Shyamala Gopinath: Philosophy and practice of financial sector
regulation - space for unorthodoxy
Speech by Ms Shyamala Gopinath, Deputy Governor of the Reserve Bank of India, at the
FSA Turner Review Conference, London, 2 November 2009.
* * *
It is a privilege to be invited to share my thoughts at this conference. The contribution of FSA
in setting the terms of the debate in the aftermath of the crisis has been very significant and
crucial. The clarity, conviction and clinical sharpness of arguments one encounters while
reading the Turner review ask of us a very fundamental question - how could the world not
have expected this crisis? How could the policy regimes world over, barring a few
exceptions, failed to even recognize what now seems to be obvious? Perhaps it had to do
with the force and might of the reigning doctrinaire regarding financial markets.
Post crisis, there was a natural effort to understand and assess the nature of various
inexactitudes which had earlier been missed and incorporate these into the policy
frameworks. Phrases such as systemic risk oversight and macro-prudential regulation have
become the new touchstones for a repaired regulatory framework. There is a renewed effort
to redefine the regulatory philosophy and principles around a different mould. The danger is
in this organic mould continuing to derive its legitimacy from the pre-crisis framework.
Hopefully, a crisis of such magnitude would not fail to provide the necessary impetus and
support for departure of a more fundamental nature. I realize the huge challenge for this,
given the sheer weight of the academic work of nearly four decades in the field of finance
and the entrenched orthodoxy around it. To bring out any paradigm shift would require an
equally weighty intellectual case for an alternative model. Yes, this crisis could provide a
trigger for that process but as history shows us, paradigm shifts of such magnitude do not
follow a set path.
It would however be imprudent to ignore the basic lesson of the crisis, which is that the
existing framework has severe pitfalls. As with any stable ecosystem, what is needed is a
space for heterogeneity - the space for unorthodoxy. As identified by the UN President's
Commission1, "strengthening the diversity of ideas" would be a key principle in addressing
the issues underlying the crisis.
India has had the fortune of having a relatively stable financial system through the past few
major crises affecting the world - the Asian crisis, the dotcom bubble and the recent financial
crisis. I intend to divide my remarks today in two parts - I would like to start off with a
discussion on the evolution of the financial sector regulation in India, particularly focusing on
the elements of the policy framework which have contributed to the broader stability in the
financial sector. In the second part, I would like to share my perspectives on some of the key
issues in the current debate on future of financial sector regulation mainly dealt in detail in
the Turner Review.
Indian financial system: the basic structure
Historically, the Indian financial system has been a bank dominated one and the gradual
process of disintermediation through "public markets" has been of relatively recent origin.
Banking institutions account for nearly 70 percent of the total assets of all financial
institutions. The banking sector, as a whole, however has not grown disproportionately as a
percentage of GDP and the challenge for us is to increase penetration of the banking system
and ensure access of financial services to the large numbers excluded from the system.
The non-banking finance space comprises of heterogeneous entities separated across
functional regulatory frameworks. Broadly speaking, the RBI regulates companies taking
public deposits and non-deposit taking entities undertaking financial services involving asset
financing, loan and investment companies. 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
regulators. There is also a separate framework for financial markets with equity markets
completely under the securities regulator but the forex, interest rate and credit markets and
the related derivatives being regulated by the central bank, i.e. RBI, which is also the banking
regulator.
Evolution of regulatory framework
The philosophy and practice of financial sector regulation in India has largely evolved in
response to the sui generis nature of contexts and imperatives over the years, which is also
reflected in the division of regulatory responsibilities over different markets. The bank-based
financial system, as a concept had come in for sharp criticism in the wake of the Asian crisis,
and an "arm's-length, market-based, Anglo-Saxon system"2 was propounded as a better
model from a stability, accountability and governance perspective. The recent crisis has
again brought the centrality of banks in a financial system into focus and underlined their role
as ultimate risk repositories and ultimate liquidity providers, whatever be the form of the
financial market model.
