMD, Union Bank of India, Mr. Pratip Chaudhuri, Chairman, State Bank of
India, senior members of the banking fraternity, delegates to the Conference, members of
the print and electronic media and other distinguished guests. It is my privilege to be here in
FIBAC 2012 whose theme is "Sustainable excellence through customer engagement,
employee engagement and right use of technology". FIBAC is an important forum for serious
deliberations on banking sector issues. This year an impressive range of topics is being
covered in this Conference with an objective of achieving and sustaining excellence by the
banking system. You will appreciate that for achieving these objectives, financial stability is
an absolutely necessary backdrop. Therefore, I have chosen to speak on the evolution of the
concept of financial stability in the post-crisis period and the regulatory framework around it.
Financial stability is a shared responsibility and therefore, apart from the Reserve Bank of
India and the Government, banks also carry a significant responsibility in this regard. Banks
have to ensure that their business models and conduct, promote financial stability.
Let me step back a little and briefly touch upon the background which prompted financial
stability to assume centre stage. Global financial markets froze abruptly following collapse of
Lehman Brothers on September 15, 2008, and have never fully recovered since then. While
there have emerged signs of hope, of "green shoots", from time to time, they too have been
quickly dashed. While it was the financial sector which triggered the instability at the outset, it
is now the high debt burden in advanced economies which threatens the safety of the
financial system and continues to be a drag on economies. The financial system is far from
being sound as banks in several advanced economies, particularly in the Eurozone remain
vulnerable. Structural imbalances, predating the crisis, persist. The room for fiscal and
monetary manoeuvre has shrunk drastically due to the burden of rescue shared by these
policies in the aftermath of the sub prime crisis of 2007. Central bank balance sheets across
the world have grown in size and have almost doubled in the last decade and now amount to
about 30 per cent of world GDP. Central banks have quickly emerged as the single largest
creditors of governments, especially, in the beleaguered Eurozone. Interest rates too have
been slashed in a bid to stimulate the sagging economies and the rates are either zero or
nearly zero in advanced economies. The expanded balance sheets of the central banks and
the near zero policy rates have raised concerns that financial imbalances may buildup all
over again.
It is now five years since the outbreak of the global financial crisis. The developments during
these years have thrown the global economy off balance and seriously challenged the
intellectual framework and traditionally held beliefs about the functioning of the financial
system, theory and practice of monetary policy and macro-economic modelling. In the new
order of things, financial stability has come to the centre stage of policy making across the
globe.
Against this backdrop, I will speak today about three sets of developments. First, I will
present a brief synopsis of the regulatory changes which have been effected in the years
since the financial crisis first broke out. Second, I will present a snapshot of the attempts
being made to assess and measure systemic risk, in its many facets. Third, I will discuss the
institutional arrangements made to manage financial stability in different countries. I will then
present the Indian approach to financial stability and conclude with some of the challenges
that confront us in the days to come as we strive together to put in place a healthier and
more resilient financial system.
II. Financial stability - pre and post crisis
The global financial crisis of 2007 was caused by a combination of macroeconomic and,
regulatory and supervisory factors and their interaction. At the core of the crisis lay an
interplay between macro imbalances which had grown rapidly in the last ten years, and the
financial market developments and innovations which accelerated over the last 10 to
15 years, partly under the stimulus of the macro imbalances1. In the years leading up to the
financial crisis, policy framework for the financial sector globally was guided by a few
doctrines. One, monetary policy should focus only on price stability (the inflation targetting
framework). Second, price stability ensures financial stability, the latter being pursued
through micro prudential regulatory and supervisory framework. Third, the approach towards
asset price bubbles, when they are building up, should be one of "benign" indifference and
central banks should "mop the dust" when bubbles burst, with aggressive easing of monetary
policy - the now infamous Greenspan orthodoxy. Fourth, light touch regulation is the way
forward in a "free market" environment where markets self correct in the larger interest and
welfare of the economy. Fifth, a set of individual financial institutions constitutes a healthy
and robust financial system.
