GLOBAL CRISIS : TOWARDS A NEW MACRO-PRUDENTIAL FRAMEWORK IN INDIA

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GLOBAL CRISIS TOWARDS A NEW MACRO-PRUDENTIAL
FRAMEWORK IN INDIA

• IDEAS CONFERENCE
• MUTTUKADU, TAMIL NADU
• 25-27 JAN 2010

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• DILIP NACHANE
• DIRECTOR
• IGIDR
• MUMBAI , INDIA

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PLAN OF THE PAPER

• A. CHALLENGES POSED FOR EMEs BY GLOBAL CRISIS
• B. COPING WITH THE CHALLENGES
• C. LIKELY OFFICIAL ROADMAP FOR FINANCIAL SECTOR
  REFORMS IN INDIA TARAPORE, PERCY MISTRY CFSR
  REPORTS
• D. CFSR REPORT A MIXED RECIPE ?
• E. SUGGESTED ALTERNATIVE AGENDA FOR REFORMS

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CHALLENGES BROUGHT TO THE FORE BY CURRENT CRISIS

• 1. HIGH SOCIAL COSTS OF FINANCIAL FAILURES
• 2. SYTEMIC RISKS
• PRO-CYCLICALITY OF BANK CAPITAL REGULATION

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CHALLENGES BROUGHT TO THE FORE BY CURRENT CRISIS
(CONTD.)

• 4. HOW MUCH RELIANCE CAN WE PUT ON MARKET
  INCENTIVES FOR PRUDENT BEHAVIOUR ?
• 5. ANY ROLE FOR INTERNATIONAL BODIES LIKE THE
  IMF, FSB, G20 ETC. ?

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I. REDUCING COSTS OF FINANCIAL FAILURES - PROBLEMS

• 1.LARGE FISCAL COSTS AND MORAL HAZARD PROBLEMS
  POSED BY FINANCIAL BAIL-OUTS
• 2. ASYMMETRIC INFORMATION ABOUT
• THE INCIDENCE OF MACRO-ECONOMIC SHOCKS ON THE
  FINANCIAL SYSTEM
• 3. CONTAGION ACROSS COUNTRIES IN SECURITIES
  ASSET MARKETS
• 4. CONFLICTS BETWEEN MONETARY STABILITY
  FINANCIAL STABILITY OBJECTIVES OF CENTRAL BANKS

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I. REDUCING COST OF FINANCIAL FAILURES - MEASURES

• 1. IMPLEMENT A PROMPT CORRECTIVE ACTION CODE
  (INDIA ALREADY HAS ONE IN PLACE)
• 2. ORDERLY CLOSURE RULES FOR IMPORTANT FINANCIAL
  INSTITUTIONS
• (AS PREVALENT IN THE US FOR BANKS UNDER THE
  FDIC IMPROVEMENT ACT COMPETITIVE EQUALITY
  BANKING ACT)
• 3. RECOGNIZE THE PRINCIPLE THAT USE OF CREDIT
  RATINGS BY PRIVATE AGENCIES COULD BE TEMPORARILY
  SUSPENDED IN FAVOUR OF REGULATORS RATINGS.
• 4. ESTABLISH CLEARING HOUSES IN OTC DERIVATIVES
  MARKETS

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II. SYSTEMIC RISK DEFINITION

• No Single Definition Of Systemic Risk
• G-10 DEF (2001) The Risk That An Event Will
  Trigger A Loss Of Economic Value Or Confidence
  In, And Attendant Increases In Uncertainty About,
  A Substantial Portion Of The Financial System
  That Is Serious Enough To Quite Probably Have
  Adverse Effects On The Real Economy

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THREE BASIC CONCEPTS UNDERPINNING SYSTEMIC RISK

• 1. Interlinkages across institutions
• 2. Changes in the returns distributions of FIs
  assets during periods of stress especially
  additional risks in the tails of the
  distribution.
• 3. General market conditions relevant for the
  existence propagation of risks through the
  financial system.