The gradual process to introducing structural reforms in the banking sector was a unique
experiment undertaken with the key objective of strengthening the banking sector balance
sheets and governance frameworks in a non-disruptive manner while managing the given
political-economy considerations. The reforms were carefully sequenced in terms of
instruments and objectives. Thus, prudential norms and supervisory strengthening were
introduced early in the reform cycle, followed by interest rate deregulation and gradually
lowering of statutory preemptions. The more complex aspects of legal and accounting
measures were ushered in subsequently when the basic tenets of the reforms were already
in place. More recently, the regulatory framework has also focused on ensuring good
governance through "fit and proper" owners, directors and senior managers of the banks.
Broadly speaking, the evolution of regulatory framework for financial sector entities has been
intrinsically derived from the objective of financial stability which has always been an
objective for the RBI.
A unique feature of the reform of public sector banks, which dominated the Indian banking
sector, was the process of financial restructuring. Banks were recapitalized by the
government to meet prudential norms through recapitalization bonds (no cash payment was
made). The mechanism of hiving off bad loans to a separate government asset management
company was not considered appropriate in view of the moral hazard. The overhang of
nonperforming loans had to be managed by the banks themselves. The subsequent divestment
of equity and offer to private shareholders was undertaken through a public offer and not by
sale to strategic investors. Consequently, all the public sector banks, which issued shares to
private shareholders, have been listed on the exchanges and are subject to the same
disclosure and market discipline standards as other listed entities. The cost of
recapitalization to GDP has been low relative to experience in other countries. On a
cumulative basis it worked out to about one percent of the GDP and the value of the equity
held by Government is much above the amount recapitalized. All these recapitalization
bonds have since been converted to marketable securities.
The financial system has since expanded significantly across various segments and a
number of cross-sector organisational forms combining banks, insurance companies and
investment firms have emerged. In respect of certain identified conglomerates based on well
defined criteria, there is an inter-regulatory mechanism for focused monitoring and
supervision. However, in most cases, the non-banking functions are carried out in the form of
bank-subsidiaries. While from a market perspective, such a model may tend to constrain
growth, this model offers an interesting perspective in the "too-big-to-fail" debate. I will be
touching on this aspect later but internally within India there is support from certain quarters
for a "holding company" structure.
The other aspect of the "too-big-to-fail" debate, as succinctly dealt in the second FSA
discussion paper on Turner Review relates to the core-banking versus trading activities of
banks. We have a kind of hybrid model with banks being allowed to undertake proprietary
trading as also sell insurance products. Insurance, all forms of asset management, merchant
banking and broking have to be undertaken through separate subsidiaries. Issues with
banks' involvement with private pools of capital are being sought to be addressed through
appropriate capital requirements for such exposures and the reputation risk.
As the financial system exists today, there are no major segments operating in an
unregulated manner. The focus of regulation, though, is primarily on deposit taking
institutions and systemically important non-deposit taking institutions. The model for
regulation combines both direct entity regulation as well as overarching market regulation,
where applicable. What such a framework enables is to provide a mechanism for containing
market-based leverage, apart from a prudential oversight. 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.
The problem, I realize, 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 with the unregulated entities
can acquire systemic proportions. That is why it would be important to ensure that the
markets too should not provide leverage capabilities to such entities beyond a limit.
Regulation of Non-Banking Finance Companies in India has gradually evolved from a focus
on acceptance of deposits to acceptance of public funds in any form. With the growth of the
financial system, it gradually came to be realized that even non-deposit 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. Banks exposure to these
entities are subject to exposure norms and are separately monitored.
