Usha Thorat: Learning from crises
Text of the "Institute of Banking and Finance (IBF) Distinguished Speaker Series" lecture by
Mrs Usha Thorat, Deputy Governor of the Reserve Bank of India, at the Institute of Banking
and Finance (IBF), Singapore, 12 October 2009.
* * *
Ladies and Gentlemen,
Harvard Economics Professor
The late John Kenneth Galbraith, Emeritus, attributed the
longevity of his book The Great Crash 1929 - published in 1955 and never since out of print
- to the tendency of history to threaten a repeat. "Each time it has been about to pass from
bookstores," he wrote in a later foreword, "another speculative episode - another bubble or
the ensuing misfortune - has stirred interest in the history of this, the great modern case of
boom and collapse, which led on to an unforgiving depression." So here we are again. The
financial crisis that has engulfed credit markets over the recent period has pushed the old
Keynesian economist's book back into the Amazon charts.
"Bad distribution of income" is the first of five weaknesses of the U.S. economy that Galbraith
cites in his definitive work on the stock market collapse. Though Galbraith says it was 5
percent, not 3 percent, of Americans who received one-third of personal income in 1929, he
says this well-heeled group played a crucial role in the crash. "The collapse in securities
values affected in the first instance the wealthy and the well-to-do. But in the world of 1929
this was a vital group. The members disposed of a large proportion of the consumer income;
they were the source of the lion's share of personal savings and investment".
History has an eerie way of repeating itself and memory of the pain of busts, according to
Galbraith, is perhaps the best regulator
The Ascent of
In the latest best seller Money, Niall Ferguson has also highlighted the fact
that the income of the median household in US has scarcely changed since 1980, increasing
by just 7 per cent in the last 18 years while their borrowings multiplied several times and
made what seemed a sub prime mortgage crisis to a full blown global financial crisis.
In the current global crisis, no country has been spared be it big or small, developing or
developed, relatively insulated or more open. The shock has impacted both the financial and
real sectors although it was financial sector led. In India, the impact though significant, has
not been to the same extent as in other parts. This is partly attributed to the curbs India still
has on the capital account, but mainly to the dominance of domestic expenditure -
consumption and investment - and high savings rate, leading to a balanced macro economy,
having small current account deficits. Nevertheless, the impact has been felt by the domestic
credit equity and forex markets leading to slowing down in the growth rate and employment
generation. Still, the country is the second fastest growing economy in the world with over 6
% growth projected for the current year.
The topic of my talk is "Learning from crises". As Galbraith recalled it is amazing how the
same mistakes get repeated. Hence I think we owe it to the system to recollect and recount
lessons from crises. The key lessons are how to anticipate and take pre-emptive action and
equally important, once you are in the middle of it, how to respond effectively viz. crisis
management. Post crisis, the critical issues are - how do we put in systems and buffers that
can cushion the impact of economic cycles and booms and busts that are so typical of
market driven systems.
During the journey I have traversed in the RBI, I have been witness to many crisis situations
of differing dimensions, especially since 1991. Delving into the past I feel veteran enough to
share these experiences and draw lessons.
The BOP crisis of 1991
This was a major crisis in the country. In mid 1991, the foreign exchange reserves of the
country were down to 11 days imports, even what little reserves that remained were not
unencumbered. While the crisis was triggered by increase in oil prices and the Gulf war, the
underlying factors were the macro imbalance in the form of unmanageable current account
and fiscal deficits. External debt servicing as a proportion of current receipts increased from
10.2 per cent in 1980-81 to 35.3 per cent of current receipts in 1990-91. The responses
included curbing imports through a system of administrative controls for large value letters of
credit, giving incentives for exports, pledging of gold reserves with Bank of England and
Bank of Japan, devaluation of the Indian Rupee, issuing attractive bonds in foreign currency
to Non-Resident Indians, encouraging return flow of capital, an amnesty scheme through
gold bonds, borrowing from multilateral institutions, etc., and so on. The long term response
included major reforms in trade industry foreign investment fiscal and financial sector paving
the way for development of equity, forex money and government securities markets. There
were fundamental changes in monetary management consequent upon stoppage of
automatic monetisation of the government deficit and switch over to an auction based market
borrowing for meeting the fiscal deficits.
