The “official” onset of the global financial crisis is usually associated with the collapse of Lehman Brothers on September 15, 2008. Today, we enter the decadal year of the global financial crisis, and it is time to reflect on what went wrong and how the global banking and financial system has moved to safety. However, with a huge load of stressed assets on their balance-sheets, Indian banks, particularly public sector banks (PSBs), are still a drag on the growth potential of India.
There is no one single cause or reason for the global financial crisis of 2008. Many reasons are ascribed. There was a continuing imbalance in the “real” sector of the global economy: in the trade account, China (and some other Asian economies) and Germany had huge surpluses against advanced economies like the US and other European countries, and thereby accumulated foreign exchange reserves. These reserves created imbalances in these trade surplus economies and spilled into the capital accounts of advanced economies of the US and Europe.
Fault-lines were developing in the socio-economic fabric of the USA, as described by Dr Raguram G Rajan in his seminal book, Fault lines, due to stagnant income and increasing poverty. When politicians could not reduce poverty and inequality, they found abundance of money in the economy and devised schemes for banks to lend mortgage loans to the sub-prime borrowers. If they can’t eat bread, “let them eat credit.”
The persistence of capital flows into the advanced economies depressed yields or returns on investment and in “search for yield” financial engineers developed innovative products like securitisation, re-securitisation, credit default obligations, credit default swaps, and etc, on the mortgaged-backed securities.
The banks’ business model underwent a change from “origin to hold till maturity” to “origin to distribute”. Cheap liquidity available in abundance in the wholesale funding market encouraged banks to over-leverage. What was missing was capital, that too high quality, core equity capital in the banks’ books. The regulatory requirement of common equity Tier 1 capital, of Basel I vintage (1988), was too meagre and did not keep pace with time. Banks indulged in capital arbitrage by keeping their trading exposures to mortgage-backed securities in the banking book, instead of the trading book where capital requirement was higher.
The corporate governance and executive compensation schemes of banks were poorly designed, which rewarded short-term performance over long-term achievement. The leaders of the financial world were lulled by the success of “financial engineering” and got carried away by “irrational exuberance” and could not see the “black swan” lurking at the door. Their immense faith in the capitalist system of “free markets” dissuaded them to “lean against the wind”. When interest rates did turn, they were caught unprepared.
Credit rating agencies did a poor job while rating the sub-prime mortgage backed securities and the derivatives based on them. Did they “junk” themselves? And finally, what about the regulators? They were perhaps sleeping at the wheel. In focusing on individual financial institutions (micro-prudential regulation and supervision), they missed the macro picture. The financial sector had become too big in relation to the real sector and was perhaps beyond the capacity of the regulators.
“This time was different”: The global financial crisis of 2008 was different from earlier crises on account of the roles played by the wholesale funding markets and the “shadow” banking system. Unregulated, or under light-touch regulation, they froze the funding markets when the crisis hit the financial institutions and there was a liquidity squeeze. The liquidity risk soon spread to the entire financial system and became a systemic risk going out of control. A liquidity crisis became the global financial crisis, nay, economic crisis, where the support extended by the authorities of advanced economies to their banks and financial system was almost a quarter of their GDP: the so-called “privatisation of profits and socialisation of losses”.
Post-crisis, under the auspices of G20, the Financial Stability Board (FSB) and the Basel Committee on Banking Supervision (BCBS), several measures have been introduced to strengthen the financial regulatory system. The Basel III package envisaged improving the banking sector’s ability to absorb shocks and reducing risk spill over to the real economy. The Basel III package includes micro-prudential regulation at individual bank level and overlay of macro-prudential regulation at system-wide level.
As a micro-prudential measure, Basel III raised the quality, quantity, consistency and transparency of the capital base of banks, with emphasis on core equity capital, to absorb losses during crisis like situations. The risk coverage of capital has been enhanced in respect of counter-party credit risk. A leverage ratio has been stipulated to supplement capital ratio and to contain build-up of leverage in the banking system. A liquidity framework to contain short-term liquidity risk (liquidity coverage ratio) and to contain structural liquidity risk (net stable funding ratio) has been introduced.
From macro-prudential or systemic risk regulation perspective, the Basel III leverage ratio would contain system-wide build-up of leverage that results in a destabilising unwinding process during stress and protects the perverse incentive to pile into low-risk assets, producing a systemic risk. Capital conservation buffer has been designed to create capital buffer, instead of distributing dividends, when times are good, and the same can be drawn down during times of stress. Counter-cyclical capital requirement has been put in place to protect banking system from periods of excessive credit growth, which is often associated with system-wide risk.
To avoid the moral hazard associated with “too big to fail” problem, a list of global systemic important banks (G-SIBs) has been drawn. The G-SIBs are required to self-insure themselves with additional capital, without depending the exchequer to bail them out during a crisis. Similar arrangements have been made for domestic systemic important banks (D-SIBs). The FSB and the BCBS have also put in place a Total Loss-Absorbing Capacity (TLAC) framework for G-SIBs, which will obviate the need for public money to rescues the big banks when they are in stress.
In collaboration with accounting standard setters, substantial progress has been made in devising a “expected loss” based loan loss provisioning, instead of the present “incurred loss” approach.
The Basel Committee has been monitoring the progress of implementation of Basel III package, to be fully the phased-in by January 1, 2019. In its latest Basel III Monitoring Report published on September 12, 2017, based on a sample data of 200 banks from different jurisdictions, as on December 31, 2016, Basel Committee has reported that on an average, banks have met with the new requirements.
India has also introduced the Basel III package with right earnest. However, the present stress in the balance sheets of our PSBs has considerably eroded their capital base. Bereft of adequate capital, PSBs can only manage to survive, not grow. Time is now opportune to reflect how to immediately recapitalise the PSBs in order to achieve healthy growth.
The author is former executive director, Reserve Bank of India.