As regards the markets, there are two features that need to be noted: first, unlike many
jurisdictions, there is a statutory responsibility on the central bank, the RBI, to explicitly
regulate the forex, rate and credit markets and related derivatives; and second, since the
dominant players in these markets are banks, there is also the added layer of entity
regulation. The key aspects implicit in the regulation of organized financial trading in these
markets relate to the product specifications, nature of participants, prudential safeguards,
reporting requirements etc. OTC trades in such markets are legal only if one party to the
counterparty is a RBI regulated entity. The operational aspects of trading and post-trade
clearing and settlement in case of exchange traded instruments are regulated by the
securities regulator i.e. the Securities and Exchange Board of India. The regulatory
framework takes into account the macroeconomic situation as well as the huge costs of
economic booms and busts brought on by financial instability - a cautious approach that has
till now served us well. That we could consider putting in place a more conservative
framework for securitization markets - incorporating those very elements which are now
being included as part of Basel II framework - was possible only on account of the cautious
approach.
Lot of emphasis has been placed on the development of market infrastructure. As early as in
2001, the Clearing Corporation of India was set up to settle interbank spot forex transactions
and all outright and repo transactions in government securities whether negotiated or order
driven systems. CCIl has also introduced a collateralised money market instrument called
CBLO which is also settled through the CCP. CCIL has also commenced non-guaranteed
settlement of OTC trades in interest rate swaps in 2008. Once the risk management norms
are determined they will be commencing guaranteed settlement of these trades. In the near
future it will also act as central counterparty for forward contracts which will mitigate risks
releasing counterparty exposure limits. The margins are in the form of cash and government
bonds ensuring the quality and liquidity of the settlement guarantee fund.
One of the early lessons from our past experience that we incorporated in the policy
framework was to be very careful about the vulnerabilities originating in the external sector.
Perhaps not entirely in conformity with the then established policy axioms, we have
dovetailed the capital account management framework with the prudential framework. Now,
of course, when financial stability has come to be recognized as an overarching objective,
the merits of such a harmonized approach are being appreciated. As part of a differential
approach, the policy in respect of financial intermediaries, including banks, is distinct from
that for individuals or corporates.
Prudential framework for banks - unorthodox measures
In respect of the prudential framework for banks, while there was a commitment to move
towards the international prudential standards for banks, in many areas a more contextual
approach was adopted keeping in view the idiosyncratic and systemic concerns.
•
Counter cyclical measures were first taken on board in 2005 when risk weights and
provisioning on certain segments were increased on account of rapid credit growth
in these segments leading to concerns about potential impact of asset price bubbles
and impact on credit quality. However, the important difference was that Indian
approach entailed sector-specific prescriptions. To illustrate, the housing loans and
commercial real estate are the sectors which experienced high credit growth during
the high credit phase of 2002-03 to 2006-07. Accordingly, the risk weights on real
estate lending and mortgage backed securities over the years were increased. The
objective was not so much to lean against the wind of rising asset prices but as a
cautionary measure to contain the exposure of the banking sector to sensitive asset
classes where rapid credit expansion was observed.
•
Banks are required to hold a minimum of 25 percent of their liabilities in the form of
liquid domestic sovereign securities. This stipulation has worked both as a solvency
as well as a liquidity buffer.
•
The credit conversion factors (CCF) used for calculating the potential future credit
exposure for off-balance sheet interest rate as well as exchange rate contracts were
doubled across all maturities in 2008. This was done since it was felt that the CCFs
as per the Basel norms did not fully capture the volatility in the interest rate and
forex markets in the Indian context.
•
Banks were encouraged to build floating provisions as a buffer for the possible
stress on asset quality later. With the same objective, all banks have been advised
recently to achieve a certain minimum provision cover. Very recently, provisions
against commercial real estate standard loans have been increased from 0.4
percent to one percent.
•
In regard to wholesale funding markets, prudential limits were placed on aggregate
inter-bank liabilities for banks as a proportion of their net worth. The overnight
uncollateralised funding market was gradually restricted only to banks and primary
dealers and there are ceilings for both lending as well as borrowing by entities in
these markets in order to reduce the systemic risk arising from interconnectedness.
Other entities can participate in the overnight market but only on a collateralized
basis. Repo markets are subject to a regulatory framework.
