Financial Markets – Some Regulatory Issues and Recent Developments - ଆରବିଆଇ - Reserve Bank of India
Financial Markets - Some Regulatory Issues and Recent Developments
Smt. Shyamala Gopinath, Deputy Governor, Reserve Bank of India
delivered-on ଜାନୁଆରୀ 04, 2010
1. It is my pleasure to be here today again, at the FIMMDA-PDAI annual conference as we enter into a new decade. The last decade in the Indian financial sector has been a forward continuum marked by significant developments. It was in 1999 that guidelines for interest rate swaps and forward rate agreements were first introduced. 1999 was also the year when FEMA was enacted and since then it has been a process of measured opening up of the capital account. That was also the time when the LAF framework for modulating short term liquidity was introduced and a plan was put in place for making uncollateralized call money market as a pure inter-bank market. Looking back, we have come along a long way. One thing that perhaps connects through the regulatory approach during this period has been the pursuit of financial stability. Some may be surprised to note that as far back as the start of this decade, the conceptualization of financial stability had been ingrained into the macro-economic and policy framework of the RBI. There was a stated focus on the need to treat financial stability as a dominant objective of macroeconomic management and as a necessary, if not the sufficient, condition for accelerating economic growth1. Financial stability, of course, has acquired its rightful place as a key policy objective globally since the onset of crisis. I. Regulatory approach for markets 4. In the post crisis scenario, the new important variable that is being sought to be addressed globally is the oversight of systemic risk. It is being acknowledged that institutional regulation alone is not sufficient in capturing and addressing systemic risks and it is imperative to have a mechanism to monitor and act upon the risks inherent in the interconnectedness across the financial system – a macro-prudential approach to regulation and supervision. It is recognized that systemic risk is created endogeneously rather than having exogeneous origins beyond the remit of financial markets. Macro-prudential regulation – The Concept 6. The two key elements of macro-prudential regulation4 that have acquired maximum attention are one, existence of common (correlated) exposures which arise either because institutions are directly exposed to the same or similar asset classes or because of indirect exposures associated with linkages among them (e.g. counterparty relationships) and two, collective homogeneous actions on the part of institutions resulting in amplification of risks because of interconnectedness, the pro-cyclicality element. 7. Integral to the above approach is also the role of financial markets – by and in themselves, different market segments, assessed in terms of the usual metrics such as liquidity, turnover, etc. may be functioning absolutely well, but there may still be underlying systemic vulnerabilities arising out of the interactions of different market participants, both regulated as well as unregulated, across different markets. 8. However, there is still no coherent framework emerging for regulation of financial markets from a stability perspective. Indeed, the joint IMF-BIS-FSB paper on assessing the Systemic Importance of Financial Institutions, Markets and Instruments also acknowledges that the assessment of systemic importance of markets presents more conceptual challenges than for institutions. In the area of reforming markets, the singular area of action has been to address counterparty risks and non-transparency in the OTC market by taking all such markets onto central clearing platforms. Other elements impinging on market functioning flow from the focus on entity regulation such as addressing excessive leverage, higher capital charge for trading and securitization transactions. 15. In regard to direct links, there is need for bringing all inter-bank/intra-financial system exposures both on and off-balance sheet within the macro prudential framework. While there are prudential requirements for individual bank’s exposures to other banks, there is appreciation of the need to prescribe safeguards on the liabilities side of the balance sheet too and to ensure availability of adequate good quality liquid assets. 16. The growth in financial sector over the past few years has been exponential. While many have argued that this has also contributed to real economy growth, behind the numbers lays the critical role of leverage and off-balance sheet financing. As mentioned in the Turner Review, from about 2003 onwards there were significant increases in the measured on-balance sheet leverage of many commercial and investment banks, driven in some cases by dramatic increases in gross assets and derivative positions. This coupled with the growth of ‘shadow banking’ meant that the so-called benefits from financial sector growth have been mostly illusory. 17. Firms whose business models were based on high leverage and excessive dependence on uninterrupted access to secured funding markets were highly vulnerable in the crisis. Many firms relied on excessive short-term wholesale financing of long term illiquid assets including on cross border basis. During the crisis they were faced with lenders demanding substantial cushions or haircuts on the assets they were willing to finance. Moreover, these assets taken as collateral were illiquid and lenders failed to factor in this risk. This combined with excessive leverage accentuated the vulnerability. 