Basle III provides the key macro prudential tools in relation to capital, both quantity and quality, liquidity and leverage of the banks as safeguards against several vulnerabilities noticed during the crisis due to excessive credit growth and leverage fuelled by poor credit appraisal standards and underpricing of credit and liquidity risks insufficient high quality capital and interconnectedness. India has laid down the road map for full implementation by March 2019, in line with the global road map.
Given the perception of potential data inadequacies in banks, RBI has been more conservative than the global standards; e.g. prescription of 1% higher minimum Tier 1 capital and suggestion of 1.5% higher Leverage Ratio. It has rightly not yet gone ahead with Net Stable Funding Ratio (NSFR) implementation as major jurisdictions are yet to do so though final guidelines in this regard have been published .In respect of High Quality Liquid Assets (HQLA) the treatment of State Government papers has been a contentious issue before the BCBS.
Globally issues relating to enhancing the robustness of Standardized Approaches, efficacy of the internal models, and carve outs for smaller banks , calibration of liquidity ratios and capital floors are still being debated. India has to play major role in such discussions, given the structure of our banking system, limited complexity of some of our banks and the fact that that vulnerability of our banks have gone up manifold in the recent times.
Domestically there is a debate that if macro prudential tools were more suited than imposition of micro prudential measure of Prompt Corrective Action
(PCA) on more than half of the Public Sector Banks (PSBs). Since Financial Resolution and Deposit Insurance Bill, because of various reasons, have been withdrawn a framework for orderly resolution of financial sector entities within the remit of the concerned regulator and risk based insurance premium collection from the banks for protection of depositors along with enhancement of the insured amounts have to be attempted now.
Lesson #3 Macro prudential tools alone are however not sufficient to safeguard the financial system
from crisis that could potentially arise from bank failures due to poor underwritings, perverse incentive structure, irresponsible financial innovations and nominal risk culture besides, of course, deterioration of macroeconomic fundamentals like inflation, growth, fiscal consolidation and CAD. This underscores need for high standards of corporate governance, risk management and supervisory capability. This has become more relevant for Indian banks, more so for the PSBs.
Post GFC Indian banking system got bouquets for coming out unscathed, partly due to preemptive macro prudential measures taken by RBI much before the crisis. It was, in hindsight, proved to be too early a celebration as issues like ownership and governance ,exuberant and excessive lending, particularly to projects with uncertain viability, delayed recognition of problem assets, underdeveloped in-house capability for underwriting, business development, risk management, and adapting to technological changes remained unaddressed and consequently now we are in the midst of a mini banking crisis. Important steps, though bit belated and, as some would argue, bit heavy handed, have been taken to address some of these issues – RBI’s Asset Quality Review, the revised framework for problem assets issued in February this year and the promulgation of the Bankruptcy Code are some of them. But more needs to be done, especially on governance reforms if the Indian banking sector is to turn around quickly.
Lesson#4 For financial stability managing capital flows is critical from EMEs’ perspective.
GFC proved that in the era of globalisation the EMEs and the advanced countries are closely coupled through the channels of cross border commerce, commodity prices, confidence, action and advisories of the central banks of major countries and, most important, capital flows. Volatile capital flows have huge implications for financial stability through their impact on asset price, balance sheets of corporates and banks, and the macro economy.
Hence having a framework of active capital account management, more so for EMEs with structural weaknesses in the areas of fiscal consolidation, financial markets, asset quality of banks and price stability, has come to stay in line with long standing policy of India. Alongside though simiplification, liberalisation and rationalization of policies in the areas of FDI, portfolio flows and debt have also been undertaken in India. As the economy
matures and we become more integrated with rest of the world our policies and procedures have to become more time consistent and transparent.
Lesson #5 Robust regulation of the Over The Counter (OTC) derivatives (OTCD) is very important. This is borne out of the fact that GFC was triggered by complex nature of the derivatives trade which was marked by market abuses and counterparty failures.G-20 therefore had focused on trading of all standardized on exchanges or electronic platforms, clearing through central counter party (CCP), reporting on Trade Repositories (TRs) for greater transparency and disincentives for non- centrally cleared derivatives (NCCDs) through higher capital and margin requirements. India has been on the compliance path in this area and, in fact, a fore runner in some aspects of reforms in the OTCD markets; however, partly because other major jurisdictions have not yet moved in this direction, certain measures are still work in progress: implementation of higher capital and margin requirements and regulatory framework for authorization of electronic trading platforms.
Lesson#6 Vibrant corporate debt market as a back stop to the banks is essential for risk diversification.
Although India has been a bank dominated financial system, post Asian Crisis and the GFC, the need for deep and broad local currency debt market for systemic risk diversification, funding of the corporates through market based means rather than through relationship based bank borrowing, resource flow to infrastructure sector and meeting the long term investment needs of insurance companies and pension funds has been an imperative. Indian efforts have in the last few years shown good results: primary market has grown at more than 13% in the last five years, outstanding corporate debt now accounts for about 17% of the GDP, bond to bank loan ratio is rising , daily trading volumes in 2017-18 have gone up to about Rs.7500 in 2017-18 from Rs.6100 crore in the year before and Insolvency and Bankruptcy Code has become a reality.
Ongoing initiatives of Government/SEBI/RBI like launch of tri party repo, order mtching trading platforms, regulatory nudge for certain minimum bond issuances by large corporates, market making, lowering of regulatory investment grade to A from AA and enhancing the credibility of the Credit Rating Agencies and early action on launch of products like zero coupon/ on tap /covered bonds, setting up of bond guarantee funds, streamlining of stamp duties across states, providing legal basis for netting of Credit Default Swaps and enabling provision for acceptance of corporate bonds in the repo window of RBI will further boost the market.
Lesson #7 Financial stability and financial inclusion should coexist but could work at cross purposes if regulatory safeguards do not exist. Financial inclusion by providing diversified client base, facilitating formaliastion of the economy, contributing to the resilience and prosperity of the low income population and small business and entrepreneurs and thereby reducing income inequality leading to social and political stability enhance financial stability. On the other hand , such efforts, when they result in overextension of credit to subprime borrowers ( as happened in the US prior to the GFC ) with implications for portfolio quality, reputation risks to the financial institutions arising out of agent banking / outsourcing ,and compliance with KYC/AML requirements, can be sources of financial instability.
Hence, safeguards in the form of credit bureaus, financial literacy and protection of consumer rights of the first time users of formal financial services, oversight over the doorstep banking agents (e.g. Business Correspondents in India) and regulatory framework for all types of microfinance institutions become critical. In India often populist measures like loan waivers resulting in poor credit culture and target oriented Government credit programmes have the potential to discredit the inclusion efforts and disrupt the system stability.
The above is not an exhaustive list. For example, there are many other areas where post GFC issues need to be carefully analysed from global and national perspectives : role of excessive financialisation, interplay of political economy with the financial system, availability of safety nets nationally in the form of buffers/reserves of the central bank and internationally through enhanced resource base of the IMF/ multilateral pooled arrangements/swap lines from the central banks of major countries, financial stability implications of inflation targeting framework, mechanics of sovereign debt management, coordination and cooperation framework within and across national jurisdictions for crisis prevention, and disruptive challenges from Fintech revolution, crypto currencies and cyber security. “Last words”, as Karl Marx had said, “are for fools who haven’t said enough!”
The author is former Deputy Governor, Reserve Bank of India. Views expressed are his own
Disclaimer: Views expressed are personal. They do not reflect the view/s of Business Standard.