Shyamala Gopinath: Financial markets - some regulatory issues and
recent developments
Inaugural address by Ms Shyamala Gopinath, Deputy Governor of the Reserve Bank of
India, at the Fixed Income Money Markets and Derivatives Association-Primary Dealers
Association of India (FIMMDA-PDAI) Annual Conference, Mumbai, 4 January 2010.
* * *
1. It is my pleasure to be here today again, at the FIMMDA-PDAI annual conference as
we enter into a new decade. The last decade in the Indian financial sector has been a
forward continuum marked by significant developments. It was in 1999 that guidelines for
interest rate swaps and forward rate agreements were first introduced. 1999 was also the
year when FEMA was enacted and since then it has been a process of measured opening up
of the capital account. That was also the time when the LAF framework for modulating short
term liquidity was introduced and a plan was put in place for making uncollateralized call
money market as a pure inter-bank market. Looking back, we have come along a long way.
One thing that perhaps connects through the regulatory approach during this period has
been the pursuit of financial stability. Some may be surprised to note that as far back as the
start of this decade, the conceptualization of financial stability had been ingrained into the
macro-economic and policy framework of the RBI. There was a stated focus on the need to
treat financial stability as a dominant objective of macroeconomic management and as a
necessary, if not the sufficient, condition for accelerating economic growth.1 Financial
stability, of course, has acquired its rightful place as a key policy objective globally since the
onset of crisis.
2. In my address last year, I had touched upon some of the burning issues that the global
policy makers were grappling with. The financial markets have since stabilised and there is
recovery in risk appetite but this primarily reflects the unprecedented and extraordinary policy
measures taken by central banks and governments. Public sector assumed the role of not
only the lender but also the risk taker of last resort. Much water has flown in the interregnum
and in terms of outcomes, at the very least, we have a common minimum globally agreed
program for repairing the financial system. The key elements of this program are: a
strengthened capital adequacy and liquidity regime for banks, developing a framework for
systemically important entities and resolution arrangements, extending the regulatory
perimeter to unregulated pools of money, de-risking the OTC derivatives trading and new
frameworks for regulating compensation within the financial sector. The main action on the
above program is primarily concentrated on both sides of the Atlantic for obvious reasons.
However, most of the other countries, including India, have agreed to the broad
commitments being driven by the G20 and the FSB.
3. My address today will be in two parts. In the first part I propose to discuss broad issues
relating to financial market regulation and in the second part will briefly review the key
developments in major markets in India and certain unsettled issues.
I. Regulatory approach for markets
4. In the post crisis scenario, the new important variable that is being sought to be
addressed globally is the oversight of systemic risk. It is being acknowledged that institutional
regulation alone is not sufficient in capturing and addressing systemic risks and it is
imperative to have a mechanism to monitor and act upon the risks inherent in the
interconnectedness across the financial system - a macro-prudential approach to regulation
and supervision. It is recognized that systemic risk is created endogeneously rather than
having exogeneous origins beyond the remit of financial markets.
Macro-prudential regulation - the concept
5. Macroprudential approach, generically, can be defined as policy that focuses on the
financial system as a whole, and also treats aggregate risk as endogenous with regard to
collective behaviour of institutions. It aims to limit system wide distress so as to avoid output
costs associated with financial instability.2 The underlying philosophy of macro-prudential
regulation is that behind the individual prudence of financial firms may underlie systemic
problems caused by their collective behavior. A recent Bank of England discussion paper3
interprets macroprudential policy as lying on a spectrum with monetary policy at one end and
microprudential policy at the other, concerned with the stability of the aggregate provision of
financial intermediation services to the real economy.
6. The two key elements of macro-prudential regulation4 that have acquired maximum
attention are one, existence of common (correlated) exposures which arise either because
institutions are directly exposed to the same or similar asset classes or because of indirect
exposures associated with linkages among them (e.g. counterparty relationships) and two,
collective homogeneous actions on the part of institutions resulting in amplification of risks
because of interconnectedness, the pro-cyclicality element.
7. Integral to the above approach is also the role of financial markets - by and in
themselves, different market segments, assessed in terms of the usual metrics such as
liquidity, turnover, etc. may be functioning absolutely well, but there may still be underlying
systemic vulnerabilities arising out of the interactions of different market participants, both
regulated as well as unregulated, across different markets.
