Financial Stability: Issues and Challenges - આરબીઆઈ - Reserve Bank of India
Financial Stability: Issues and Challenges
Dr. D. Subbarao, Governor, Reserve Bank of India
delivered-on સપ્ટે 10, 2009
I. Global Banking - Paradigm Shift Thank you for inviting me to participate in this FICCI-IBA conference on “Global Banking: Paradigm Shift”. I understand this is one of the important banking conferences in the annual calendar, and so I struggled through what I should say at this valedictory that is central to the theme of the conference. 2. Quite understandably, public discourse over the last one year has been dominated by the global financial crisis; and the future of global banking has clearly been one of the important facets of this discourse. How the regulatory architecture around the world is reinvented will be a critical determinant of the paradigm shift in global banking. In his 1962 book, ‘Structure of Scientific Revolutions’, Thomas Kuhn argues that when evidence against a prevailing scientific theory piles up, that theory is jettisoned and a new one is adopted signalling a paradigm shift. As we contemplate the lessons of the crisis, the questions that arise are what is the evidence against the old model of central banking and regulation, and what is the new model. What is the paradigm shift required? I will position my speech this afternoon on some of the issues in this paradigm shift. II. Financial Stability - Key Lesson of the Crisis Breakdown of Trust Anatomy of Financial Instability 5. The epicentre of the crisis lay in the advanced economies, but it soon spread in two directions. First, in the advanced economies, it spread from the financial sector to the real sector severely hurting consumption, investment, export and import. Second, it spread geographically from the advanced economies to the emerging market economies and soon engulfed almost the entire world through trade, finance and confidence channels. In short, financial stability that we had grown to take for granted got impaired. Financial Stability Comes Centre Stage 6. That indeed is one of the many lessons of the crisis - that financial stability cannot be taken for granted. We have learnt that financial stability can be jeopardized even if there is price stability and macroeconomic stability. We have learnt that a threat to financial stability anywhere in the world is potentially a threat to financial stability everywhere. We have learnt that financial stability has to shift from being an implicit variable to an explicit variable of economic policy. 7. Financial instability, as we have seen, can hurt even the most advanced economies, but the damage it can cause in poor and developing economies can be particularly severe. People with low levels of income have no headroom to bear downside risks, and their livelihoods can be disrupted by financial instability. It is therefore even more important that countries such as ours pay particular attention to preserving financial stability even as we deepen and broaden our financial sector at home and integrate with the rest of the world. 8. All of us in the financial sector have a role in managing financial stability. Given the centrality of this topic to our mandate, I would like to focus my comments this afternoon on financial stability. I will start by examining how and why central banks let financial stability fall through the cracks, and then review the international initiatives under way to remedy the system. I will then explain the Indian approach to financial stability, in particular highlighting the stability enhancing features of our policy and regulatory framework. Finally, I will look ahead to some issues and challenges on the way forward. III. Central Banks and Financial Stability 9. Central bankers around the world are clearly in the forefront battling the crisis. While they are clearly part of the solution, questions are being asked about whether they were, in fact, part of the problem. In particular, did they fail to see the crisis coming? Were they behind the curve in preventing excesses from building up? Did they neglect financial stability in their zealous pursuit of price stability? More importantly, did they behave like this because the accountability mechanisms were weak? To address these questions, let me refer to three egregious failures attributed to central banks. First Failure - Exclusive Focus on Price Stability 11. The crisis has blunted that sense of triumph. It has called into question the wisdom of exclusive inflation targeting and even challenged the notion of price stability being the only objective of monetary policy. It has underscored the importance of acknowledging financial stability as an explicit variable in the policy matrix of central banks. Second Failure - Failure to Prevent Asset Price Bubbles Third Failure - Lightness of Regulation Warnings Ignored IV. Global Action Towards Financial Stability 15. Expectedly, the crisis has triggered a vigorous debate on how financial stability should be safeguarded. Even as the crisis is not fully behind us, several lessons are clear. First, the received wisdom is that prevention is better than cure and that central banks should take countercyclical policy actions to prevent build up of imbalances. Second, a consensus is emerging around the view that central bank purview should explicitly include financial stability. Third, there is growing acknowledgement that financial stability needs to be understood and addressed both from the micro and macro perspectives. At the micro level, we need to ensure that individual institutions are healthy, safe and sound; we need in addition, to safeguard financial stability at the macro level. 16. Some of the significant actions already taken to bolster the resilience of the international financial system include the enhancement of the Basel II capital framework, particularly with regard to trading and off-balance sheet securitisation activities of banks, setting strong risk management standards for banks and financial institutions on governance, management and disclosure of liquidity risk and stress testing, integrating sound compensation principles in the Basel capital framework, introducing central counterparties for derivatives trading, developing new accounting standards to enhance the consolidation of special purpose vehicles, making transparent banks' relationships with such entities and the issue of internationally agreed principles for the oversight of hedge funds. 17. Beyond actions already taken, work is under progress on several initiatives to strengthen stability and I want to highlight some of the more important ones.
