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Pursuit of financial stability: The Indian experience

Pursuit of financial stability: The Indian experience. Dimple Bhandia January 15, 2013. Financial Stability – In search of a definition.

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Pursuit of financial stability: The Indian experience

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  1. Pursuit of financial stability:The Indian experience Dimple Bhandia January 15, 2013

  2. Financial Stability – In search of a definition There is no universally accepted definition of financial stability. Definitions by various experts abound but most definitions are not amenable to quantification. Financial system functioning without disruption and return to steady state after periods of volatility/vulnerability without significant impairment to longer term prospects, is generally considered an indicator of stability. Financial Stability… Dimensions • Broad, encompassing • And Forward looking Volatilities within an acceptable/tolerable range can represent a state of financial stability.

  3. Factors Affecting Financial Stability • Vulnerabilities in the real economy • Global imbalances and rapid capital flows • Complex financial products and rapid technological development • Asset price bubbles • Shadow banking system • Light touch regulation • Contagion • Interconnected markets • Too big to fail counterparties Well….. Virtually anything…. Anywhere!!!

  4. Why Financial Stability • Impact – potentially severe • Especially for emerging markets • Contagion – worldwide tentacles • Financial instability anywhere can be a threat to financial stability everywhere… • Theory of decoupling weaker than accepted • Sectors • Real and financial sectors through feedback loops

  5. Lessons learnt from the Crisis

  6. Lessons learnt from the Crisis Innumerable! • Recognition of the need to pursue financial stability as an explicit policy objective • The Need to strengthen the macro-prudential framework • To see both the forest and the trees!! • The need to better identify, assess and manage the systemic risks prevailing in the financial sector. • Renewed policymaker interest in developing and improving tools to promote financial stability

  7. Systemic Risks Systemic events • Can be broadly understood broadly as financial instabilities spreading to the extent that the financial intermediation process is impaired and economic growth and welfare suffer materially Systemic risks • Risk of occurrence of a systemic event

  8. Systemic Risks Time dimension: • Financial imbalances that build up gradually over time may unravel suddenly. Cross sectional dimensions: • Contagion risk - an initially idiosyncratic problem that becomes more widespread, often in a sequential fashion. • Shared exposure to financial market shocks or adverse macroeconomic developments that affect a range of financial intermediaries and markets at the same time

  9. Measuring Systemic Risks • Identification of systemic risks is far from straightforward given that systemic risks per se are complex and multifaceted. • There is a need to have a wide range of measures and tools covering different aspects of systemic risks. • A host of new quantification measures have, post the crisis, emerged in academic literature, while central banks are developing tools and techniques which will help identify and measure systemic risks.

  10. Measures of systemic risk contribution • Treat systemic risk as the extent to which individual financial institution pollutes the “public good” of overall financial stability • Focus on the systemic risk contribution of individual institutions • In principle, such measures, if accurate, could be used for Pigouvian taxes, levies or other regulatory interventions aimed at internalizing the negative externalities • The additional capital surcharge proposed to be levied on Globally Systemically Important Banks

  11. Modeling Risks of Aggregate Shocks • Focus on the impact of macroeconomic shocks on the financial system • Adverse macroeconomic scenarios used in stress testing • To assess resilience of financial institutions • Macroeconomic shocks matter for financial stability! • They tend to affect all firms in an economy, financial and nonfinancial, at least to some extent. • A macro shock causes an increase in correlated default losses, with detrimental effects on financial stability. • Stress-testing models are designed to map adverse macro-financial scenarios into losses in shared credit and asset exposures.

  12. Financial Stability Reports • Role of FSRs • Limiting instability by pointing out key risks and vulnerabilities to policy makers, market participants and the public at large • A part of the macroprudential toolkit “These reports serve to assure the public and economic agents that everything is well in the financial sector when this is the case. They also serve as early warnings when problems show up at the horizon. Early action can then prevent any financial instability to materialise.” • Lars Svensson (2003), NBER WP 9486

  13. Trends in Reporting Financial Stability Number of countries publishing FSRs Source: “Financial Stability Reports: What are they good for”, Martin Cihak, et al, World Bank, Dec 2011

  14. Characteristics of FSRs • Standalone document • Generally central bank oriented • Focus on risks and exposures of the financial system • Systemic risk • Forward looking perspective • Analysis of financial interconnectedness • Regularly published

  15. Trends in contents of FRS • Of late • Use of more sophisticated market based indicators • Use of stress testing • Presenting results of early warning systems • Extensive use of disaggregated data • Extensive use of modelling

  16. Central banks and financial stability • Prior to the crisis • Exclusive (excessive?) focus on price stability • Asset price bubbles – central banking function? • Greenspan orthodoxy • Light touch regulation • Risks identified – but no action taken

  17. Central banks and financial stability • Post the crisis • Recognition of the need to pursue financial stability as an explicit policy objective • Widespread amendments to regulatory infrastructure (national and international) and legislations to pursue financial stability • THE HOLY TRINITY! • Price Stability, Financial Stability and Sovereign Debt Sustainability

  18. The Reserve Bank of India Raison d'être • ……to regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage The Preamble of the Reserve Bank of India Act, 1934 First RBI Building 1935, Kolkata

  19. Now… “A full services central bank” • Monetary Authority • Issuer of Currency • Banker and Debt Manager to Government • Banker to banks • Regulator of the Banking System • Manager of Foreign Exchange • Regulatory of Payment and settlement systems • Maintaining Financial Stability • Development Role RBI Central Office Building, Mumbai

  20. Financial Stability and the Reserve Bank of India Maintaining financial stability has been an explicit objective of the Reserve Bank since 2004. The Reserve Bank has, over the years, attempted to address both aspects of systemic risks – the time dimension (procyclicality) and the cross sectional dimension (interconnectedness) within a macroprudential framework, without christening these policies as macroprudential policies.