Many valuable lessons were learnt from the crisis:
•
Exchange rates should not be overvalued for long periods.
•
Providing exchange guarantees by the central bank or government are best
avoided.
•
On the external account, liberalising equity flows first is a better option followed by
commercial credit and longer term debt , while limiting the access to foreign debt by
the financial sector.
•
Central bank funding of the government in the primary market should not be
resorted to.
•
Excessively high remuneration on reserve requirements erodes monetary control.
•
Financial sector repression - excessive interest controls and credit rationing - is
deleterious to growth.
• A strong financial sector requires prudential regulation and effective supervision.
•
Removing or reducing entry barriers to facilitate more competition.
•
Coordinated action by the Government and the central bank with a well knit
professional team working together greatly facilitates the process.
The securities irregularities of 1992
The irregularities reflected speculative buying in the stock market funded by bank liquidity
through repurchase transactions in government securities and bonds, facilitated by a nexus
between brokers and banks. In part this reflected a way of earning higher yields in an
otherwise administered interest rate structure. Such transactions were done against bank
receipts where there were no underlying government securities. The events that led to these
irregularities could be attributed to weaknesses and lack of transparency in the market
infrastructure for government securities, excess liquidity with public sector undertakings,
nexus between banks and brokers and inadequate internal controls that led to bank funds
flowing to the stock markets fuelling abnormal stock price increase. Poor internal controls
were reflective of low levels of computerisation and reliance on manual processing.
Consequences resulted when a settlement failure triggered panic and the irregularities
surfaced in the open. RBI had to undertake a series of investigations to unravel the irregular
transactions and fix responsibility. A Joint Parliamentary Committee (JPC) constituted to
investigate into these operations required enormous resources of the management.
There were several positive fall outs of this crisis:
•
Acceleration of capital market reforms and introduction of screen based order
matching systems with commensurate depository custody clearing and settlement
arrangements that are continuously upgraded.
•
Institution of a delivery versus payment mechanism for settlement of trades in
government securities initially in RBI but later led to establishment of a central
counterparty in the form of CCIL (Clearing Corporation Of India) which today
undertakes guaranteed settlement for government securities, repos in G Secs and
forex market trades.
•
Dissemination of information on all individual transactions in the government
securities market on a daily basis and currently on real time basis.
•
Tightening of internal controls in investment transactions.
•
Removal of administered interest rates -currently only the savings bank deposit rate
is fixed by the RBI, while all other deposit rates are deregulated.
•
Strengthening supervision over banks and other financial institutions and
establishment of the Board for Financial Supervision (BFS) in 1994 with the primary
objective of undertaking supervision of the financial sector comprising commercial
banks, financial institutions and non-banking financial companies.
•
Recognition of the possibility of systemic risk in the absence of proper assessment
of counterparty risk and well functioning securities markets with greater
transparency.
•
Focused attention on the role of the regulator which ensures adherence to
regulations in letter and spirit and need for greater accountability.
Imbroglio caused by dealings of Non-Banking Financial Companies in 1997
Non-Banking Financial Companies (NBFCs) have been historically subjected to a relatively
lower degree of regulation vis-à-vis the banks, the higher rates of return on deposits they
could offer enabled them to attract a large base of small savers and a potential threat to the
stability of the financial system. Added to these was the fact that operations of NBFCs were
characterised by several distinctive features viz. no entry barriers, no requirement for large
investment in fixed assets and inventories, freedom to open branch offices, all of which led to
their proliferation in an unbridled manner. A few such companies which were perceived as
well-functioning, well-managed and financially healthy and consequently had a large
depositor base, defaulted in repayment of deposits, leading to the realisation that the extant
framework was inadequate to monitor and regulate these companies. Though there were no
systemic problems, confidence of the depositors in the NBFCs as a sector was eroded and
the Reserve Bank faced the risk of loss of reputation. In a specific instance, the in-principle
approval given by the Reserve Bank to start a bank was used by the entity to mobilise huge
funds from the unsuspecting public and the payable-at-par cheques issued by the entity on a
leading commercial bank resulted in a huge exposure and default to the bank because of the
lag between the timing of payments and providing funds cover.