• To reduce systemic risk, investments by banks in subordinated debt of other banks
is assigned 100% risk weight for capital adequacy purpose. Also, the bank's
aggregate investment in Tier II bonds issued by other banks and financial
institutions is limited to 10 percent of the investing bank's total capital.
•
Securitisation guidelines issued in 2006 provided for a conservative treatment of
securitisation exposures for capital adequacy purposes, especially in regard to the
credit enhancement and liquidity facilities. A unique feature of these guidelines is
that any profits on sale of assets to the SPV are not allowed to be recognised
immediately on sale but over the life of the pass through certificates issued by the
SPV. The policy enabled a liquidity facility by the originator or a third party, to help
smoothen the timing differences faced by the SPV and was subject to certain
conditions to ensure that the liquidity support was only temporary and got invoked to
meet cash flow mismatches. Any commitment to provide such liquidity facility, is to
be treated as an off-balance sheet item and attracts 100% credit conversion factor
as well as 100% risk weight. The facility was specifically prohibited for the purposes
of a) providing credit enhancement; b) covering losses of the SPV; c) serving as a
permanent revolving funding; and d) covering any losses incurred in the underlying
pool of exposures prior to a draw down.
•
There are limits on the proportion of wholesale foreign currency liabilities
intermediated through the banking system, other than for lending for exports. Retail
foreign currency deposits from non-residents are subject to minimum maturity
requirements and interest rate caps.
•
The incremental credit-deposit ratio of banks is monitored as part of the
macroprudential framework since this ratio indicates the extent to which banks are funding
credit with borrowings from wholesale markets.
Some thoughts on the key issues in the current debate
India as a key constituent of the international fora designing the blueprint for the reshaped
financial system such as G20, FSB, BCBS has been committedly engaged in the
discussions. The exercises in multilateral conformism have, understandably, tended to round
off some of the sharper reactions witnessed in the immediate aftermath of the crisis. It would,
however, be myopic to ignore so early some of the fundamental issues raised by the crisis.
While the repair of the banking system, through a strengthened prudential framework, has
seen progress, the much needed reform of the financial markets must be the next focus area
for global oversight bodies, particularly the G20 and the FSB.
The financial industry has an excellent way with assuming a self-regulatory role whenever a
crisis happens and coming out with a corrective framework. The experience shows that such
self-framed codes of conduct have not really worked. More than the intent part, I would like to
believe that an inside view, in the realm of financial policy which necessarily has to deal with
systemic issues, will always be an incomplete perspective.
The most fundamental issue pertains to the role of the financial sector relative to the real
sector. Before the crisis a view was gaining ground that while the need for "banking" will
increase, there will be a seamless transition to a bank-less, market based financial system.
Issues of competitive neutrality gained importance and the view that banks are "special" and
therefore need to be effectively regulated perhaps assumed less attention. Now, with the
kind of bank bailouts that the Governments have had to undertake, largely in view of the
deep entrenchment of banks in the major markets, it is very clear that the amorphous
existence of even the most deep and liquid financial markets also needed the sound
institutional pillars of a banking system as the funding provider of the first and last resort.
There is an unequivocal consensus on some kind of control on the operations of banks,
particularly the large financial institutions having cross border presence. Any discussion on
systemically important financial institutions needs to put the institutions in the perspective of
the surrounding market dynamics. The FSA discussion paper has given a comprehensive
overview of all the major aspects concerning the issue viz. interpretation of failure, definition
of systemic importance and alternative policy approaches. There is really little one can add
but I would briefly like to comment on each of these.
Interpretation of failure
The paper makes an explicit distinction between failures where only common equity holders
face losses and others where even creditors, providers of debt capital, are forced to share
part of the losses. It would thus seem that the moral hazard issue is more relevant for
creditors, since equity holders in all cases will have to face the losses. This point regarding
the influence of creditors i.e. debt providers/debt holders of different classes of debt
securities issued by banks comes out more starkly in banking systems in pre-dominantly
market based economies.