The overall policy framework, prior to the crisis, reflected these doctrines. The policy
approach comprised inflation targetting to ensure price and macroeconomic stability and
prudential regulatory and supervisory policies focussed on the health and stability of
individual institutions. Systemic concerns, especially contagion risks, were sought to be
contained through a robust financial infrastructure.
In this scheme of things, liquidity risk did not receive the serious consideration that it was
entitled to and there was a glaring conceptual flaw inasmuch as there was no framework to
address systemic risks. The experiences during the crisis drove home the fact that the risk of
financial system disruptions that can destabilize the macroeconomy were not correctly
understood and that the impact of interlinkages and common exposures across the financial
system were not fully appreciated. The critical lesson which has emerged from the crisis is
that financial stability needs to be pursued as an explicit policy objective, and the pre-crisis
notion of mopping up the debris from financial bust is not a viable policy as it can have huge
macroeconomic costs which we are witnessing today.
The crisis also brought to the fore the role of the sovereign in financial stability - first as a
lender of last resort in case of bankruptcy and then as the harbinger of financial instability.
The burden of past fiscal indiscretions in several advanced economies, coupled with the
stimulus measures taken as part of the crisis management has returned to haunt policy
makers. Global instability acquired a new "avatar" - that of a sovereign debt crisis.
To address the deficiencies which led to the global crisis, the international standard setters -
Basel Committee on Banking Supervision (BCBS) and Financial Stability Board (FSB) - have
undertaken a massive overhaul of the regulatory framework. The comprehensive reform
package known as Basel III framework is designed to address both firm specific risk and
broader systemic risk. Basel III essentially enhances the regulatory framework introduced by
Basel II at the level of individual banks. It also sets up a macro-prudential overlay to limit
systemic risk. The measures relate to enhancing the quality and quantity of capital, liquidity
risk management, valuation practices, dealing with procyclicality issues and with systemically
important banks. It also encompasses resolution mechanism, compensation practices, stress
testing, disclosures to enhance transparency and moving OTC derivatives to central clearing
and settlement mechanisms for reducing the systemic risk in derivative markets.
III. Systemic risk - the elephant in the room
Measuring and analyzing systemic risk is at the core of ensuring financial stability. It is,
therefore, important to understand what systemic risk is. While there is no single universally
accepted definition of systemic risk, it is now commonly accepted that these are risks which
affect large chunks of the financial system and which have the potential to adversely impact
the real economy. A comprehensive definition of risk as defined by the IMF, FSB and BIS is
risk of disruption to financial services that is caused by an impairment of all or parts of the
"a
financial system and has the potential to have serious negative consequences for the real
economy." There is also a broad agreement that there are two facets to systemic risk. In its
first dimension, systemic risk evolves over time. This time dimension of systemic risk is also
called procyclicality and it deals with the buildup of risks through financing imbalances. The
imbalances i.e. high leverage, rapid credit growth and compressed risk premia build up
during the expansionary phase of a business cycle due to the inherent procyclicality of the
financial system and through the risk taking channel. These imbalances interact with macro
economy amplifying the booms and busts. Larger booms lead to larger busts and larger
damage to macro economy. The second dimension, interconnectedness, relates to systemic
risks being distributed across the financial system at any given point in time. These risks
relate to common exposures, entangled balance sheets, common business models or
profiles and interconnectedness amongst financial institutions.
The set of policies which deal with managing the systemic risk is known as macro prudential
policy. Macro prudential policy tools are essentially micro prudential tools i.e. capital
provisioning, Loan-to-Value ratios, debt to income ratios, etc. which are applied both at the
institution level as well as at the system level as an overlay to micro prudential requirements
in a countercyclical way. These tools are used to limit systemic risk and thereby minimize
disruptions in the provision of key financial services that can have serious consequences for
the economy by (i) dampening the buildup of financial imbalances; (ii) building defenses that
contain the speed and sharpness of subsequent downswings and their effects on the
economies; and (iii) identifying and addressing common exposures, risk concentrations,
linkages and inter-dependencies that are sources of contagion and spillover risks that may
jeopardize the functioning of the system as a whole. While the third objective of macro
prudential policy [(iii) above] is concerned with the cross-sectional dimension, the first two
objectives [(i) and (ii) above] are concerned with the procyclicality issues. Reserve Bank of
India has been using macro prudential policies, more notably the countercyclical policies,
since 2004 as a toolkit for ensuring financial stability though it had used them sporadically
even earlier.
