Systemic Risk and Macroprudential Policies – Emerging Paradigm

1. Systemic Risk and Macroprudential Policies – Emerging Paradigm Anand Sinha Executive Director Reserve Bank of India Presentation made at BANCON 4 December 2010, Mumbai

2. STRUCTURE OF PRESENTATION A. What is Systemic Risk? B. How does Systemic Risk Build up? C. Enhancing Regulatory Framework to Address Systemic Risk D. Review of Indian Experience inAddressing Systemic Risk E. Institutional Framework of Systemic Regulation F. Open Issues & Challenges

3. A. WHAT IS SYSTEMIC RISK ? • Systemic risk is defined in various ways. • A representative definition following the work of the IMF, FSB and BIS for the G20 is “a risk of disruption of financial services that is caused by an impairment of all or parts of the financial system and has the potential to have serious negative consequences for the real economy”. • Some features of the current “Great Financial Crisis” • Estimated 210 million people unemployed, an increase of 30 million since 2007 • Cumulative output loss relative to trend in G20 countries facing systemic crisis is 26 percent of GDP • Debt to GDP ratio of advanced G20 countries is set to go up from 75 percent in 2007 to 110 percent by 2014. Source : Towards a Safer Global Financial System – Speech by Jose Vinals, IMF – November 2010

4. Systemic risk has two dimensions : - Cross-sectional dimension - Time dimension Cross sectional dimension pertains to how risk is allocated within the financial system at a point in time. - In this dimension the source is common expsoure and interlinkages in the financial system leading to domino effect (contagion) or vulnerability to joint failure due to vulnerability to common sources of risk. Time dimension deals with how aggregate risk in the financial system evolves over time. - Source is the pro-cyclicality of financial system. The dynamics of the financial system and macroeconomy intereact with each other increasing the amplitude of booms and busts.

5. B. HOW DOES SYSTEMIC RISK BUILD UP • Systemic risk builds up through • Contagion (inter-connectedness) and common exposures • Procyclical nature of financial system and prudential regulations –Leverage and Maturity Mismatches • Regulatory arbitrage due to limited perimeter of regulation • Complex Products • Institutions • Markets • financial innovation – opaque and poorly understood products • OTC Derivatives –Inadequate infrastructure

6. Procyclical nature of financial system amplifies the business cycles which are further amplified with the inter play of prudential regulations relating to – • Capital • Provisioning • Fair value & VaR • Pro-cyclicality is also aided by rules relating to margins/haircuts and triggers and compensation policies.

7. Procyclical Nature of Financial System • Financial factors can be a powerful amplifier of the business cycle – Financial Accelerator (FA) at work • FA Mechanism is procyclical. • Asset Prices( ) Collateral ( ) Availability of credit ( ) Consumption & Investment ( ) • Reverse Process in a downturn • Financial firms themselves act procyclically.

8. Nature of Systemic Risk: Asset Prices-Balance Sheet-Leverage Effect

9. Procyclical Nature of Prudential Regulation • During upswing, PD is low (lower capital requirement under IRB), credit losses are low (lower provisioning), asset values are high and market liquidity volumes rise with narrow bid-ask spreads. • Build up of high leverage • Conditions reverse in downturn. • From 2003, onwards significant increase in leverage of many commercial and investment banks though banks remained adequately capitalised. Two large Swiss banks were among best capitalised large international banks and on simple leverage were among the worst capitalised. • In retrospect conclusion is that capital estimated from risk models particularly for trading book was grossly inadequate.

10. During downturn process reverses. Larger the leverage built up during upturn, more severe would be the deleveraging during downturn. • When risks are perceived to be low during upturn, systemic risks are increasing and building up. Fair Value and VaR • In the trading book, application of fair value and use of VaR results in procyclical behaviour, high asset values and low VaR leading to build up of risk positions and leverage and accentuates a downward price spiral triggering a vicious cycle of asset sales and further price decline in downturn.

11. In the initial phase of current crisis- severe losses from trading book positions – several times what VaR models would have predicted. Margins/Haircuts/Triggers • Margins/haircuts in derivatives and securities transactions –lower in upswing (liquid markets, low volatility) – higher leverage and are higher during downturn (illiquid markets, high volatility) exhibiting procyclical behaviour as defense against counterparty risk.

12. Ratings/Market Value based triggers in OTC derivatives contracts- requirement to post collateral when rating goes below a trigger large liquidity shock – Procyclical e.g. • AIG – Protection seller (CDS) on higher tranches of exotic products like CDOs and CLOs– obligations $ 400 billion –rating downgrade –collateral calls-possibility of bankruptcy- systemic risk due to threat to protection buyers-could result in massive write offs /sales-received $ 85 billion loan secured against all assets. Compensation Policies • Compensation schemes tied to short-term profits and no link to risk lead to misalignment of incentives and encourage excessive risk-taking in upswing.