On this issue we need to take into account a few other dimensions arising from the ex-ante
treatment of uninsured creditors. One is whether this will induce unintended distortions in
market practices. The other is a more fundamental issue. One of the less appreciated fallouts
of the market-based financial system, which is that over the years there has been an
increasing tendency in encumbrance of parts of banking assets either for issuance of various
classes of debt/hybrid securities or to raise short term funds through money markets.
Protection accorded to secured creditors as against unsecured creditors and depositors in
case of banks, in a sense, goes against the basic model of banking which presupposes
deposit mobilization by banks thereby requiring strict regulation. The classic dilemma, the
likes of which the public policy needs to reflect upon is the case of covered bonds which has
now gained centre place in few of its success in some countries. From the perspective of the
bank and investors, this is an excellent instrument with sound collateral backing. It has been
in operation for over a century and has facilitated fundraising by banks at lower rates and
avoids pitfalls of securitization. However, by carving out a part of good assets of the bank
backing the bonds, these create a risk to the deposit insurance system since these investors
have priority over other creditors.
The above problem is further exacerbated by the exemption accorded to certain category of
financial instruments from bankruptcy, an issue which has been widely commented upon in
the post-Lehman phase. In all major well-developed securities markets, derivative securities
and repurchase agreements (repos) enjoy special protections under insolvency resolution
laws. Such transactions also enjoy netting and close-out benefits which are not always
available to most other creditors. With these counterparties having first claim on available
liquidity other creditors may have an incentive to push for bankruptcy impeding the use of
other options for an orderly resolution. Though the primary argument for this was to contain
systemic risk, in practice this dispensation has resulted in increasing systemic risk given the
incentive structure for pushing the funding markets to more and shorter term. There is need
to reflect on how to involve these creditors in burden sharing in the event of failure of an
institution.
Defining systemic importance
Identification of systemically important banks is a very difficult and complex issue. As brought
out in the FSA discussion paper the key variables to be taken into account are size and
interconnectedness. Size, by itself, may not be very useful but it becomes important in
respect of large conglomerates having presence across major segments as also for entities
having dominance in the funding markets. Thus, size and interconnectedness need to be
looked together as a matrix quadrant.
Both qualitative and quantitative criteria will be relevant; whether the bank is largely a
domestic focused bank or multinational, complex or a constellation of subsidiaries and
interconnectedness with the system. A large bank will also be dominant in financial markets
and payment systems. On interconnectedness, an institution is clearly systemic if it is a
dominant player in the inter-bank market or other funding and derivatives markets. The
benchmark will no doubt be the guidelines that will emerge from the IMF/FSB paper. But
emerging market countries would largely have to take into account the structure of their
domestic financial system and its unique features. The definition of systemic importance has
to be calibrated in a manner that it provides the right incentives for institutions which are
large but not very interconnected or complex.
Policy responses
Broadly two kinds of policy responses are being debated: (i) reducing the probability and
impact of failure of a systemically important institution and (ii) making the financial system
better able to deal with such a failure. The single most important element in respect of both
the above approaches would be containment of interconnectedness in the financial system.
The specific measures being discussed are: higher capital and liquidity requirements for
systemically important firms; preparation of "self wills" by each of the systemically important
firms and moving all OTC derivative markets onto a CCP model.
Although identifying an institution as systemic does present a moral hazard, in any event this
element is present even today. Higher capital and liquidity requirement will be eminently
sensible to make such larger firms internalize the costs of their externalities. The use of
contingent capital can be explored once the details of this proposal are formulated. Apart
from the quantitative parameters, the institution's business model and its legal structure
should also dictate the quantum of higher capital requirement. Less complex and less
interconnected firms may have to be provided a different leeway.
The "winding down plan" seems useful since it will force the Board to understand group
structures and raises the credibility of the threat. It is however premised on two basic
assumptions: one, the entity has been transparent enough in terms of the information content
in drawing up its own demise plan - the adverse selection issue and two, the regulatory
authorities would actually be able to enforce these plans in times of crisis. In unexpected
scenarios, as our experience has shown, the regulatory actions would largely be a function of
contextual assessments and any readymade plans may be dysfunctional. It would however
be interesting to see how this plan is actually operationalised.