While there is credible evidence regarding the ability of countercyclical policies to enhance
the resilience of the financial system, the evidence regarding their ability to dampen the
buildup of financial imbalances is not unequivocal and credible. RBI had countercyclically
raised risk weights and provisioning for certain sectors during the expansionary phase of
2004-08. While these policies could dampen the rapid credit growth of the Commercial Real
Estate sector, they were not as effective for other sectors. Spain's case is another example,
which had pioneered dynamic provisioning, a countercyclical tool. Dynamic provisioning had
significantly enhanced the resilience of the Spanish banking system but it could not dampen
the credit boom in the housing sector. The inability of macro prudential policies to dampen
the buildup of financial imbalances would leave the system still vulnerable despite building up
the resilience. It is thus evident that macro prudential policies would need support from other
policies, more notably monetary policy. The question of monetary policy having a role in
containing the buildup of financial imbalances by leaning against the wind has thus got
reopened. There is still a lack of consensus on this issue but increasingly an opinion is
gaining ground that monetary policy should complement the macro prudential policies for
dampening the upswing by leaning against the wind. In effect, it means that when the
financial imbalances are building up in the system threatening financial stability, the policy
rates could be raised above what would, otherwise, be warranted for achieving the inflation
target within the defined time horizon. In this framework, the monetary policy response to
financial cycles would be more symmetric during the expansionary and recessionary phases
unlike under the Greenspan doctrine which prevailed earlier. The coordination between the
two policies and with other policies is important. Generally the two i.e. monetary policy and
macro prudential policy would operate in the same direction. However, there could be
situations where the two may be pulling in opposite directions and that is where the hierarchy
of policy objectives will have to be determined and acted upon.
IV. Measuring systemic risk
Over the last five years, as our understanding of systemic risks has increased, so has our
realization that assessment of such risks is far from straightforward. Systemic risks per se
are typically complex, encompass multiple facets of the financial system, and are very often
opaque. It became clear during the crisis that no single measure or tool would be sufficient to
cover all the different aspects of systemic risks. Assessment of systemic risks necessitated
development of diagnostic tools that simultaneously trace the changes in macro-financial
conditions which pose risks to financial stability, identify "point in time" risk conditions, while
also assessing the potential future impact of all these risk factors, jointly, on systemic
stability. The tools, thus, needed to take simultaneous cognisance of various facets of the
financial system with their myriad correlations and intersections and also peep through the
proverbial "crystal ball"2 into the future as to how these facets may evolve.
These challenges have spurred a great deal of research within central banks, in academia,
and elsewhere leading to the development of a host of new quantitative measures of
systemic risk. The models variously attempt to measure the systemic risk in the financial
system, quantify the contagion, capture distress dependencies amongst financial institutions,
measure the systemic importance and the resilience of the financial system. Other class of
models relates to stress tests while yet another class aims to develop coincident indicators of
systemic stress and attempt to develop early warning indicators. Let me discuss some of
these emergent techniques.
(i) Measuring systemiticity and assessing resilience
The first set of quantitative techniques, which I am going to touch upon, deals with the
systemic importance of institutions. The experience during the global financial crisis brought
to the forefront, the concept of "too big to fail" and "too connected to fail" institutions and
raised a whole range of questions. Why are these entities important? How do they affect the
risks of the overall financial system? How does distress in any financial firm and especially in
a "too big to fail" financial institution, affect the rest of the financial system? There are, in fact,
several ways in which this can happen and understanding each of these, is the key to
designing prudential policies to address such risks3.
First is the domino effect - a distressed financial institution may be unable to meet its
liabilities to other financial institutions, resulting, in turn, in these counterpart financial
institutions failing to meet their liabilities to others. If the distressed firm is significantly large,
the overall contagion impact of its failure can severely strain the financial system.
