GLOBAL CRISIS TOWARDS A NEW MACRO-PRUDENTIAL FRAMEWORK

GLOBAL CRISIS : TOWARDS A NEW MACRO-PRUDENTIAL FRAMEWORK IN INDIA IDEAS CONFERENCE MUTTUKADU, TAMIL NADU 25 -27 JAN 2010 1

• DILIP NACHANE • DIRECTOR • IGIDR • MUMBAI , INDIA 2

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 3

CHALLENGES BROUGHT TO THE FORE BY CURRENT CRISIS 1. 2. 3. HIGH SOCIAL COSTS OF FINANCIAL FAILURES SYTEMIC RISKS PRO-CYCLICALITY OF BANK CAPITAL REGULATION 4

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, G 20 ETC. ? 5

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 6

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 7

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” 8

THREE BASIC CONCEPTS UNDERPINNING SYSTEMIC RISK • 1. Interlinkages across institutions • 2. Changes in the returns distributions of FI’s 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. 9

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 (< 1 year maturity) /total debt 10

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 11

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 12

SUGGESTED NEW MEASURES OF FINANCIAL INDICATORS • IMF Occ. Paper No. 212 (Sunderarajan et al. 2002) • (i) Core Set • (ii) Encouraged Set 13

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 14

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 COUNTERPRODUCTIVE 15

III. COUNTERING PRO-CYCLICALITY OF CAPITAL REQUIREMENTS • 1. RELATE CAPITAL REQUIREMENTS TO THE STATE OF THE MACROECONOMY (A RANGE OR BAND TO BE SPECIFIED) • 2. HIGHER CAPITAL REQUIREMENTS ON SYSTEMICALLY IMPORTANT FINANCIAL INSTITUTIONS 16

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 17

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 ( < 50% OF TIER I CAPITAL). SUCH DEBT IS PART OF TIER II CAPITAL 18

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) 19

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 UNDERVALUATION, CURRENCY MIS-MATCHES ETC. ) 20

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 VALUEWEIGHTED YIELD ON THE BUNDLE OF SECURITIES OFFERED AS COLLATERAL (SEE CALOMIRIS (1999), GOLDSTEIN (2008), BRUNNERMEIER ET AL (2009) ETC. ) 21

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 (FCLFLEXIBLE 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 22

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). 23

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) 24

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) 25

G 20 INSURANCE SOLUTION • • E. PRASAD (MAY 09) INSURANCE POOL FOR G 20 MEMBERS ENTRY FEE BETWEEN $10 BN TO $20 PREMIUM TO DEPEND ON THE LEVEL OF INSURANCE DESIRED— 1% 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 26

G 20 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 27

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 28

Likely Future Course of Financial Sector Reforms : India • • Four Committees 1. Tarapore I & II 2. Percy Mistry 3. Raghuram Rajan 29

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 INNOVATION TO ADDRESS CONCERNS BEARING ON SYSTEMIC RISK, FRAUD, TRANSPARENCY, CONTRACT ENFORCEMENT ETC. 5. SUPERVISION OF ALL DEPOSIT-TAKING INSTITUTIONS TO BE BROUGHT UNDER RBI 6. MINISTRY OF CORPORATE AFFAIRS SHOULD REVIEW ACCOUNTS OF UNLISTED COMPANIES , WHILE SEBI SHOULD REVIEW ACCOUNTS OF LISTED COMPANIES 30

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. 31

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. 32

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. 33

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 34

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 • 35

• THANK YOU 36