8. However, there is still no coherent framework emerging for regulation of financial
markets from a stability perspective. Indeed, the joint IMF-BIS-FSB paper on assessing the
Systemic Importance of Financial Institutions, Markets and Instruments also acknowledges
that the assessment of systemic importance of markets presents more conceptual
challenges than for institutions. In the area of reforming markets, the singular area of action
has been to address counterparty risks and non-transparency in the OTC market by taking
all such markets onto central clearing platforms. Other elements impinging on market
functioning flow from the focus on entity regulation such as addressing excessive leverage,
higher capital charge for trading and securitization transactions.
9. Holistically speaking, regulation of financial markets per se would involve two separate
strands, apart from entity regulation:
(i) policy framework that includes the product specifications, macro level regulations
that apply to all entities operating in this market, systemic safeguards, nature of
participants, reporting requirements etc.
(ii) operational aspects of trading and post-trade clearing and settlement.
10. The concept of market regulation in most of the developed financial centres has largely
been concentrated around the operational aspects of trading - the conduct of business part
and has left prudential focus to entity regulation. More importantly, there was no explicit
policy framework for markets from a stability perspective. Mr. Howard Davies, the previous
chairman of the FSA recently admitted that "The political mood, and certainly the mood in the
markets, was that regulators should observe how markets evolved and try to craft their
regulatory environment to cope with the risks that emerged. We have now seen that an
approach of that sort can step too far back... We now can see that if you step too far back,
trends can develop in a way which creates trouble, and that there needs to be, I think, more
self-confidence in the regulatory world to be prepared to step in at an earlier stage and to
challenge the judgments of the markets."5
11. It is surprising that this paradoxical approach Mr. Howard Davies talks about is not
being altered even now though there is recognition of the need to monitor systemic
interconnectedness. The macro-prudential approach to regulation, now being considered
imperative for financial entities, is still some way from being applied to financial markets.
12. Just to illustrate, one of the arguments against the way financial products have evolved
relates to the problem of information asymmetries: the gulf between the market makers and
market takers. Large financial firms run huge positions across multiple assets and have the
ability as well as incentive to move markets in a way advantageous for them. This is not
merely an exaggerated concern: there are increasing number of articles trying to interpret the
link between the creation and selling of CDOs by large investment firms on underlying
securities of doubtful nature prior to the crisis and simultaneously going short. In plain words,
on the one hand you sell the derivatives to less informed investors betting on the upside,
while at the same time place huge bets to gain yourself from the downside. Here comes the
systemic perspective in regulation: what may be good for a particular entity may be sowing
seeds of instability for the system.
13. As part of general public discourse many interesting issues are being raised and
debated fiercely, particularly relating to the social good being contributed by the markets and
the systemic implications of some of the innovations. I came across an interesting
classification of opinionists in the context of the raging debate on climate change -
calamitists and denialists at the two extremes and warners and skeptics somewhere in the
middle.6
Through the crisis, there have been similar voices in the context of the role of
markets. On one end of the spectrum are the denialist notions that there is inherently nothing
wrong with the markets and the primary drivers for the crisis lay in the macro-economic
realm. At the other end, there are the calamitists arguing for a radical shift in the way markets
are regulated since they have failed spectacularly. The truth, as usual may lie somewhere in
the middle. Some key issues have indeed been acknowledged and are being addressed.
There have been broad agreements on the principles, the problem is that these are the
common minimum principles and the implementation is being driven by contextual issues in
each country.
Interconnectedness
14. The crisis has highlighted the importance of improving our understanding of
interconnectedness in the financial system through direct links between financial institutions and
the indirect links created through financial markets. The key channels of propagation of risks
are maturity mismatches and leverage.
15. In regard to direct links, there is need for bringing all inter-bank/intra-financial system
exposures both on and off-balance sheet within the macro prudential framework. While there
are prudential requirements for individual bank's exposures to other banks, there is
appreciation of the need to prescribe safeguards on the liabilities side of the balance sheet
too and to ensure availability of adequate good quality liquid assets.