Second is the potential market impact of the fire sale of assets, by the distressed financial
institutions which may affect asset prices, margin calls and mark to market losses for other
financial sector entities holding similar assets. These entities may, in turn, be forced to sell
their own assets to meet their liquidity requirements. As the financial crisis showed, the
adverse impact of such collective sales by financial institutions could result in a significant
dislocation of asset markets.
Third, the impact of a "too big to fail" financial institution is further aggravated if the entity is
also a provider of a critical service in financial markets, such as payment and settlement
systems, as would typically be the case with most large financial institutions.
Fourth, there is also the reputational impact that the failure of a financial institution has on
other financial institutions, especially those with similar business profiles. Failure of an
institution may reinforce and magnify the adverse feedback loop leading to a chain of
failures. This contagion impact is, however, not necessarily a function of the size of the
financial institution. Indeed, the failure of even a relatively small financial entity could cause
widespread systemic concerns if it highlighted a hitherto unrealised source of risk.
Given the potential of large or systemically important financial institutions to cause
systemwide distress in the event of their failure, there have been concerted efforts to develop
models/ techniques for the measurement of, first, the systemic risk of the financial system
and, second, methodologies through which such systemic risks could be attributed to
individual financial institutions. These models attempt to quantify or assess the role that the
bank's/financial institution's size, its risk profile, the degree of exposure to a risk factor, etc.,
play in determining the institution's contribution to systemic risks.
Traditional attempts to measure systemic risk have focused on banks' balance sheet
information, such as non-performing assets, earnings, liquidity and capital adequacy ratios.
Post crisis, the focus has increasingly moved to market based measures both because of the
availability of higher frequency data and the fact that such data is usually forward looking and
reflects the market expectation of the future performance of the underlying institutions.
Different sets of models have been developed using equity prices, CDS prices, CDO indices,
LIBOR spreads, etc., as proxies for systemic risks, employing techniques such as
econometric analysis including Principal Component Analysis to derive the systemic risk
measure. Another set of techniques use the Merton model to estimate the asset portfolio of
banks and to derive a systemic risk measure which is based on the probability of default of a
given proportion of banks in a given financial system. Another set of measures assesses
systemic risk by computing the multivariate density of a portfolio of banks. For example,
these models propose a set of banking stability measures based on distress dependence,
which is estimated by the Banking System Multivariate Density (BSMD). Another set of
systemic risk measures are based on the traditional risk management tools such as
value-atrisk (VaR) and expected shortfall (ES).
(ii) Stress testing measures
Stress testing has assumed great importance as a risk management tool, particularly
because it helps in overcoming limitations of models and historical data. Stress tests
evaluate the potential impact of an extreme event on a financial firm or financial sector.
Stress testing exercises, especially macro stress testing, are increasingly becoming an
important component of a macro prudential policy framework. These tests provide a thorough
assessment of what could happen if the identified risks materialise.
A wide variety of stress tests are employed to assess the resilience of financial institutions
and of the financial sector. The methodology employed varies from "top down" approaches
(which are typically implemented by regulators/ supervisors by applying uniform stress
scenarios to the balance sheets of all financial institutions) to "bottom up" approaches (where
the stress tests are conducted by individual institutions themselves, relying on a common set
of assumptions and/or scenarios determined by regulators/ supervisors) and also a
combination of both.
The adverse scenarios that underpin the stress tests typically encompass both sensitivity
tests and scenario analysis. In the first case, only a single key variable, e.g. interest rates or
exchanges rates, is shocked. Such single factor sensitivity tests are typically the starting
point of stress testing exercises as they are relatively simpler to implement. These tests,
however, lack plausibility as, in the event of the shock materialising, it is unlikely that only a
single variable will be affected.
In contrast, scenario analysis based stress tests examine the impact of simultaneous
changes in a number of key economic variables. These tests, based on historical or
hypothetical stress scenarios, lend greater plausibility to the stress testing exercise and also
yield a more accurate assessment of total losses under adverse developments. Not
surprisingly, they are relatively more difficult to implement as it is difficult to anticipate the
manner in which different macro variables would move together, especially under conditions
of stress.