19. This also raises the issue of interconnectedness of banks to private pools of capital that are largely unregulated. While the reform of the financial system does cover regulation of hedge funds, the general issue of banks exposures to these funds directly as well as through markets needs greater attention. The same applies to private equity which are unregulated entities. These entities rely on funding markets for leverage. From a macro prudential perspective it is not just necessary to regulate banks exposures to these entities but also to limit the overall leverage of these entities if they are permitted to access funds directly from banks and other financial intermediaries and indirectly via funding markets. 21. Increasingly more nuanced perspectives on this issue are being articulated, the most recent one being the discussion paper of December 2009 from the HMT and the FSA in UK which argues against the need for mandating the trading of standardized derivatives on organized trading platforms provided steps are taken to improve transparency and mitigate the risks of OTC derivatives. According to this paper regulatory objectives of reducing counterparty risk and improving transparency can be achieved by other means and they would review progress of initiatives in this area. Moreover, mandating the use of organised platforms would imply a regulatory imposition of trading structure, which they do not believe is necessary. The paper argues that mere standardisability cannot be a sufficient condition for central clearing and other factors such as availability of prices, depth of market liquidity and whether the product contains inherent risk attributes that cannot be mitigated by the CCP need to be considered by regulators. 22. The essence of a CCP arrangement is netting and margining, which are contingent on homogeneity of the underlying asset, availability of reliable prices and sound risk models to capture future potential exposures. The ability of models to capture tail risks has been comprehensively put to question post crisis. How would the exchanges be better able to measure and manage risk where some of the biggest financial firms with the soundest risk management systems failed? This would be particularly true of credit products such as CDS. In this context, the nature of collateral regime becomes extremely important. Any instrument with a credit risk element would inherently not be suitable for a collateral. If these aspects are not addressed by the regulators, mandatory clearing would only result in a potentially riskier system. 23. The real sector i.e. end users are opposing mandatory move to exchanges and clearing platforms on the ground that the crisis was inherently due to complex transactions between financial intermediaries and there should be no increase in cost to the real sector, i.e. genuine end-users, for undertaking derivative trades. 25. A key criticism of the proposed reforms has been that it doesn’t address the fundamental issue of speculative use of derivatives and excessive financialisation of all products. In fact, by transferring most of OTC market onto exchanges, it might be further accentuating it. It is not surprising to hear major global exchanges as well as brokers betting on a manifold increase in the CDS market as a result of electronic trading and central clearing. A recent study7 has found that of the gross CDS position of 23 large US Banks only around 2 per cent was for hedging the rest was for their dealer activities. Though the figures pertain to 2005, they give a fair idea of really how much of the CDS market was actually for pure speculation. Speculation does play an economic role in increasing market liquidity and price discovery but beyond a point, trading without an underlying interest could only increase systemic risk particularly when the same market prices and volatilities get entrenched into the balance sheets of the real sector. Market Discipline 28. In the past, it has been argued that market discipline can play a key role in incentivising market participants to limit their excessive risk taking activities. However, the events of the last few years have proved the inadequacy of market discipline and bankers have been engaged in risk-taking activities disguised as value-creation. Time and again market participants have engaged in herd behaviour and put the financial system at risk. It is poignant to note how relevant Charles Mackay’s observation in his popular book Extraordinary Popular Delusions and Madness of Crowds, writtenin 1841, even today. Mackay wrote, ‘‘Men, it has been well said think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one”. The events of the past few years tell us that market discipline expressed via market prices cannot be expected to play a major role in constraining risk taking, and that the primary constraint needs to come from regulation and supervision. 29. So how do we manage the trade-off between financial stability, effective regulations on the one hand and free markets on the other? One, the responsibility for financial stability cannot be fragmented across several regulators; it has to rest unambiguously with a single entity, and that single entity optimally is the central bank. And second, that there is need for coordination across regulators on a regular basis and for developing a protocol for responding to a crisis situation8. 30. In my opinion, any regulation that is envisaged should be based on the touchstone of the following: Regulations that does not lead to excessive leverage of not only financial institutions, but also of households and corporates. Regulations that augment the market process and strengthen the invisible hand. Regulations that address the information problems associated with complex financial instruments and improve the transparency of instruments and institutions. Regulations that acknowledge and address the systemically important nature of key markets that have wider implications for the real economy. Regulations that recognize and address the country specific circumstances. Part II – Indian context
Money Markets
33. Therefore, despite the daily overnight rates remaining around the interest rate corridor, the daily absolute change in the weighted average rates have not been smooth.