16. The growth in financial sector over the past few years has been exponential. While
many have argued that this has also contributed to real economy growth, behind the
numbers lays the critical role of leverage and off-balance sheet financing. As mentioned in
the Turner Review, from about 2003 onwards there were significant increases in the
measured on-balance sheet leverage of many commercial and investment banks, driven in
some cases by dramatic increases in gross assets and derivative positions. This coupled
with the growth of "shadow banking" meant that the so-called benefits from financial sector
growth have been mostly illusory.
17. Firms whose business models were based on high leverage and excessive
dependence on uninterrupted access to secured funding markets were highly vulnerable in
the crisis. Many firms relied on excessive short-term wholesale financing of long term illiquid
assets including on cross border basis. During the crisis they were faced with lenders
demanding substantial cushions or haircuts on the assets they were willing to finance.
Moreover, these assets taken as collateral were illiquid and lenders failed to factor in this
risk. This combined with excessive leverage accentuated the vulnerability.
18. The excessive dependence of entities on wholesale funding markets such as repo or
other collateralised markets is an issue of systemic concern since one, it accentuates
systemic procyclicality through haircuts/margins and two, the leverage loop that builds
through these markets in high liquidity periods induces rigidity and gets entrenched into
funding models of entities. It is therefore imperative to bring the secured funding markets
such as repo markets within the regulatory perimeter/macro prudential framework,
particularly since many entities participating in these markets are unregulated/lightly
regulated. There is need for a cautious approach when the securities that are
repo'ed/collateralised carry credit risk and are illiquid.
19. This also raises the issue of interconnectedness of banks to private pools of capital that
are largely unregulated. While the reform of the financial system does cover regulation of
hedge funds, the general issue of banks exposures to these funds directly as well as through
markets needs greater attention. The same applies to private equity which are unregulated
entities. These entities rely on funding markets for leverage. From a macro prudential
perspective it is not just necessary to regulate banks exposures to these entities but also to
limit the overall leverage of these entities if they are permitted to access funds directly from
banks and other financial intermediaries and indirectly via funding markets.
OTC market infrastructure
20. A large number of initiatives are underway at the international level to strengthen the
infrastructure for OTC derivatives, a clear amplifier of stress particularly in credit derivatives
market in the crisis as evidenced by AIG, Bear Stearns, Lehman episodes. The deficiencies
within the OTC derivatives market viz. the management of counterparty credit risk and the
absence of sufficient transparency have pushed the policy preference to exchange
traded/centrally cleared models. However the specific proposals being discussed in various
countries do envisage continuance of non-standardised OTC contracts albeit with a stricter
bilateral collateralization requirement and higher capital charge.
21. Increasingly more nuanced perspectives on this issue are being articulated, the most
recent one being the discussion paper of December 2009 from the HMT and the FSA in UK
which argues against the need for mandating the trading of standardized derivatives on
organized trading platforms provided steps are taken to improve transparency and mitigate
the risks of OTC derivatives. According to this paper regulatory objectives of reducing
counterparty risk and improving transparency can be achieved by other means and they
would review progress of initiatives in this area. Moreover, mandating the use of organised
platforms would imply a regulatory imposition of trading structure, which they do not believe
is necessary. The paper argues that mere standardisability cannot be a sufficient condition
for central clearing and other factors such as availability of prices, depth of market liquidity
and whether the product contains inherent risk attributes that cannot be mitigated by the
CCP need to be considered by regulators.
22. The essence of a CCP arrangement is netting and margining, which are contingent on
homogeneity of the underlying asset, availability of reliable prices and sound risk models to
capture future potential exposures. The ability of models to capture tail risks has been
comprehensively put to question post crisis. How would the exchanges be better able to
measure and manage risk where some of the biggest financial firms with the soundest risk
management systems failed? This would be particularly true of credit products such as CDS.
In this context, the nature of collateral regime becomes extremely important. Any instrument
with a credit risk element would inherently not be suitable for a collateral. If these aspects are
not addressed by the regulators, mandatory clearing would only result in a potentially riskier
system.
23. The real sector i.e. end users are opposing mandatory move to exchanges and
clearing platforms on the ground that the crisis was inherently due to complex transactions
between financial intermediaries and there should be no increase in cost to the real sector,
i.e. genuine end-users, for undertaking derivative trades.