18. As a member of G20, the expanded Financial Stability Board (FSB) and the Basel Committee on Banking Supervision (BCBS), India is actively engaged in several of these international initiatives. The task for us will be to draw the lessons of the crisis, understand international best practices and adapt them to our context. V. Financial Stability - Indian Approach Financial Stability in India During the Crisis India’s Approach to Financial Stability 21. What have been the key features of our approach to safeguarding financial stability? On financial globalization, our stance has been gradualist - of making haste slowly. We view capital account liberalisation as a process and not an event. The extent of opening is contingent upon progress in other sectors. The policy framework encourages equity flows, especially direct investment flows but debt flows are subject to restrictions which are reviewed and fine-tuned periodically. The exchange rate is largely market-determined and we intervene in the foreign exchange market in times of excessive volatility. 22. Our approach to financial sector regulation has been informed by the fact that our system is dominated by commercial banks. Thus, as early as mid-1990s, the Reserve Bank instituted the prudential framework governing banks, especially commercial banks, as a part of the overall structural reforms. As of April 2009, all our commercial banks are Basel II compliant. 23. We established a Board for Financial Supervision for focussed regulation and supervision of banks and other financial institutions under RBI’s jurisdiction. We widened and deepened the financial markets in terms of instruments, products and participant, while continuing with a cautious approach towards exotic products. India - Important Measures Towards Financial Stability
Financial Stability Unit in RBI VI. Financial Stability: Challenges on the Way Forward 26. Like all other policy measures, maintenance of financial stability involves trade-offs and throws up a number of challenges. I want to highlight five important challenges that we will need to address on the way forward. In doing so, I will draw from global experience. First Challenge: How to Define and Measure Financial Stability 28. Despite widespread usage, financial stability is difficult to define let alone measure. This is in contrast to price stability which can be defined and quantified. Some define financial stability as the absence of financial instability which, of course, is tautological. From a macro-prudential perspective, financial stability can be defined as a situation where the financial sector functions without any discontinuity. This definition is conceptually neat but is not useful for policy purposes unless it can be quantified for measurement purposes. Policy makers and analysts at international fora are actively engaged in fleshing out the definition so that it is precise, measurable and comprehensive. Some critical elements of any financial stability framework, aspects that need to inform the definition of financial stability, are the following:
Second Challenge: Financial Stability - Exclusive or Shared Responsibility? 30. But this model raises fresh questions. In particular, can the central bank have exclusive responsibility for financial stability? Conversely, can the government completely delegate this responsibility to the central bank under a principal-agent model? 31. Consider, for example, a situation where the banking system is under threat of instability. Decisions have to be made on which banks to bail out and how much support to extend. In all this, fiscal support may need to be extended. Would a government, especially if it is democratically elected and accountable to a legislature, not want to have a say in this regard? This calls for the following question to be resolved. How should the responsibility for financial stability be shared between the government and the central bank? What should be the protocol for decision making? Who should prevail, and under what circumstances, in the event of a deadlock? Third Challenge: Growth and Financial Stability - Managing the Trade-offs 33. It needs to be recognized that after a crisis, with the benefit of hindsight, all conservative policies appear safe. But excessive conservatism in order to be prepared to ride out a potential crisis could thwart growth and financial innovation. The question is what price are we willing to pay, in other words, what potential benefits are we willing to give up, in order to prevent a black swan event? Experience shows that managing this challenge, that is to determine how much to tighten and when, is more a question of