Of late, there is an evidence of the increased use of macroeconomic models to design stress
tests. Economic models are being used to examine the linkages between the health of
financial institutions and underlying driving factors (macro-financial variables or latent
factors). Often, these models also incorporate the feedback effect from the banking system
to the rest of the economy. Some models also use the joint vector auto regression (VAR)
systems to incorporate financial market variables into a framework for stress testing the
stability of the banking system. The attempt is to design an integrated micro-macro model
that takes into account dynamic linkages between the health of the financial system and
macro-financial conditions4.
Coordinated stress tests are, thus, being used to estimate the losses that a group of financial
institutions, typically the banking system, could suffer under adverse macroeconomic
developments. Such stress tests offer an overall assessment of the vulnerability of the
banking system over a defined time period. They are also important tools for the individual
banks themselves and for their micro prudential supervisors e.g. from the perspective of
capital planning and ensuring the resilience of individual financial institutions.
In the aftermath of the Global crisis, financial sector regulators initiated various types of
coordinated disclosures of bank exposures, stress test results and similar metrics to rebuild
trust in the financial sector. Prominent examples of such disclosures are the 2009
Supervisory Capital Assessment Program in the United States, followed by the disclosure of
the stress scenario projections of the Comprehensive Capital Analysis and Review in 2012.
Similarly, the European Banking Authority and its predecessor, the Committee of European
Banking Supervisors, conducted EU-wide stress tests from 2009, disclosing the
disaggregated results. The stress testing exercises focused on assessing the resilience of
both individual banks and the EU banking system as a whole to possible adverse economic
developments, while the capital exercise estimated banks' recapitalisation needs to meet a
target capital ratio. These initiatives marked the beginning of disclosures of firm level data on
stress tests in contrast to the disclosure of sectoral or aggregate data as has been the earlier
practice. The aim was to enhance market transparency at a time of prevailing uncertainty
and to provide market participants with the necessary information to conduct their own risk
assessments.
(iii) Developing early warning framework
The third set of models I will discuss today relates to the coincident stability indicators which
are used to evaluate prevalent conditions of financial stability. These indicators assess the
movements in a range of factors which could have a bearing on financial stability and aid in
measuring how risks develop over time and in putting in place an early warning framework.
Several types of indicators are being developed in this context. Macroeconomic indicators
are typically compiled at the country level and measure changes in macroeconomic data.
These include measures such as GDP growth, growth in total credit, inflation,
unemployment, measures of external sector balance such as the current account deficit and
measures of fiscal imbalances. Another class of indicators uses aggregated data pertaining
to financial institutions representing developments in the financial sector's assets and
earnings. Banking sector indicators examine the risks emanating from the banking sector,
given the typical importance of this sector for financial stability. These indicators examine the
movements in financial soundness indicators of the banking system to assess how risks
posed by the banking system are evolving. Another set of indicators examine conditions in
financial markets.
Five years on, there is clearly no widely accepted single indicator or model capturing
systemic risks and instabilities comprehensively. Most models/techniques that have been
developed cover one or a few specific aspects of systemic risk. Each measure is an
approximation and each has its own strengths and weaknesses. No single measure is
complete in all aspects in a macroprudential context and policy-makers need, therefore, to
rely on a wide range of measures and tools, covering various segments of financial systems
and various types of shocks and transmission mechanisms. The challenge remains one of
constructing a comprehensive systemic risk surveillance and assessment system which
serves as an effective early warning system.
V. Institutional and governance arrangements
Institutional and governance arrangements for ensuring financial stability is another critical
issue. The overlap between macro prudential and monetary policies raises questions about
the role of central banks in financial stability both in peace as well as crisis time. The broad
consensus which has emerged is that central banks must be involved in the formulation and
execution of financial stability policy, exclusively or as part of a collegial arrangement.
Much work has been undertaken over the last two years on the design of financial stability
policy and related governance arrangements in some of the world's major jurisdictions.
