Column: Managing the too-big-to-fail

Written by K Vaidya Nathan | Updated: Dec 16 2013, 10:32am hrs
Reserve Bank of India (RBI) recently released on its website the draft framework for dealing with Domestic Systemically Important Banks (D-SIBs). The draft framework discusses the methodology to be adopted by RBI for identifying the D-SIBs and proposes regulatory and supervisory policies that large banks would be subjected to. Reserve Bank had indicated in the second-quarter review of monetary policy that it would place a draft of the proposed framework for

D-SIBs on its website by end-November 2013 and, for a change, it actually pretty much stuck to its schedule by releasing it in the first week of December.

Post the financial crisis of 2008, an important policy focus for regulatorssome would say the major focuswas, and continues to be, risks to the financial system posed by SIBs as they have come to be known. These institutions, at the domestic level (D-SIBs), are institutions of such size, interconnectedness, and financial system importance that their failure, or even their severe distress, causes significant destabilisation and substantial adverse economic consequences. For instance, a bank like SBI or ICICI is so systemically significant that if it were to exit, it could potentially cause a major disruption to the Indian financial system. A D-SIBs contribution to systemic risk is therefore reflected in the size of its liabilities and the impact its failure may have on markets and the real economy. If a bank like HDFC is domestically viewed as too-big-to-fail, it exacerbates moral hazard concerns. The implicit public guarantee for such banks is seen as translating into a funding advantage that distorts market competition. RBI therefore needs to regulate the D-SIBs more sternly so that they pay for the negative externalities they create and are incentivised to become less-systemically important.

My assessment of the new capital requirements by RBI is that it has maintained the Basel Committees buffer-on-a-buffer approach in determining the safety net to make D-SIBs more resilient to financial and economic shocks and, as such, to reduce the likelihood of failure. More capital absorbs more losses in bad times; however, the magic number approach propagates a tick-box compliance mentality (see chart) typical of Indian banks rather than support proactive risk management. The add-on prescription for D-SIBs by RBI undermines the need for bank management to think critically about risk management, while the one-size-fits-all approach, even with tier-ing banks into buckets of systemic importance, is an agnostic approach to the source and concentrations of risks.

My sense is that this latest framework could have some impact on capital-raising of Indian banks, though as of now, it is a sealed verdict on how each bank would get affected. The actual verdict would be known only in August 2015, when the first list of banks identified by RBI as D-SIBs is out. For instance, a brokerage house expects at least 15 banks to be classified as D-SIBs (Financial Express, December 4, http://goo.gl/2dZiBQ). There would be some speculation around the names till then and even some conjecturing on what the additional capital requirement will be for each of these banks. Without full clarity as of now, this could have an effect on the market pricing of securities issued by large Indian banks and possibly also affect capital available to them. I would expect the potential D-SIBs to start preparing to meet this additional loss requirement sooner rather than later. Banks are likely to operate with a small cushion above the Basel capital buffer layers, due to the consequences they may face such as restrictions placed on distributions to shareholders, should the buffer get eroded, or if they grow in systemic importance.

Banks in India have a number of options to comply with the new loss absorbency requirement. These include capitalising retained earnings (assuming profitability is maintained), raising new equity, or reducing risk-weighted assets, which means reducing trading activity and lending. Banks will also probably try and keep lending off their balance sheets, either by helping Indian companies to issue bonds, or through securitisations. The capital surcharge could therefore impact adversely, not just the return on equity of these banks, but also the supply and pricing of credit by banks to the rest of the Indian economy. In essence, the surcharge penalises banks for diversifying their risk profile across business lines and assets geographically within India. There could therefore be an unintended consequence of reducing their financial stability. For instance, banks like Canara Bank which have a strong regional presence in south India may start to review their long-term strategies and evaluate their product and geographic mixes (especially in north India) in order to assess where adequate returns can be made. This creates the likelihood of potential exits from lines of business and specific geographic markets within India, which in turn, could weaken national banking systems as other domestic banks may not have the scale, infrastructure, or loss-bearing capacity to fill in the vast Indian economys demand for banking services. Alternatively, exits may translate into higher pricing for certain services by national providers, or business growth in unregulated segments (shadow banking system). All in all, even though RBI, for a change, may have stuck to its schedule of announcing the D-SIB guidelines in time, it adds uncertainty to the capital raising process and operations of banks at a time when they are dealing with a challenging domestic economic environment.

The author, formerly with JPMorganChases Global Capital Markets, trains finance professionals on derivatives and risk management