The learning points were:
•
Recognition of the possibility of regulatory arbitrage between the entities regulated
by banks and non banking financial companies and between the securities regulator
and the bank regulator.
•
Need for legal powers to regulate the activities of NBFCs, including framing of
guidelines for compulsory registration, stringency in conditions for deposit-taking
companies akin to banks, and applicability of prudential norms for such companies.
In the recent period, it has been noted that, even if not accepting deposits, these companies
can contribute to systemic risk as they access public funds and participate in various markets
(debt, equity and foreign exchange markets). Hence capital ratios and a quarterly system of
reporting were introduced for large non-deposit taking NBFCs in 2007.
Asian crisis of 1997 - the first global contagion
The South-East Asian crisis started with stock market and currency crashes followed by
financial crisis which spilt over to the real sector. It changed irrevocably the way Asian
countries look at issues of financial stability. The Indian market was not immune and even
though there was a general belief that some correction in the rupee was required, the
pressure on the rupee in later part of the year required RBI to intervene to maintain orderly
conditions. Withdrawal of funds by foreign institutional investors (FIIs) hit the equity and
foreign exchange markets and the sale of foreign exchange by RBI also affected the money
and bond markets. In addition to intervention, monetary and administrative measures had to
be taken to stabilise markets. The impact on the domestic interest rates and liquidity was the
cost to be paid for restoring stability. The government borrowing programme was managed
through private placement and subsequent open market operations when the markets
stabilised.
The learning points were:
•
Need for complementarity between macroeconomic stability and financial stability
and exchange rate management for preserving competitiveness and confidence in
the economy.
•
Need for closer supervision and regulation of banks and other financial institutions.
•
During asset price booms it is important to ensure that banks' exposure to capital
markets and real estate is not excessive and to understand that banks can be
subject to foreign exchange risk even without any currency mismatches in their
books, when their constituents have huge unhedged exposures.
•
Management of capital account is important for countries having chronic CAD and
where inflation and interest rates are persistently over global levels.
•
Dollarisation of the domestic market or internationalisation of the domestic currency
can both require careful management.
•
Financial stability emerged as a specific objective of policy as the cost of instability
to the real sector is huge especially on the vulnerable segments of society.
Urban Co-operative Banks - the weak link
The tightening of regulation over the banking and NBFC sectors saw the gravitation of risk to
the lightly regulated Urban Co-operative Banks (UCBs) which were under dual regulation of
the RBI and the registrar of cooperative societies. The stock market crash in 2002 triggered a
payments problem and it was found that the nexus between the broker and a large UCB
(Madhavpura Mercantile Co-operative Bank) led to huge exposure to the broker and the
bank collapsed. The systemic implication was that hundreds of small UCBs had exposure to
this bank and the collapse of these banks would have been very disruptive though confined
to a small region. The Deposit Insurance and Credit Guarantee Corporation (DICGC) had to
make a large payout to the collapsed bank under a restructuring package and averted the
domino effect. But the Madhavpura Bank collapse led to erosion in public confidence and
there were a series of UCB failures across the country. The immediate measures taken were
to ban connected lending, exposure to share-brokers and inter-UCB deposits. The
supervisory system - both on-site and off-site - was triggered and strengthened. In 2004, all
new branch and bank expansion was stopped and a vision document was put out in 2005
which provided for a MoU with the state governments to work out a way for non-disruptive
exit of weak UCBs while simultaneously incentivising the growth of strong banks.