34. While we are all aware of the skewed distribution of liquidity in the banking system due to different balance sheet sizes of the banks, the rapid roll-out of RTGS system and the core banking solutions perhaps offers us an opportunity to go back to the drawing board and optimize the day to day liquidity management to reduce the opportunity costs and more importantly improve the ability to lend on term basis. The term money market continues to remain dormant with low turnover despite several initiatives taken by the Reserve Bank, mainly reflecting the inability of the market participants to take a medium-term view on interest rates and liquidity, corporates’ continued preference for cash credit and other modes of loan disbursements. However, the CD market is active and reflects the unsecured term money market rates. 35. RBI has addressed the issue of vulnerabilities arising from excessive intra financial sector activity by limiting the unsecured overnight market to banks and primary dealers and imposing limits on unsecured borrowing and lending in overnight markets as also by limiting the gross interbank liabilities. 36. On the market infrastructure side, over the years, the collateralised segment of money market has assumed increasing importance for the entire gamut of market players including non-banks without engendering financial instability. All collateralized trades including market repos are settled through a CCP. These developments have contributed to the increased transparency and liquidity in these markets and imparted stability to the financial markets. 37. On the regulatory front, the gap that existed in the case of NCDs with maturities less than one year has received the regulatory attention. Non Convertible Debentures of maturity of less than one year are being issued with innovative features such as, interest rates linked to overnight rate, American style put/call optionality, which imparts demand liability character to these instruments. Further, the innovative features and the high amount of issuance of such instruments pose systemic risks. The suggestion of the market participants in expanding the eligible entities that can act as Debenture Trustees for the issuance of NCDs with less than one year maturities is being examined by the Reserve Bank. However, the suggestion for relaxing the minimum tenor of these NCDs from the proposed tenor of 90 days to 7 days cannot be acceded to as under the law, corporates are prohibited from issuing unsecured debentures with maturity of less than 90 days. Allowing markets to issue very short-term instruments can have systemic implications. In any case, there are other instruments in the short-end like repo, CBLO and CPs that can meet the requirement of investors. Government securities market Initiatives to widen investor base 41. With the average daily trading volumes of about Rs. 13,000 crore and Rs. 22,000 crore in outright and repo market respectively , the G-sec markets are on the growth path. Primary Dealers Performance of PDs in Primary Auctions of Government Securities Recent initiatives
45. The RBI is impressing upon the PDs to expand their outreach to widen the investor base for government securities and act as market makers for the smaller entities in non-institutional segment. Corporate Bond Market: 47. Introduction of OTC repo in corporate bonds, as already announced, would further enhance the secondary market activity by encouraging more participants to hold bonds. However, we need to tread with prudence since the repo facilitates leverage. As indicated earlier secured funding markets globally were the key leverage-enabling channels that played an exacerbating role during the crisis. While such collateralized funding markets generally help market integration by enabling participants to fund their long positions and deliver into short positions and by helping them to manage their short term liquidity needs, during times of crisis, the same mechanism may accentuate the crisis by forcing the borrowers into insolvency due to steep fall in the value of collaterals, leading to margin calls and fire sales (Gorton and Metrick, 2009). 