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MEASURES TO CONTAIN SYSTEMIC RISK TRADITIONAL
(INDICATOR)APPROACH

• 1. Capital adequacy (i) total capital /total
  assets (ii) common equity/total assets (iii) Tier
  1 capital/risk-weighted assets (RWA) (iv) Tier 1
  Tier 2 capital/RWA
• 2. Asset Quality (i) non-performing
  loans/assets (ii) provisioning for loan
  losses/total loans
• 3. Leverage (i) Debt/Common equity (ii)
  short-term debt (lt 1 year maturity) /total debt

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MEASURES TO CONTAIN SYSTEMIC RISK TRADITIONAL
(INDICATOR)APPROACH

• 4. Liquidity (i) Loans/Deposits (ii)
  Loans/assets
• 5. Earning Profit () (i)Return on Assets
  (ROA) (ii) return on equity (ROE)
• 6. Stock Market Performance (i) P/E ratio (ii)
  earnings per share (iii) book value per share

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LIMITATIONS OF TRADITIONAL MEASURES

• 1. Backward looking rather than forward
  looking
• 2. Institution specific and ignore linkages among
  FIs
• 3. Often perform poorly in practice

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SUGGESTED NEW MEASURES OF FINANCIAL INDICATORS

• IMF Occ.Paper No. 212 (Sunderarajan et al. 2002)
• (i) Core Set
• (ii) Encouraged Set

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CONTAINING SYSTEMIC RISK

• 1. EARLY WARNING SYSTEM
• 2. HIGHER CAPITAL RATIOS ESPECIALLY FOR LARGE FIs
• 3. CORE LIQUIDITY RATIOS (CORE FUNDING/TOTAL
  LIABILITIES). CORE FUNDING TIME DEPOSITS OTHER
  SOURCES OF LONG-TERM FUNDING
• 4 CENTRAL COUNTER-PARTY FOR INTERBANK LENDING

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CONTAINING SYSTEMIC RISK- CONTD.

• 5. RISK-BASED DEPOSIT INSURANCE
• 6. REGULATORY CODE OF CONDUCT FOR CREDIT RATING
  AGENCIES
• 7. BASEL II NEEDS TO LAY GREATER STRESS ON
  MODELLING SYSTEMIC RISKS.
• 8. EXCESSIVE RELIANCE ON MARKET DISCIPLINE MAY
  PROVE COUNTER-PRODUCTIVE

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III. COUNTERING PRO-CYCLICALITY OF CAPITAL
REQUIREMENTS

• 1. RELATE CAPITAL REQUIREMENTS TO THE STATE OF
  THE MACRO-ECONOMY (A RANGE OR BAND TO BE
  SPECIFIED)
• 2. HIGHER CAPITAL REQUIREMENTS ON SYSTEMICALLY
  IMPORTANT FINANCIAL INSTITUTIONS

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IV. SUGGESTED MARKET INCENTIVES FOR PRUDENT
BEHAVIOUR

• 1. REPLACE PRACTICE OF PAYING BONUS TO TOP
  MANAGEMENT UP-FRONT BY A DEFERRED COMPENSATION
  PLAN
• 2. IMPROVING DISCLOSURE REQUIREMENTS FOR BANKS
  WITH RESPECT TO CAPITAL,COMPLEX STRUCTURED
  PRODUCTS, CREDIT ISK, MARKET RISK, OPERATIONAL
  RISK ETC. (BASEL II PILLAR III)
• 3. REQUIRING ORIGINATORS OF SECURITIZED PRODUCTS
  TO TAKE AN EQUITY SLICE IN THE IN PRODUCTS THAT
  THEY SELL/DISTRIBUTE
• 4. BETTER SEPARATION OF RATINGS AND CONSULTANCY
  ACTIVITIES OF CREDIT RATING AGENCIES

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IV. SUGGESTED MARKET INCENTIVES FOR PRUDENT
BEHAVIOUR (CONTD.)