24. Currently, a CPSS-IOSCO Committee is looking into the existing standards for the
systemic entities like the CCP. Given the nature of their functions which require incentives for
strong risk management and building adequate financial resources in the form of settlement
guarantee funds and their systemic importance, it is worthwhile to consider central
counterparties as "public utility" and not-for profit entities to reduce moral hazard.
25. A key criticism of the proposed reforms has been that it doesn't address the
fundamental issue of speculative use of derivatives and excessive financialisation of all
products. In fact, by transferring most of OTC market onto exchanges, it might be further
accentuating it. It is not surprising to hear major global exchanges as well as brokers betting
on a manifold increase in the CDS market as a result of electronic trading and central
clearing. A recent study7
has found that of the gross CDS position of 23 large US Banks only
around 2 per cent was for hedging the rest was for their dealer activities. Though the figures
pertain to 2005, they give a fair idea of really how much of the CDS market was actually for
pure speculation. Speculation does play an economic role in increasing market liquidity and
price discovery but beyond a point, trading without an underlying interest could only increase
systemic risk particularly when the same market prices and volatilities get entrenched into
the balance sheets of the real sector.
Rating agencies
26. Another area where progress has been slow relates to the rating agencies. There have
been some proposals to mitigate conflicts between raters and issuers who pay them but
these have largely been in the nature of more disclosures by rating agencies and separation
of the consultancy/advisory roles. Some of the fundamental issues have been left
unaddressed, particularly the methodological issues, accountability arrangements and
overstretching of rating agencies. A key issue that has not been addressed is the ratings given by
rating agencies based on implicit support without the need to disclose the rating status
without such implicit support. From the point of view of transparency to investors and
accountability there is need for further disclosures in this regard.
Capital account management
27. For emerging countries the macro prudential framework has also to deal with
vulnerability arising from cross-border capital flows, currency mismatches and foreign
currency liquidity in the financial system. Rapid and volatile capital inflows or outflows can
present significant policy challenges - potentially leading to exchange rate overshooting,
asset price volatility and financial instability. In this context, appropriate and pragmatic use of
capital account regulations may have to be considered by emerging markets in order to
maintain financial stability if considered necessary.
Market discipline
28. In the past, it has been argued that market discipline can play a key role in incentivising
market participants to limit their excessive risk taking activities. However, the events of the
last few years have proved the inadequacy of market discipline and bankers have been
engaged in risk-taking activities disguised as value-creation. Time and again market
participants have engaged in herd behaviour and put the financial system at risk. It is
poignant to note how relevant Charles Mackay's observation in his popular book
Extraordinary Popular Delusions and Madness of Crowds, written in 1841, even today.
Mackay wrote, ''Men, it has been well said think in herds; it will be seen that they go mad in
herds, while they only recover their senses slowly, and one by one". The events of the past
few years tell us that market discipline expressed via market prices cannot be expected to
play a major role in constraining risk taking, and that the primary constraint needs to come
from regulation and supervision.
29. So how do we manage the trade-off between financial stability, effective regulations on
the one hand and free markets on the other? One, the responsibility for financial stability
cannot be fragmented across several regulators; it has to rest unambiguously with a single
entity, and that single entity optimally is the central bank. And second, that there is need for
coordination across regulators on a regular basis and for developing a protocol for
responding to a crisis situation.8
30. In my opinion, any regulation that is envisaged should be based on the touchstone of
the following: Regulations that does not lead to excessive leverage of not only financial
institutions, but also of households and corporates. Regulations that augment the market
process and strengthen the invisible hand. Regulations that address the information
problems associated with complex financial instruments and improve the transparency of
instruments and institutions. Regulations that acknowledge and address the systemically
important nature of key markets that have wider implications for the real economy.
Regulations that recognize and address the country specific circumstances.
Part II - Indian context
31. Having touched upon some of the broad issues for financial regulation in the context of
emerging global consensus, let me turn to the Indian context. I would like to briefly review the
key developments in major markets and try to flag some of the unsettled issues.
Money markets
32. The overnight rates have an important contributory role in terms of managing day to
day liquidity and as a point of origin for building expectations on the term structure of interest
rates. Domestically, while the overnight rates have more or less remained around the
corridor in the recent past, the daily cash maintained by the banking system with RBI - one
of the most important determinants of the overnight rates - have remained highly volatile as
compared to the required CRR balances.