48. The feedback received on the draft guidelines has largely been positive but the key issue that has been raised relates to inclusion of short term money market instruments such as CDs/CPs as eligible securities for repo. To begin with, it is proposed to start only with highly rated bonds. The final guidelines in this regard would be issued shortly. Foreign Exchange Market 50. The sudden change in the external environment that started around mid-September 2008 led to heightened volatility in the currency market. The Rupee exhibited a sharp downward trend, like other emerging market currencies, in the backdrop of de-leveraging in global financial markets, sharp declines in equities markets and deterioration in the inter-bank money markets prompting investors to shun emerging market assets. While FDI flows exhibited resilience, access to ECBs and trade credits was rendered somewhat difficult. The net outflows under portfolio investment, banking capital and short-term trade credit led to capital account balance having turned negative during the third quarter (October-December) of 2008-09, the first time since the first quarter of 1998-99. 51. In this context, the Reserve Bank took all preemptory actions as necessary to preserve orderly conditions in the markets. Apart from undertaking market operations to bridge the demand supply gap, other measures were also taken such as upward adjustment of the interest rate ceiling on the foreign currency deposits by non-resident Indians, substantially relaxing the external commercial borrowings (ECB) regime for corporates, and allowing non-banking financial companies and housing finance companies to access foreign borrowing. The RBI had also introduced special forex swaps of tenors up to three months on November 7, 2008 in order to provide flexibility to Indian banks in managing their short-term funding requirements at their overseas offices. 52. The average daily turnover of FCY-INR in the foreign exchange market (including forwards and FX swaps) decreased from USD 33.44 billion in July 2008 to USD 29.45 billion in October 2009. While the turnover in the inter-bank segment fell from USD 25.48 billion to USD 20.23 billion, that in the merchant segment increased from USD 7.96 billion to USD 9.22 billion. Derivatives Market Interest Rate Derivatives 54. With most of the market microstructure of the G-sec market well established, it set the stage for the re-launch of the Interest Rate Futures market in August 2009. RBI has on its part put in place the physical delivery infrastructure that creates an interface of the Public Debt Office with the clearing houses of the exchanges with near straight through processing ability. RBI has also given its approval to the exchanges to reduce the delivery period in the IRF to one single day. The market participants should ultimately harness the hedging potential that this product has to offer. One of the primary reasons for going in for physical settlement in the IRF as against cash settlement was precisely to link the cash segment with the futures segment, which would be critical for hedging purposes. 55. Unlike in other markets, there is a regulatory framework for OTC markets in cash and derivatives markets in instruments coming under RBI regulatory purview. There is a role for OTC markets since they can meet specific requirements of end users. For the purpose of OTC interest rate derivatives we have classified the participants into market makers and users. These products have achieved considerable amount of standardization that has in turn facilitated technological intervention. We have already achieved significant success in the trade reporting and settlement of these OTC interest rate products. We are therefore, significantly ahead on these parameters compared to most of the developed markets. 56. While there has been a significant buildup of outstanding notional principal10 the market participation is much skewed. As per the latest CCIL data, the foreign banks dominated the MIBOR swap market with an average share of 81.96% as against the share of the private banks at 11.76%, Primary Dealers at 5.79% and public sector banks at 0.49% during October’09. Further, foreign banks dominated the MIFOR swap market with an average share of 87.38% as against that of the private banks at 11.79% and public sector banks at 0.83% during October’09. There is, therefore, a clear need for some of the participants to scale up their level of participation in these markets. Currency Derivatives 58. The substantial rise in the currency futures volume, in a sense, is quite natural keeping in view cash settlement, the lack of requirement of underlying exposure and absence of any restriction on cancellation and re-booking, as currently applicable in the case of forward transactions. In case of forward foreign exchange contracts, AD Category-I banks, through verification of documentary evidence, have to be satisfied about the genuineness of the underlying exposure, irrespective of the transaction being a current or a capital account transaction. 