Subsequently various resolution options have been provided such as merger with or without
support from DICGC, restructuring of liabilities, introduction of new capital-like instruments,
and transfer of assets and liabilities. The UCB sector has seen a reduction in the number of
weak banks from 725 to 496. 102 banks have gone out of the system through mergers and
liquidation. DICGC has also strengthened its claim payments system to ensure that prompt
relief is given to small depositors of failed banks.
The lessons learnt were:
•
In dealing with a crisis arising out of interconnectedness, breathing time needs to be
provided through liquidity injection.
•
Reduce interconnectedness within the financial system as it leads to a "moral
hazard" problem of "too interconnected to fail".
•
The most lightly regulated entity in the financial system becomes the weakest link.
The system's weakest link becomes a source of reputation risk and erosion in public
confidence.
•
Even though under dual regulation, the bank regulator has to use its powers more
effectively and take steps to resolve weak banks.
Failure of a fairly significant mid sized commercial bank in 2004
The Global Trust Bank Ltd, a private sector bank had reported substantial growth and was
growing too fast. The bank's balance sheet was flawed and disclosures inadequate. Very
large capital market exposures and shortfall in provisioning were the causes for downfall of
the bank. The common depositor does not have the wherewithal to study bank balance
sheets before making a deposit, but even the institutional investors seem to be gullible
investors. It was also realised that even though insolvent, a bank can carry on without a run
as long as it has adequate liquidity or access to liquidity. Interestingly, even at the time of
moratorium, the bank had huge inter-bank borrowings and deposits reflecting the confidence
placed by other banks and institutional investors or the moral hazard view that banks will not
be allowed to fail. Auditor accountability came under focus. The problem had to be dealt with
heads on when all avenues and options for revival by the promoters and directors failed.
Compulsory amalgamation with a public sector bank was resorted to.
This experience gave us valuable lessons of how to deal with a bank run.
• The process of resolution should be swift and decisive and preferably over the
weekend.
• In a computerised system with 24/7 banking, and large retail base, the preparation
for a moratorium has to be much more meticulous than in traditional banking.
•
Role of media is critical and in any crisis management media management has to be
given priority. We actually had to go on media to give out reassurances about the
bank to stop the run.
•
Adequate liquidity and currency needs to be kept ready to stem a run once the
resolution strategy is decided.
•
A moratorium is useful to give breathing time to put a resolution package in place
but hardship requests can become tedious to handle.
Institutional factors
This decade has been one of challenges in managing capital flows both inflows and outflows.
Both monetary policies and prudential policies have been used through a variety of
instruments to manage the macro economic and financial stability challenges arising out of
large capital flows, external shocks such as 9/11, political uncertainty, geo political events,
and have called for vigilance and prompt actions. While evolving policy instruments to
manage these conditions such as the Market Stabilisation Scheme for sterilising the impact
of inflows are important I would like to flag a few critical institutional factors which I think are
required to be encouraged and made part of the automatic trigger mechanisms in the
system. I would like to turn to these:
Problem recognition
The meaning of being vigilant is to be able to constantly scan the horizon and recognise that
a problem is brewing and take pre-emptive action before the problem becomes disruptive.
The indicators could be asset values, excess credit growth, large unhedged exposures,
continuing current account deficits financed by short term credit, weakly regulated entities in
the system, opportunities for regulatory arbitrage, large leveraged positions, prolonged
periods of liquidity excesses or shortages; or the tendencies of entities to leverage,
especially by exploiting the inter-linkages in the financial system .
Committee approach
As part of crisis management, it is necessary to have a harmonised approach. First it is
essential to have close coordination with the Government. As in 1991, this was an important
requirement in responding to the recent crisis. Putting in place an institutional mechanism
and systems that can facilitate continuous dialogue and co-ordination between those in
charge of monetary policy, debt management, foreign exchange management, regulation
and supervision of banking entities, supervision of non-banking entities, securities markets
regulation and the like is a sine-qua-non. Within each of these segments it is crucial to be in
sync. We have a Financial Markets Committee (FMC) in the central bank consisting of senior
executives responsible for monetary policy and operations, debt management and foreign
exchange reserves management. The FMC meets at least once every day in the morning
and emergent meetings are also convened when there are episodes of sharp volatility in
equity markets, or when any of the other markets are significantly affected. Other regulatory
departments including the department responsible for payment system also get involved
during such times. The Committee keeps in touch with the securities regulator (SEBI), the
stock exchanges especially the clearing and settlement corporation of the exchanges, the
Clearing Corporation of India Ltd. (CCIL) and the like. We also have a Crisis Management
Group that meets whenever a crisis is anticipated or occurs.