• 5. CHICAGO FED PLAN (SEE KEEHN 1989). INCLUSION
  OF A MANDATORY SUBORDINATED DEBT COMPONENT IN
  BANK CAPITAL REQUIREMENTS TO STRENGTHEN MARKET
  DISCIPLINE (SEE ALSO CALOMIRIS POWELL (2000),
  EVANOFF WALL (2000) ETC.).
• IN INDIA THERE IS NO MANDATORY REQUIREMENT FOR
  SUBORDINATE DEBT, BUT THERE IS A CEILING ( lt 50
  OF TIER I CAPITAL). SUCH DEBT IS PART OF TIER II
  CAPITAL

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IS MARKET DISCIPLINE EFFECTIVE?

• MANY EMPIRICAL STUDIES INDICATE THAT MARKET
  DISCIPLINE FROM STOCK BOND HOLDERS NOT VERY
  EFFECTIVE (e.g. Borio et al (2004) Market
  Discipline Across Countries Industries ). INSTEAD
  EFFECTIVE DISCIPLINING COMES FROM COUNTERPARTIES
  (DEPOSITORS, CREDITORS REGULATORS)

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V. STRENGTHENING IMF ROLE IN ENSURING FINANCIAL
STABILITY

• 1. VIGOROUS ENFORCEMENT OF IMF GUIDELINES ON
  EXCHANGE RATE SURVEILLANCE (WITH SPECIAL
  REFERENCE TO GLOBAL IMBALANCES, PROTRACTED
  CURRENCY UNDER-VALUATION, CURRENCY MIS-MATCHES
  ETC.)

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STRENGTHENING IMF ROLE IN ENSURING FINANCIAL
STABILITY (CONTD.)

• 2. LENDER OF LAST RESORT FUNCTION. IMF SHOULD
  LEND FREELY DURING CRISES ON GOOD COLLATERAL AT A
  PENALTY RATE AND FOR SHORT PERIODS ( SAY LESS
  THAN 90 DAYS) WITH LIMITED ROLLOVER
  POSSIBILITIES.
• 25 OF THE COLLATERAL COULD BE IN THE FORM OF
  FOREIGN GOVT. SECURITIES AND THE PENAL RATE COULD
  BE 2 ABOVE THE VALUE-WEIGHTED YIELD ON THE
  BUNDLE OF SECURITIES OFFERED AS COLLATERAL (SEE
  CALOMIRIS (1999), GOLDSTEIN (2008), BRUNNERMEIER
  ET AL (2009) ETC.)

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PROPOSED IMF REFORMS MAR. 09

• GENERAL DIS-SATISFACTION AMONG LDCs AND EMEs
  ABOUT INADEQUATE REPRESENTATION OF THEIR POINT OF
  VIEW
• IMF GOVERNANCE REFORM COMMITTEE 24 MAR. 09
• (i) RADICAL CHANGES IN ACCESS, PRICING
  CONDITIONALITY FOR IMF BORROWERS (FCL- FLEXIBLE
  CREDIT LINES)
• (ii) BY RECOMMENDING THE LOWERING OF THRESHOLD ON
  CRITICAL DECISIONS FROM 85 TO 70-75, THE US
  VETO IS PROPOSED TO BE ANNULLED (AS THE US HAS
  17 VOTING POWER)
• (III) ON THE FUNDAMENTAL ISSUE OF RAISING
  QUOTAS/VOTES OF CERTAIN EMEs THE REPORT IS SILENT

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IMF REFORMS DO NOT GO FAR ENOUGH

• NEED TO LEND A GREATER VOICE AND MORE EFFECTIVE
  REPRESENTATION TO DEVELOPING AND TRANSITIONAL
  ECONOMIES (DOMINIQUE STRAUSS-KAHN WALL ST.
  JOURNAL SEPT . 07).