good judgement rather than analytical skill. This judgement skill is the one that central banks, especially in developing countries such as India, need to hone as they simultaneously pursue the objectives of growth and financial stability. Fourth Challenge: Reforming Regulatory Architecture 35. The first issue has to do with regulatory coordination. In India, we have a host of regulators in the financial sector - RBI, SEBI, IRDA and PFRDA. In order to facilitate coordination between them, there is a High Level Coordination Committee on Financial Markets (HLCC-FM) comprising all the regulators and the Finance Secretary. While the Governor of the Reserve Bank chairs the HLCC-FM, the Ministry of Finance provides the secretariat. The hallmark of the HLCC meetings, and one that adds most value to them, is that the meetings are informal and there is free exchange of positions, views and opinions. There is a view that the HLCC-FM should be given a formal structure. While a formal structure will have the merit of enforcing accountability, the flip side is that it may make the forum excessively bureaucratic and detract from its other value adding features. This is an issue that we must debate further. One area where the HLCCFM could have a more defined role relates to oversight of large financial conglomerates. 36. The second issue relating to regulatory architecture with relevance for financial stability has to do with changes, if any, warranted in the regulation of financial markets. Two recent reports, both influential, one by Percy Mistry on Mumbai as an International Financial Centre and the other by Raghuram Rajan on Financial Sector Reforms, have recommended that regulation of all trading of financial products and instruments be brought under SEBI. We need to seriously debate the advisability of such a unification. 37. Currently, the arrangement for regulation of financial markets is as follows. Apart from banks, NBFCs and other financial institutions, RBI regulates the money market, the government securities market, the credit market and the foreign exchange market and the derivatives thereon. In respect of OTC derivatives, only those derivatives where one party to the transaction is an RBI regulated entity have legal validity. In respect of products traded on the exchanges, procedures for trade execution fall within the regulatory purview of SEBI. Therefore, unlike many countries, India has had established procedures for regulation of OTC derivatives. 38. By far the most important reason why the present arrangement should continue has to do with preserving financial stability. Unlike equity prices, interest rates and exchange rate are key macroeconomic variables with implications for monetary policy and overall macroeconomic stability. In addition, banks dominate the interest and exchange rate markets. By also being the regulator of these markets, the Reserve Bank is in a position to exercise oversight of institutions, markets and products, to monitor market developments, sense impending developments, take advance action, prevent excessive volatility and maintain financial stability at the systemic level. This is an arrangement that has stood to the test of time, has protected our financial stability even in the face of some severe onslaughts. This is an arrangement that we should not jettison lightly in quest of a unified market regulator. 39. The third issue in the reform of regulatory architecture is about whether a central bank should also be a banking regulator. Pre-crisis, there was a dominant argument for separation of the monetary and regulatory functions premised on a possible conflict of interest. According to this view, if financial stability becomes the dominant concern of a central bank, it could result in a moral hazard for banks. Banks will likely take excessive risks in the full confidence that the central bank, being also the regulator, will ease policy and extend regulatory forbearance to bail them out in a crisis. Paradoxically, the aggressive pursuit of financial stability can itself threaten financial stability over the long horizon. 40. The crisis has clearly weakened this argument. The concern over regulatory forbearance is exaggerated. It is worth noting that some advanced economies where regulation and supervision are with an agency other than the central bank are themselves revisiting their regulatory structures and contemplating some unification. The crisis has also shown that there are clear synergies between monetary policy management and financial sector regulation. In particular, the central bank can perform its lender of last resort function more effectively if it has a clear view of the institution’s current and prospective balance sheet and its liquidity and solvency position. 