Abstracting from details, the amendments to the regulatory and oversight architecture made
in different jurisdictions have, inter alia,
•
designated the central bank as the systemic regulator with accountability;
•
placed central banks in charge of micro prudential regulation, where not already so
responsible, in addition to macro prudential regulation, especially with respect to
systemically important financial institutions;
•
set up financial stability councils/commissions to provide high level focus on
financial stability.
Let me recapitulate some of these changes. The reform of supervisory arrangements in the
European Union (EU) drew largely upon the report of the de Larosière Group. In the second
half of 2009, the European Commission presented two sets of legislative proposals that saw
the creation of two new pan-European authorities for micro prudential and macro prudential
supervision. For micro prudential supervision, the European System of Financial Supervisors
(ESFS) was established which brings together the national supervisors and three new
independent supranational European Supervisory Authorities (ESAs) set up replacing the
former European committees for the banking, securities, and insurance and occupational
pensions sectors. With respect to macro prudential oversight, a European Systemic Risk
Board (ESRB) was created and tasked with detecting risks to the financial system as a
whole. Though the ESRB has no formal directive power, it can issue recommendations and
risk warnings to EC member states, to national supervisors and to the ESAs, all of which will
be expected to comply or else explain.
In Mexico, a Financial Stability Council (FSC) was established. The FSC comprises the Bank
of Mexico, the Finance Ministry and the country's other principal regulatory agencies and is
tasked with the identification of potential risks to the country's financial stability,
recommending appropriate policies and actions, and coordinating their implementation by
member agencies.
The Bank of Korea Act was amended in August 2011. The amendment, inter alia, granted
the Bank of Korea a financial stability mandate that calls on it to play a more proactive role in
financial stability
With the introduction of the Central Bank of Malaysia Act 2009, the 1958 version of the Act
was repealed. The 2009 Act provides greater clarity on the Bank Negara Malaysia's mandate
for financial stability and granted it specific powers for macro-prudential financial stability,
including for crisis prevention, management and resolution.
In the United Kingdom, the Banking Act 2009 introduced a new special resolution regime and
entrusted the Bank of England with a statutory objective for financial stability. The financial
sector reforms envisaged replacing the United Kingdom's current tripartite institutional
framework by a new framework integrating macro- and micro prudential oversight within the
Bank of England. The reforms focus on three key institutional changes: Creation of a
Financial Policy Committee within the Bank of England as a formal committee of its Court of
Directors and tasked with responsibility for delivering systemic financial stability through
macroprudential regulation. Second, an operationally independent subsidiary of the Bank,
the Prudential Regulation Authority (PRA), will be responsible for day to day supervision of
financial institutions that manage significant risk on their balance sheet. Third, a new
specialist regulator, the Financial Conduct Authority (FCA), which will have responsibility for
conduct of business issues across the entire spectrum of financial services.
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was passed by
US Congress with the objective of promoting financial stability by improving accountability
and transparency in the financial system, ending "too big to fail", protecting the American
taxpayer by ending bailouts, and protecting consumers from abusive financial services
practices. Under the Act, the extant American system of multiple supervisors continues.
However, a new Financial Stability Oversight Council (FSOC) under the chairmanship of the
Treasury Secretary was created to identify systemic risks and gaps in supervision, and to
recommend regulatory enhancements. Though the Federal Reserve's role in the FSOC is
not apparently very prominent, it has become the primary regulator for systemically important
entities, thus expanding its supervisory role beyond large bank holding companies.
In India, the Financial Stability and Development Council has been set up but I will discuss
this a little later.
Financial stability would require governance arrangements to ensure independence of the
macro prudential regulator, clarity of objectives and mandates and accountability.
VI. Financial stability: the Indian context
In India, prior to the crisis, no agency had explicit mandate for financial stability though the
Reserve Bank acted as the implicit systemic regulator for the country. The Reserve Bank of
India Act, 1934 provides a broad legal mandate to the Reserve Bank to secure monetary
stability and generally to operate the currency and credit system of the country to its
advantage. In practice, this meant the dual objective of growth and price stability, the relative
emphasis being dependent on the context. In 2004, the Reserve Bank formally added
financial stability as an additional objective in view of the growing size and importance of the
India