13. Maturity Mismatches • Asset-liability maturity mismatch exposes firms to funding liquidity risk. • Funding liquidity risk shoots up if funding liquidity dries up liquidity freeze or high credit risk high margins/ haircuts, restrained lending forced liquidation of assets Fire sale discounts- losses- market liquidity evaporates • Large maturity mismatches in the system Acute funding liquidity risk aggravates maturity mismatches liquidity spiral.

14. With the above sequence affecting many market players, booms and busts amplified • Current crisis – large aggregate maturity transformation by banks, investment banks and shadow banking sector: • SIVs, Conduits funded long term investments with short term notes. • Investment banks - value of outstanding Repos tripled between 2001 and 2007 with particular rapid growth of overnight repos. • Mutual funds, particularly in USA held long term credit assets against on demand, at par (implicit/explicit) redemption of liabilities to investors.

15. Limited Perimeter of Regulation- Shadow Banking • Emergence of highly leveraged non-deposit taking bank-like entities performing bank like functions • lending long (holding poor quality illiquid long term securities) funded by short term borrowings with little capital and governance standards • Assumed significant credit and liquidity risks • Outside regulatory perimeter and without LOLR support • SIVs, Conduits, Money Market Funds, Hedge Funds, PEFs, other off-balance sheet vehicles. • Total assets of shadow banking sector in USA estimated at USD $ 10 trillion in late 2007, about the same size as those of the banking system.

16. When liquidity froze on credit risk and valuation concerns of toxic assets held, the entire shadow banking system collapsed due to very high funding liquidity risk transferring risks to the regulated banking system in many cases where credit enhancement and contingent liquidity lines had been provided and/ or on reputation concerns i.e. run on SIVs, conduits • Failure of Lehman Brothers, insolvency early in the crisis of two Bear Sterns managed hedge funds. • Regulation was institution specific (Microprudential). Did not take adequate account of systemic risk posed by interconnectedness, activities and markets despite some steps taken (consolidated supervision, oversight of fund managers (hedge funds), supporting codes of conduct for private equity, etc.)

17. Misplaced approach – fallacy of composition. In reality the risk of distress to financial system as a whole (systemic risk) is larger than the sum of risks of individual components. • Action of individual entities impose negative externality (spillover risk) to the rest of the system. Financial Innovation Limited scope of regulation, along with ineffective market discipline fostered innovation of opaque and poorly understood products which increased systemic risk – investors relied on credit ratings when conflict of interest was growing in the rating of structured products • Securitisation of large part of exposures remained within the banking system.

18. C. ENHANCING REGULATORY FRAMEWORK TO ADDRESS SYSTEMIC RISK • A fundamental lesson from the current crisis is: effective supervision at the individual firm level, while necessary, is not sufficient • Supplement strong microprudential regulation and effective supervision with a macroprudential policy overlay • Strengthening of Microprudential regulation (Basel III) - Enhancement in quantity and quality of capital - Raising of risk weight of instruments in the trading book - Liquidity buffers - Leverage ratio, etc.

19. Macroprudential Policy and Tools are: • Prudential (regulatory and supervisory) policies and tools for efffectively monitoring and addressing the build-up of systemic risks for pursuing systemwide stability. • Even a well developed macroprudential approach is not a panacea.

20. Policies and Tools for addressing time dimension of systemic risk (Procyclicality) • Basic idea is to build up capital buffer and provisions in good times that can be drawn down in bad times so as to enable banks to continue to lend and support the economy. • Reducing/ eliminating the procyclicality of the minimum capital requirement • Capital conservation buffer (2.5% of common equity) • Countercyclical capital requirement • Countercyclical provisioning i.e. forward looking provisioning • Compensation policies.

21. Other measures used by Asian countries • Higher provisioning and/ or Risk Weights for rapidly growing sectors • LTV ratios • Direct controls on lending to specific sectors • Capital surcharges for systemically important banks • Liquidity requirements • Limits on currency mismatches • Loan to deposit ratios.

22. Policies and Tools for addressing cross-sectional dimension of systemic risk • Principle is to calibrate prudential tools based on individual institutions’ contribution to the systemic risk – Continuous approach • In practice, the approach is to identify Systemically Important Financial Institutions (SIFIs) based on size, interconnectedness, substitutability and other critieria and calibrate prudential tools (capital, liquidity, leverage, etc.) for them.

23. Main features of the policy framework being developed by BCBS and FSB are : • A resolution framework and other measures to ensure that all financial institutions can be resolved safely, quickly and without destabilising the financial system and exposing the taxpayer to the risk of loss • A requirement that SIFIs and initially in particuar global SIFIs (G-SIFIs) have higher loss absorbency capacity to reflect the greater risks that these institutions pose to the global financial system

24. More intensive supervisory oversight for financial institutions which may pose systemic risk • Other supplementary prudential and other requirements as determined by the national authorities.