59. There has been growing demands from the market participants to allow trading of currency future contracts in other major currency pairs to facilitate direct hedging of their exchange risk in such currencies. Accordingly, in the second quarter review of monetary policy, it has been proposed to permit the recognized stock exchanges to offer currency futures contracts in currency pairs of Euro-INR, Japanese Yen-INR and Pound Sterling-INR. 60. RBI had placed on its website the draft guidelines on OTC forex derivatives, in light of the developments in the domestic and international financial markets and based on the feedback received from banks, market participants, industry associations and others. It is proposed in the draft guidelines to permit the importers and exporters having foreign currency exposures in trade transactions, to write covered call and put options both in foreign currency-rupee and cross currency and also receive premia. Accordingly, the facility of zero cost structures is to be withdrawn. 61. There have been concerns on the downside risk involved in allowing the exporters/importers to write covered call and put options. This is the precise reason why the draft guidelines had stipulated stringent preconditions for use of such products. The AD category I banks have to ensure that the customers have sound risk management system, the corporates should have adopted AS 30 and AS 32, the corporates can not combine these options with any other derivative products and moreover, the pricing of the premium has to be done in a transparent manner. We have also received feedback to continue the facility of zero cost structures since some of the companies find the instrument useful in managing currency risks. However, the bundling of asymmetric risks makes it complex in pricing as well as in valuation and can be opaque to the risk managers and top management. 62. It is also proposed to continue to allow persons resident in India, other than banks and financial institutions to use FCY-INR swaps to transform long-term INR borrowing into foreign exchange liability. There have been concerns that the use of FCY-INR swap to convert long term Rupee borrowing into foreign exchange liability may lead to speculative trades in the absence of underlying risk exposures. However, this facility has been in existence for a decade and has supported distribution of foreign currency risks within the Indian market without increasing the overall external debt. Such a facility may come handy for a corporate, especially the exporters, having future foreign exchange receivables. The foreign exchange liability position assumed through FX swap may match with the foreign exchange receivables and provide the benefit of hedging. The issue is should such swaps be limited to only companies which have potential forex exposures. 64. Broadly speaking, the mandate for financial sector development should ideally derive from the regulatory assessments for each market. It has been clearly evidenced during the crisis that financial sector development per se cannot be an objective in itself. It needs to be pursued in the broader context of financial stability and has to necessarily correspond to the level of maturity of the financial system and the needs of the real economy. Reforming financial markets involves improving access to simple, transparent, and easy-to-understand products. Increasing complexity does not facilitate the market mechanism. The purpose of financial instruments is to transfer risk to those that understand these risks, not to hide or camouflage them. Regulatory comfort and assessment should therefore be a critical determinant in pursuing financial reforms. 66. The development of markets is also influenced by tax policies. Debt instruments for instance do not enjoy tax exemptions of the nature enjoyed by equity instruments whether on income or capital gains. Mutual funds fixed income products enjoy certain tax examptions not available to banks. But this is outside the regulatory purview. However, if these policies introduce any vulnerability in the financial system there is need to address this through appropriate macroprudential and microprudential regulations. 1 RBI Annual Report 1999-2000 7Minton, Bernadette, René M. Stulz, and Rohan Williamson, January 2008, “How much do banks use credit derivatives to hedge loans?, Fisher College of Business Working Paper Series 8Subbarao, Duvvuri, Financial Stability: Issues and Challenges, September 2009 9BIS triennial survey 2007. In the aftermath of the failure of the Lehman brothers, bid-ask spreads increased sharply. 10- As per CCIL data, as on November 27, 2009, the total outstanding notional principal (inter-bank and PDs only) under MIBOR OIS stands at Rs.25,72,339 crore and that under MIFOR-OIS stands at Rs.7,62,356 crore as at November 27, 2009. |