OTC markets: There is committed effort globally to move all OTC derivative transactions onto
exchanges/electronic trading platforms which is a welcome move.. This is a more
broadbrush approach but going forward, I am sure we will need to devise a more nuanced
approach in this regard as there will be continued need for OTC products i.e. customized to
the needs of the real sector. Furthermore, in regard to central counterparties, it is imperative
to examine the incentive structures. To generate more income there is need for more
volumes and that can come only from leverage. There is, therefore, need to closely regulate
the risk management systems and mandate margin requirements in the form of high quality
liquid assets. Given the nature of their functions and their systemic importance, it is
worthwhile to consider central counterparties as "public utility" not-for profit entities. It would
also become imperative for such systemic entities to be brought under systemic oversight
and be regulated by the systemic regulator.
More than the above immediate measures, what is required is a debate on some of the
fundamental issues. Now that the centrality of banks in the economic system has been
established, a much stricter view needs to be taken regarding the activities that banks can
undertake with depositors' money. Should large systemically critical banks be allowed to
heavily leverage themselves with depositors' money? Should the banks facilitate the
highrisk high-return leverage game to benefit private investors at the cost of depositor funds? In
that sense, I appreciate the arguments for separation of traditional lending business of banks
from investment business. However, the extreme view is not very practical. The "hybrid
approach" indicated in the FSA paper seems to be the way out but I would suggest some
form of quantitative limit - banks must have a substantial part of their assets in the form of
traditional banking assets in order that they perform the role of supporting the real economy.
The exponential growth in the money and funding markets outside the formal banking
system, primarily at the shorter end, was one of the critical drivers underlying the crisis. The
crisis has demonstrated the vulnerabilities of firms whose business models depended heavily
on uninterrupted access to secured financing markets. The entire market structure based on
ample liquidity available against any kind of collateral -mainly illiquid and hard to value, with
pro-cyclical haircut and margining regime hid severe underlying systemic risks The interplay
of under-pricing and not recognizing both credit and liquidity risks through these
collateralized markets, was an explosive amalgam exploited by many unregulated entities in
the financial system, such as SIVs.
Going forward, there could be a multi-pronged, focused effort in the direction of: (i) removing
the arbitrage incentives for creation of complex structures in the first place - tax, capital
requirements, regulation etc. - to create simpler structures which are transparent and easy to
regulate (ii) developing a prudential framework for funding markets, in terms of permissible
leverage by any participating entity and nature of collaterals; (iii) explicit commitment to
increase competitiveness in the financial sector to remove the perverse situation of few large
institutions influencing the market and (iv) massively scaling up the supervisory monitoring
framework for such entities.
There have been suggestions to have common cross border resolution mechanism or global
fiscal burden sharing. However, these do not appear to be feasible and the most practical
approach would be to incentivise organization of a group as a "constellation of separately
subsidiarised national banks" in the case of systemic entities rather than as a globally
integrated bank. There is inherent tension between the efficiency gains for individual
institutions provided by centralized pooling of capital/liquidity and the objectives of host
regulators/supervisors. Supervisors are accountable to the domestic depositors, creditors
and policy holders and protecting the domestic financial system and therefore there may be
justifiable reasons for requiring both capital and liquidity to be held locally, whether the
presence is by way of a branch or subsidiary. In this regard, some of the short term efficiency
gains may have to be compromised in the interest of broader financial system stability
through containment of the contagion effects.
Conclusion
Much of the current debate on many issues centres on the epicenter of the crisis, the
developed economies with relatively advanced financial systems. The emerging markets,
though, can bring a different perspective from their own past experience. Many of the
emerging countries, including India, are part of the global effort in search of a harmonized
framework but certain key differences in perspectives in these two sets of economies need to
be appreciated. The status of the financial sector of the emerging economies is different from
that of the a