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TWO ALTERNATE SCHEMES

• 1. A PROPOSED TRIPLING OF BASIC VOTES (NUMBER OF
  VOTES EVERY COUNTRY HAS QUA MEMBER) WOULD
  INCREASE DEVELOPING COUNTRY VOTES FROM 32.3 TO
  34.4 (THE CORRESPONDING WORLD BANK FIGURE IS
  42.6 PROPOSED TO BE RAISED TO 43.8)
• 2. DOUBLE MAJORITY VOTING ON SELECTED ISSUES A
  MAJORITY OF WEIGHTED VOTES (AS CURRENTLY) A
  MAJORITY OF COUNTRIES. THE SYSTEM PREVAILS AT THE
  INTER-AMERICAN DEV. BANK, ADB, AFRICAN DEV. BANK
  FOR ELECTION OF A NEW PRESIDENT/HEAD (SEE
  BIRDSALL-2009)

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V. ROLE OF FSF INTERNATIONAL STANDARD-SETTING
BODIES

• 1. FSF SHOULD ALERT STANDARD SETTING BODIES
  ABOUT LOOPHOLES IN EXISTING REGULATORY
  STRUCTURES. THE BODIES LIKE BCBS, IOSCO ETC. CAN
  THEN DEVISE SPECIFIC OPERATIONAL GUIDELINES FOR
  INCORPORATION INTO NATIONAL REGULATORY AND
  SURVEILLANCE FRAMEWORKS.
• 2. FSF CAN ISSUE PUBLIC WARNING ON EMERGING
  SYSTEMIC RISKS WHEN THE SITUATION SO WARRANTS IT
  (BRUNNERMEIER ET AL 2009)

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G20 INSURANCE SOLUTION

• E. PRASAD (MAY 09)
• INSURANCE POOL FOR G20 MEMBERS
• ENTRY FEE BETWEEN 10BN TO 20
• PREMIUM TO DEPEND ON THE LEVEL OF INSURANCE
  DESIRED1 OF THE FACE VALUE OF POLICY
• COUNTRIES FOLLOWING POLICIES THAT ENHANCE GLOBAL
  RISK (SUCH AS LARGE BUDGET OR CURRENT A/C
  DEFICITS) WOULD FACE HIGHER PREMIA

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G20 INSURANCE SOLUTION CONTD.

• VERY SIMILAR TO THE CMI SCHEME DISCUSSED ABOVE.
• PARTICIPANTS OFFERED A SHORT-TERM CREDIT LINE IN
  THE EVENT OF A CRISIS.
• PREMIA TO BE INVESTED IN US, EURO AREA AND
  JAPANESE GOVT. BONDS. IN RETURN THE CENTRAL BANKS
  OF THESE COUNTRIES WOULD TOP UP THE LINES OF
  CREDIT IN THE EVENT OF A GLOBAL CRISIS
• THE SCHEME TO BE ADMINISTERED BY THE FSF RATHER
  THAN THE IMF REASONS FOR THIS NOT VERY CLEAR

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MAIN OBJECTIVES FOR REFORMS IN INDIA

• 1. REVIVAL SANS STAGFLATION
• 2. FIREWALLS AROUND THE FINANCIAL SECTOR
• 3. SAFETY NETS
• 4. LONG TERM CREDIT NEEDS OF MICRO-SECTOR
  INFORMAL SECTOR

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Likely Future Course of Financial Sector Reforms
India

• Four Committees
• 1. Tarapore I II
• 2. Percy Mistry
• 3. Raghuram Rajan

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CFSR MAIN RECOMMENDATIONS GREEN BOX