41. The jury of course is still out on which model is the best as the crisis has discredited almost all models. I want to point out though that we need to reflect on the lessons of the crisis seriously before reforming our regulatory structures. Fifth Challenge: Fiscal Policy, Financial Stability and Central Bank Independence 42. The emerging regulatory architecture geared, among other things, to preserving financial stability will have implication for the prized independence of central banks. Before 1970, it was typical across countries for monetary policy to be hostage to fiscal compulsions. But, following the stagflation of the 1970s and the ascendency of monetary policy thereafter, a neat arrangement started to emerge. Governments started becoming fiscally responsible and monetary policy had started getting independent. 43. This arrangement is now unravelling as a result of the crisis. Unnerved by the scale and sweep of the crisis, governments and central banks around the world responded with an unprecedented show of policy force. Central banks cut policy interest rates and have resorted to injecting massive liquidity in the system through a slew of measures variously called quantitative and credit easing. Governments stepped in with fiscal stimulus packages raising fiscal deficits to levels not seen before in peace time. Even as governments and central banks cooperated, the familiar tensions between fiscal and monetary policy have started playing up. It is widely hoped though that once the crisis is behind us, these tensions will melt away and monetary policy will once again be conducted independent of fiscal compulsions. On the other hand, there are apprehensions that this may not happen soon because of the expected protracted recovery and also because of structural factors that may keep fiscal deficits at elevated levels into the medium term. 44. These tensions between fiscal and monetary policies could potentially militate against financial stability. If governments continue to incur large fiscal deficits, it will be that much more difficult for central banks to maintain price stability. While the current crisis has shown that price stability is not sufficient to ensure financial stability, price stability is decidedly a necessary condition for financial stability. Higher inflation could also push the yield curve upwards. This could result in significant mark to market losses for fixed income instruments with potentially adverse implications for banks’ profitability. This again could impair financial stability. 45. In India too, we are confronting the dilemma of managing the tension between fiscal and monetary policies. The government has asked the Finance Commission to indicate a road map for returning to a path of fiscal consolidation. It is imperative that both the centre and states in India return to a path of fiscal consolidation, for a number of reasons, including the need to preserve financial stability. VIII. Conclusion 46. Let me now conclude. To summarize, I have alluded to how financial stability has been impaired during this crisis and the flaws in the central banking paradigm that may have been responsible for this. I have narrated some of the important international initiatives under way to preserve and strengthen financial stability. I have argued that in the face of India’s rapid integration with the world, we need to be vigilant about protecting our financial stability as developments anywhere in the world can affect us. I have explained India’s approach to financial stability and indicated that the Reserve Bank is retooling itself to safeguard financial stability. Finally, I addressed five major challenges that the world, India included, will need to address on the way forward. 47. The more we study and analyze financial stability, the clearer it becomes that preserving and strengthening financial stability is a complex challenge. We need to take measured and timely action, and make a balanced judgement - not to be too benign, but also not go over board with excessive or premature tightening. 48. There is a concern in some quarters that the crisis may have dented our enthusiasm for financial sector reforms. I believe that concern is misplaced. We will not slow down on reforms, but will surely rework the road map to reflect the lessons of the crisis. 1Valedictory address by Dr. Duvvuri Subbarao, Governor, Reserve Bank of India at the FICCI-IBA Annual Conference on ‘Global Banking: Paradigm Shift’ organised jointly by FICCI and IBA on September 10, 2009 in Mumbai. |