Owing to the financial crisis and its impact on the formulation of regulations by the Reserve Bank of India (RBI) deputy governor Shyamala Gopinath has said going forward, the test for further market development will be based on an assessment of not only implications for an individual institution-micro prudential but also implications for systemic risks.
Gopinath was addressing 10th FIMMDA-PDAI Annual Conference at Mumbai on ?Lessons for Financial Policymaking ? Interpreting the Dilemmas.?
On rating agencies she said the agencies have already received their share of blame for the crisis. ?That’s the easier part; the difficult part is to find viable alternatives – the rating agencies were part of a big machine that was working well as long as the going was good. Obviously, any alternative framework has to be in sync with the changed realities of the market. Its will not be possible to think of any changes in this regard in isolation,” she said.
At a fundamental level, what needs to change, and hopefully will change, is an understanding about what the ratings convey.
“What needs to change is an understanding of the difference between a AAA bond and a AAA CDO tranche. Here, more than the rating agencies, the responsibility will lie on the regulators to capture the differential risk characterstics of various instruments, even though identically rated, in a very specific manner in their prescriptions. Uniform capital requirements just based on credit ratings will need to be replaced by a more granular and nuanced regulatory approach,” she explained.
The financial system in India has been resilient in these trying times. Whatever fault points have been felt in the recent months do not owe their origin within the financial sector.
“As governor Subbarao has aptly remarked in one of his speeches, Indian experience has been different in the sense that the strain in the real sector got transmitted to the financial sector unlike the other countries where it was the other way round. It is only thorough a constant process of mutual consultation between the market participants and the RBI that we will ride the difficult period,” she said .
However, in the medium term, what may also need to be re-looked into is the interpretation of the term ‘regulatory capital’. When there are attempts to stress test the banks’ balance sheets, the focus is on the tangible networth, which is the purest form of capital.
“The crisis, therefore, provides us an impetus to review the permissibility of hybrid/ innovative forms of capital instruments and the extent to which these should be allowed as a component of the banks’ regulatory capital and greater emphasis has to be given to maintenance of core capital,” she added.
Another important instrument to contain excessive leverage during an upswing is to introduce a “leverage ratio”, in addition to the risk weighted capital ratio, covering both, the on-balance sheet assets and off balance sheet items. This practice is already in vogue in certain jurisdictions.
She pointed out that a more fundamental issue with a capital-centric approach of bank regulation is that even the most well capitalised banks have been found to have been caught up in the crisis spiral due to massive and immediate demands on liquidity. The capital buffers are of virtually no assistance in such times and what matters is the liquidity of the assets held by the bank and the nature of its interconnected dealings with other institutions.
“One view is that the financial regulator could give up its strong focus on capital adequacy alone in favour of a broader approach, which should encompass liquidity as a major determinant of the soundness of the financial system. It is, however, preferable to consider counter-cyclical liquidity requirements along with capital requirements,” she pointed out.
A proposal is to require banks to hold a varying proportion of their assets in a war-chest of government bonds and other highly liquid assets or there should be certain constraints on the extent to which they are allowed to tap wholesale funds. The overall framework should ensure availability of ample liquidity even in stressed conditions. This must include an assessment of the potential externalities across institutions. It is gratifying to note that the significance of the age-old SLR requirement in India and the ceiling prescribed on the inter-bank liabilities a few years ago is now getting recognised internationally, in the wake of the crisis, she said .