Inter-regulatory co-ordination
Financial sector harmonisation among the securities, insurance, pension fund and bank
regulators is enabled through the High Level Co-ordination Committee on Financial Markets
(HLCCFM). The HLCCFM is headed by the Governor, RBI and meets as and when felt
required. The Ministry of Finance provides the secretariat. Sub-committees/groups formed
among SEBI, IRDA, PFRDA and RBI, meet to discuss and sort out issues relating to
developments in the financial markets having implications cutting across different regulators.
Institutionalised and formal approach to decision making in a crisis has the benefit of building
on the experience of the members.
Consultative approach
We have also reaped the advantages of using external experts in our policy making. We
have a Technical Advisory Committee for Monetary Policy consisting of academicians,
practitioners and experts, which tenders advice to RBI on monetary policy stance. There is
also a Technical Advisory Committee that consists of financial sector experts from areas
such as banking, academics, government, stock exchanges, credit rating agencies and
market representatives. This committee meets once a quarter to deliberate on developments
in money, foreign exchange and government-securities markets and offers advice on policies
for regulation, growth and further reforms in financial markets, including products, practices
and institutional arrangements.
Capacity building
Equally crucial is the need to develop people and systems to deal with scenarios and
contingencies, which can be achieved only through a sustained process of capacity building.
Giving exposure through participation in meetings at local and international levels, allowing
officers even at fairly junior levels to be part of the dialogue process at the top levels in
various co-ordination fora, enormously helps in nurturing talent. A consultative and
participative approach to decision making through setting-up of working groups consisting of
a mix of internal and external people with clearly set tasks and time-lines not only casts
responsibility but also aids developing expertise. Emphasis in these groups is on harnessing
collective wisdom and balanced judgement, typical of a college-like atmosphere for decision
making.
Robust infrastructure
I am referring to the development of sound market infrastructure for payments and settlement
for all financial transactions as also market infrastructure for trading reporting information
dissemination and clearing settlement. CCPs for clearing and settlement of equity
government securities forex and money markets are in place following the best practices laid
down by IOSCO/CPSS. The infrastructure for electronic payments and RTGS are now taken
for granted.
Summing up
A lot has been talked about the current crisis and the response. Most of these talks are on
the website. I would just like to say that the major learning from this crisis is that globalization
has meant that no country is immune from the happenings in global financial markets. Also,
at one level, the presence of complex and interconnected financial entities across several
jurisdictions with regulators at the national level has posed huge challenges in ensuring that
there is no regulatory arbitrage and that there is coordination amongst regulators. Even
within a jurisdiction, it is recognized that all regulators have to deal with systemic risk and
there is need for inter regulatory dialogue and vigilance.
At the macro level, Asian countries and Latin American countries have learnt lessons from
their own past currency and financial crises and have built up reserves and have
strengthened their financial systems apart from consciously developing their financial
markets. But they have been careful to ensure that their banks are not involved excessively
in toxic assets or innovative transactions. Even so, the countries have had to face the
consequences of falling global trade and GDP and unemployment and slowing credit growth.
Macro economic imbalances continue though they have reduced. Savings is increasing in
the western world and consumption increasing in the East.
Ultimately, we all have to be concerned about the real sector and recognize that financial
sector development is not a goal by itself but is intended to enable the growth, not just of the
rich, but more importantly inclusive growth cutting across all segments of the society and
regions. As regulators and central banks, it is our duty to ensure this.