33. Therefore, despite the daily overnight rates remaining around the interest rate corridor,
the daily absolute change in the weighted average rates have not been smooth.
34. While we are all aware of the skewed distribution of liquidity in the banking system due
to different balance sheet sizes of the banks, the rapid roll-out of RTGS system and the core
banking solutions perhaps offers us an opportunity to go back to the drawing board and
optimize the day to day liquidity management to reduce the opportunity costs and more
importantly improve the ability to lend on term basis. The term money market continues to
remain dormant with low turnover despite several initiatives taken by the Reserve Bank,
mainly reflecting the inability of the market participants to take a medium-term view on
interest rates and liquidity, corporates' continued preference for cash credit and other modes
of loan disbursements. However, the CD market is active and reflects the unsecured term
money market rates.
35. RBI has addressed the issue of vulnerabilities arising from excessive intra financial
sector activity by limiting the unsecured overnight market to banks and primary dealers and
imposing limits on unsecured borrowing and lending in overnight markets as also by limiting
the gross interbank liabilities.
36. On the market infrastructure side, over the years, the collateralised segment of money
market has assumed increasing importance for the entire gamut of market players including
non-banks without engendering financial instability. All collateralized trades including market
repos are settled through a CCP. These developments have contributed to the increased
transparency and liquidity in these markets and imparted stability to the financial markets.
37. On the regulatory front, the gap that existed in the case of NCDs with maturities less
than one year has received the regulatory attention. Non Convertible Debentures of maturity
of less than one year are being issued with innovative features such as, interest rates linked
to overnight rate, American style put/call optionality, which imparts demand liability character
to these instruments. Further, the innovative features and the high amount of issuance of
such instruments pose systemic risks. The suggestion of the market participants in
expanding the eligible entities that can act as Debenture Trustees for the issuance of NCDs
with less than one year maturities is being examined by the Reserve Bank. However, the
suggestion for relaxing the minimum tenor of these NCDs from the proposed tenor of
90 days to 7 days cannot be acceded to as under the law, corporates are prohibited from
issuing unsecured debentures with maturity of less than 90 days. Allowing markets to issue
very short-term instruments can have systemic implications. In any case, there are other
instruments in the short-end like repo, CBLO and CPs that can meet the requirement of
investors.
Fixed income markets
38. The fixed income markets in India, as is the case with the developed world is
dominated by the Government securities markets. A lot has been done to develop the market
infrastructure for the Government securities markets in the past two decades and most of the
issues that remains now have to do with the development of the non-bank non-institutional
interests in the government securities. In India, the reasons for lack of retail interest lies in
the availability of alternative instruments with higher yields and better tax treatment and the
small savings window for those in need of risk free instruments. Nevertheless, the
experience gained in the development of the Government securities market microstructure
will stand us in good stead in further development of the Corporate Bond markets and certain
other segments of the money markets mentioned earlier.
Government securities market
39. Of the various reforms towards development of the Government securities market, the
most significant one, I must say was the issuance of G-secs through auction, followed and
backed by development of market infrastructure such as trade reporting platforms for real
time dissemination, DvP and CCP clearing and settlement. Introduction and gradual
relaxation of repo has also significantly contributed to the liquidity. The Reserve Bank has
also taken up the revision of repo accounting to reflect the true economic essence of the
transaction on the books of both the repo seller as well as the repo buyer. The final
guidelines are set to be issued shortly.
Initiatives to widen investor base
40. In last few years, many initiatives have been taken to widen the investor base in G-Sec
Market. The Reserve Bank, in consultation with the Central Government and State
Governments, has introduced the Non-Competitive Bidding in the Auction of Central
Government securities and State Development Loans. NDS-OM has been extended to
insurance companies, qualified Mutual Funds, Provident Funds and Pension Funds in a
phased manner. Further, changes have been made in the manner in which bids are
submitted in the auctions of the Government of India securities so as to improve the
efficiency of the auction procedure as also the timeliness of data dissemination.
41. With the average daily trading volumes of about Rs. 13,000 crore and Rs. 22,000 crore
in outright and repo market respectively, the G-sec markets are on the growth path.