25. Strengthening core financial infrastructure to reduce contagious risk from failure of individual institutions All standardised OTC derivatives contracts should be traded on exchanges or electronic trading platforms and cleared through Central Counterparties (CCPs) OTC derivative contracts to be reported to trade repositories.

26. D. REVIEW OF INDIAN EXPERIENCE IN ADDRESSING SYSTEMIC RISK REGULATORY ARCHITECTURE • Key segments of Indian financial system ( money market, Government securities market, forex market and commercial and cooperative banks, NBFCs) fall within the regulatory jurisdiction of RBI.

27. The channels of interconnectedness between banks and other financial sector entities are within the regulatory purview of RBI. • Coordination among RBI, Securities and Exchange Board of India and Insurance Regulatory and Development Authority is ensured through the forum of - High Level Coordination Committee on Financial Markets

28. EXPANDING SCOPE OF REGULATION • Regulation of non-banking entities is being progressively strengthened by the respective regulators. • NBFCs owned by foreign banks, and regulated by RBI brought under the Group concept with the foreign bank branches to contain the regulatory arbitrage though legally they do not form a Group. • An elaborate prudential framework put in place for systemically important non-deposit taking NBFCs. • Consolidated supervision of banking groups introduced in 2003 and constantly strengthened thereafter. • RBI has become the regulator of Payment and Settlement Systems.

29. RESTRICTIONS ON NON-BANKING ACTIVITIES OF BANKS • Limits on Banks’ equity investment in individual financial subsidiaries/ affiliates. • Banks not permitted activities not incidental to banking and also not allowed to set up subsidiaries for activities which banks are not permitted. • Capital requirements for banks’ sponsoring of private pools of capital on reputational risk considerations.

30. PRUDENTIAL MEASURES • Basel-II implemented prudential limits on capital market exposure • Monitoring of sensitive sector exposure • Securitisation guidelines • Prudential limits on bank exposures (funded and non-funded) to non-bank finance companies - individual as well as aggregate. • Lending and borrowing in call money market limited to a percentage of capital funds of the lending/borrowing bank.

31. Call money market made a pure inter-bank market. • Limits on inter-bank liabilities equal to 200% of net worth • Limit on Non- Government unlisted securities • Investment in unrated debt securities not permitted.

32. OTHER MEASURES • Quality of regulatory capital: Tier I capital of banks should be at least 6% of RWA by March 31, 2010. • Tier III capital for market risk not introduced, as it is short term. • Higher RW and/ or provisioning requirement for exposure to sectors showing high credit growth.

33. ENSURING ADEQUATE LIQUIDITY BUFFERS WITH INDIVIDUAL BANKS • SLR requirements • Improvement in the framework for monitoring and reporting of liquidity position of individual banks - introduction of more liquidity buckets within the 1-14 segment ( 1 day, 1-7 days, 8-14 days). • Guidelines on Liquidity Risk Management being upgraded.

34. E. Institutional Framework of Systemic Regulation . One single macroprudential regulator – control over macroprudential tools, well formulated mandate, sufficient authority and resources, professional independence with accountability. . Large body of view favours Central Bank as macroprudential regulator – expertise, reputational authority, deep knowledge of financial markets (and institutions where it is macroprudential regulator), handling of monetary policy and experience in handling financial stability issues

35. Lost of experiementation underway • USA – Financial Stability Oversight Council (FSOC) under Dodd Frank Act headed by Treasury Secretary. FED has substantial role to impose methods to lower systemic risk • UK – BOE is the assigned body • Eurozone – European System Risk Board (ESRB) outside ECB • India – Financial Stability Development Council (FSDC)

36. F. Open Issues & Challenges • Framework in formative stage. Modelling of contribution to systemic risk or for measuring systemic instability are in infancy. • Difficult to assess the impact of tools in reducing systemic risk as no prior experience. • Filling data gaps • Those in charge of policy coordination with monetary policy, fiscal policy and microprudential policies essential. • Communication with markets essential for success of macroprudential policies • Communication with markets essential for success of macroprudential policies • Global coordination for international consistency of macroprudential policies to minimise regulatory arbitrage.

37. Consistency in implementation – peer group review process • Rules vs. discretion • Setting up adequate resolution regimes – complex legal issues, cost sharing issues • All efforts focussed on banks – advantage to non-banking financial firms. Perimeter of regulation will have to expand and greater consistency in prudential treatment will be essential • Challenging task coping with the profileration of new instituions and activities – boundary problem

38. THANK YOU