• 1. BROADENING ACCESS TO FINANCE( LIBERALIZING THE
  BANKING CORRESPONDENT REGULATION )
• 2. STRONGER BOARDS FOR LARGE PUBLIC SECTOR BANKS
• 3. BRING ALL REGULATION OF TRADING UNDER SEBI
• 4. ENCOURAGE INNOVATIVATION TO ADDRESS CONCERNS
  BEARING ON SYSTEMIC RISK, FRAUD, TRANSPARENCY,
  CONTRACT ENFORCEMENT ETC.
• 5. SUPERVISION OF ALL DEPOSIT-TAKING INSTITUTIONS
  TO BE BROUGHT UNDER RBI
• MINISTRY OF CORPORATE AFFAIRS SHOULD REVIEW
  ACCOUNTS OF UNLISTED COMPANIES , WHILE SEBI
  SHOULD REVIEW ACCOUNTS OF LISTED COMPANIES

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CFSR MAIN RECOMMENDATIONS GREEN BOX (CONTD.)

• 7. SPECIAL LEGISLATION FOR SUPERVISION OF
  FINANCIAL CONGLOMERATES
• 8. RISK-BASED DEPOSIT INSURANCE
• 9. SETTING UP OF A FINANCIAL OMBUDSMAN TO SERVE
  AS AN INTERFACE BETWEEN THE HOUSEHOLD AND
  FINANCIAL INDUSTRY.

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CFSR MAIN RECOMMENDATIONS BLUE BOX

• 1. PRIORITY SECTOR LOAN CERTIFICATES TO ALL BANKS
  LENDING TO ELIGIBLE ENTITIES IN THE PRIORITY
  SECTOR
• 2. ENCOURGAE SETTING UP OF MISSING MARKETS SUCH
  AS EXCHANGE TRADED INTEREST RTAE AND EXCHANGE
  RATE DERIVATIVES
• 3. REGULATORY ACTION TO BE SUBJECT TO APPEAL TO A
  FINANCIAL SECTOR APPELLATE TRIBUNAL.
• 4. ALLOWING A HOLDING COMPANY STRUCTURE WITH A
  PARENT HOLDING COMPANY OWNING REGULATED
  SUBSIDIARIES.

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CFSR MAIN RECOMMENDATIONS RED BOX

• 1. INFLATION TARGETING
• 2. OPENING UP OF RUPEE CORPRATE GOVT. BOND
  MARKET TO FOREIGN INVESTORS
• 3. REMOVE INTEREST RATE RESTRICTIONS ON PRIORITY
  SECTOR LENDING
• 4. FREE BANKS FROM OVERSIGHT BY CENTRAL VIGILANCE
  COMMISSION
• 5. TOATLLY SCRAP BANK BRANCH LICENSING POLICY
• 6. ALLOW TAKEOVERS BY AND MERGERS WITH FOREIGN
  BANKS
• 7. SWITCH-OVER TO A PRINCIPLES BASED (AS OPPSED
  TO THE CURRENT RULES-BASED) REGULATORY SYSTEM.

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AN AGENDA FOR REFORMS

• 1. CREDIT DELIVERY TO MSMEs
• 2. SPECIAL TREATMENT OF MSMEs (LOWER RISK WEIGHTS
  ON BANK LOANS TO THIS SECTOR)
• 3. RISK-BASED DEPOSIT INSURANCE SYSTEM
• 4. RAISING DEPOSIT INSURANCE LIMIT TO RS. 4 LAKHS
  FROM THE CURRENT RS. 1 LAKH
• 5. CODE OF CONDUCT FOR CREDIT RATING AGENCIES
• 6. STRICT MONITORING OF OBSAS AND SPVs

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AN AGENDA FOR REFORMS (CONTD.)

• 7. ADMISSION OF POSSIBILITY OF CAPITAL CONTROLS
  AT LEAST OVER LIMITED PERIODS. TW-SB APPROACH MAY
  BE CONSIDERED SERIOUSLY
• 8. IMPORTANCE OF CENTRAL BANK INDEPENDENCE
  CREDIBILITY
• 9. REGULATORY SUPERVISORY INDEPENDENCE

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• THANK YOU