  21. Financial Stability and Development Council The FSDC, set up in 2010, is a body consisting all regulators and the Ministry of Finance. It is the highest forum in matters relating to financial stability. The Council is chaired by the Union Finance Minister The responsibility of FSDC includes

  22. The Financial Stability Unit An operationally independent FSU was set up in July 2009 with the following mandate: • Conduct of macro-prudential surveillance of the financial system on an ongoing basis. • Developing models for assessing financial stability • Conduct of systemic stress tests to assess resilience • Communicating risks to financial stability

  23. The Indian Financial System Diverse but largely within a defined regulatory perimeter Percentage Share in total financial assets

  24. Financial Network Analysis … (1) • Network analysis is a tool which seeks to explore how systemic risks are affected by the structure of the financial system … • How does the size and distribution of exposures between banks determine the resilience of the system as a whole? • How does the potential for interbank exposures to transmit shocks from one bank to another inter relate with the aggregate amount of capital available to cushion shocks? • Are more concentrated banking systems with a small number of large banks, more or less susceptible systemic breakdown than systems that comprise a large number of small banks? • Are ‘tiered’ systems, where a small number of ‘core’ banks coexist with a fringe of smaller banks in the ‘periphery’ more or less susceptible to systemic breakdowns than less tiered or more uniform systems?

  25. Financial Network Analysis …(2) Tiered structure of the banking system

  26. Financial Network Analysis …(3) The network of the financial system

  27. Financial Network Analysis …(4) Contagion Analysis

  28. Banking Stability Measures Modeling Distress dependencies among banks Probability of Distress based on equity prices of select banks • Joint Probability of Distress (JPoD) - probability that all banks in the system experience large losses simultaneously. • Banking Stability Index (BSI) - the expected number of banks under distress if at least one bank is under distress.

  29. Stress testing • Macro financial stress tests • Testing the resilience of financial institutions to adverse movements in macroeconomic variables • Sensitivity Analysis • Supplement to macro stress tests • Assessing resilience of financial institutions to adverse movements in a range of risk factors covering foreign exchange, liquidity, interest rate and credit risks • Both top down and bottom up stress testing deployed • Stress testing the derivative portfolio of banks • Sensitivity and Scenario analysis

  30. Macro Stress Tests

  31. Stability Maps and Indicators… (1) Maps and Indicators • Macroeconomic Stability – assesses risk conditions in the macroeconomy • Financial Markets Stability – assesses stability of financial markets • Banking Stability – assesses changes in underlying conditions/risk factors affecting the banking sector’s stability • Financial Stability – assessesoverall stability conditions in the Indian financial system Supplementary Indicators to assess vulnerabilities emanating from • Systemic Liquidity conditions • Fiscal situation • External Sector • Housing Prices

  32. Stability Maps and Indicators… (2) Financial Stability Map and Indicator Financial Stability Map * Financial Stability Indicator ** (*) Away from centre implies higher risk (**) Higher level implies lower stability

  33. Stability Maps and Indicators… (3) Macro Stability Map Macroeconomic Stability Map * (*) Away from centre implies higher risk

  34. Stability Maps and Indicators… (4) Financial Markets Stability Map and Indicator Financial Markets Stability Map * Financial Markets Stability Indicator ** (*) Away from centre implies higher risk (**) Higher level implies lower stability

  35. Stability Maps and Indicators… (5) Banking Stability Map and Indicator Banking Stability Map * Banking Stability Indicator ** (*) Away from centre implies higher risk (**) Higher level implies lower stability

  36. Assessment of Systemic Risks - Challenges • Complex and opaque - Difficult to Measure • No universally accepted definition • Risk factors are generally not observable – hence difficult to quantify • Large mass of uncertainties – “known” and unknown” • Effectiveness and appropriateness of tools is not easily measurable • Significant data gaps • Challenges in “connecting the dots” • Assessment – a “best estimate” • Type I and Type II errors • The Learning curve is steep!

  37. Publishing of FSRs - Challenges • Some financial stability issues too sensitive to be discussed publicly • Could trigger behaviour likely to provoke a crisis, especially in times when the financial system is already disturbed • Exist real, inherent constraints in communicating tail risks • Regular publications help in preventing “over” interpretation • Loss of credibility • Crying wolf – Most risks communicated will not materialise • Data gaps and challenges in systemic risk assessment • Validity of models/conclusions

  38. Public policy? • Financial stability and growth – two sides of the same coin? • Conventional wisdom says: financial stability promotes and stimulates growth…… • “A stable financial system is a pre-requisite for sustainable economic growth” (William Dudley, New York Fed, 2011) • ……But evidence scarce! • What about financial instability? • Price stability and financial stability Are there trade offs? • Return of fiscal dominance over monetary policy? • Accountability of central banks • The new trilemma • The Holy Trinity of price stability, financial stability and growth

  39. Questions?

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