Primary dealers
42. With an objective to render the Government Securities market vibrant, liquid and broad
based, the Reserve Bank introduced the system of Primary Dealers (PDs) in 1995. In order
to broad base the Primary Dealership system, banks were permitted to undertake Primary
Dealership business departmentally in 2006-07. Further, the standalone PDs were permitted
to diversify into other business activities. With the induction of two new PDs in 2009, there
are currently 19 PDs comprising 11 banks undertaking PD business departmentally and eight
standalone PDs. As you are aware, in view of the underwriting and market making
responsibility of PDs, they have been given access to Current Account facility and Subsidiary
General Ledger (SGL) Account facility (for Government securities) with the Bank, permission
to borrow and lend in the money market including call money market and to trade in all
money market instruments, membership of electronic dealing, trading and settlement
systems (NDS platforms/INFINET/RTGS/CCIL), access to the Liquidity Adjustment Facility
(LAF) of RBI, access to liquidity support from RBI under a scheme separately notified for
standalone PDs and favoured access to open market operations by the Reserve Bank.
Performance of PDs in primary auctions of government securities
43. The share of PDs (ratio of bids accepted from PDs to the total notified amount) in
primary auctions of Central Government dated securities (Table 1) has been significant since
2006 when the Bank stopped participating in primary auctions, ensuring full subscription to
the Government securities.
Table 1: Performance of PDs in primary auctions of Government securities
(In Rs. crore)
Details 2006-07 2007-08 2008-09 2009-10*
Notified Amount 146,000 156,000 261,000 295,000
Bids Submitted by PDs 202,462 254,253 349,393 361,325
Bids accepted of PDs 64,727 72,122 111,094 117,023
Bid-to-cover ratio 1.39 1.63 1.34 1.22
Success Ratio 31.97% 28.37% 31.80% 32.39%
Share of PDs 44.33% 46.23% 42.56% 39.67%
* - till end-September 2009
Source: Trend & Progress 2009
BIS Review 1/2010
Recent initiatives
44. In view of the enhanced borrowings by the Government of India in 2008-09 and
2009-10 as part of the counter-cyclical policy in response to slowdown, structured meetings
with PDs and other major investors were taken up on a regular basis to obtain market
feedback and exchange views on relevant issues. The major initiatives taken during the
current fiscal are:
i. Consequent to the global financial crisis, the spread between corporate bond and
Government securities turned out more than 500 bps due to credit crunch in the
financial markets. To enable the PDs to raise Tier II and Tier III capital, ceiling on
interest rate spread at the time of issue of the subordinated instruments was
removed effective from April 1, 2009.
ii. Stand-alone PDs were allowed to categorize a portion of their Government Security
portfolio in the HTM category till March 31, 2010.
iii. In order to aid stand-alone PDs in managing their funding requirement, PDs are
allowed to borrow from call money market, on an average in a fortnight, up to
225 per cent up from 200 per cent.
iv. In the backdrop of global financial crisis and the need to have strongly capitalized
entities to ensure financial stability, the minimum NOF for stand-alone PDs
undertaking only G-sec business, was increased from Rs. 50 crore to Rs. 150 crore
and for the stand-alone PDs, which intend to undertake other permissible activities,
NOF is enhanced to Rs.250 crore from the existing level of Rs. 100 crore. The
enhanced level of NOF requirement shall be effective from April 1, 2010.
v. PDs are allowed to deal in Interest Rate Futures (IRFs) for both hedging and trading
on own account.
45. The RBI is impressing upon the PDs to expand their outreach to widen the investor
base for government securities and act as market makers for the smaller entities in
noninstitutional segment.
Corporate bond market
46. Corporate bond market segment has received intense attention in recent times as it
has been identified as one of the growth engines for further development of the Indian
economy with vast infrastructure needs. A well developed corporate bond market not only
enables the corporates to tap the markets for their financing needs and result in efficient
allocation of resources but also acts as a much desired supplement for the bank financing
thereby reducing the systemic stress. There has been a spurt in the secondary market
activity in the corporate bond markets. The secondary market volumes have gone up from
Rs. 5000 crore in 2007 to about Rs.30,000 crore in 2009. The bond issuance through private
placement in the first half of 2009-10 has shown an increase of 25 per cent over the
corresponding period previous year, with financial service sector accounting for 71 per cent
of the