Systemic Risk and Macroprudential Policies –
Emerging Paradigm
Anand Sinha
Executive Director
Reserve Bank of India
Presentation made at BANCON
4 December 2010, Mumbai
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STRUCTURE OF PRESENTATION
A. What is Systemic Risk?
B. How does Systemic Risk Build up?
C. Enhancing Regulatory Framework to
Address Systemic Risk
D. Review of Indian Experience in Addressing
Systemic Risk
E. Institutional Framework of Systemic Regulation
F. Open Issues & Challenges
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A. WHAT IS SYSTEMIC RISK ?
• Systemic risk is defined in various ways.
• A representative definition following the work of the IMF, FSB
and BIS for the G20 is “a risk of disruption of financial services
that is caused by an impairment of all or parts of the financial
system and has the potential to have serious negative
consequences for the real economy”.
• Some features of the current “Great Financial Crisis”
- Estimated 210 million people unemployed, an increase of 30
million since 2007
- Cumulative output loss relative to trend in G20 countries facing
systemic crisis is 26 percent of GDP
- Debt to GDP ratio of advanced G20 countries is set to go up
from 75 percent in 2007 to 110 percent by 2014.
Source : Towards a Safer Global Financial System – Speech by Jose
Vinals, IMF – November 2010
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• Systemic risk has two dimensions :
- Cross-sectional dimension
- Time dimension
Cross sectional dimension pertains to how risk is allocated
within the financial system at a point in time.
- In this dimension the source is common expsoure and
interlinkages in the financial system leading to domino effect
(contagion) or vulnerability to joint failure due to
vulnerability to common sources of risk.
Time dimension deals with how aggregate risk in the
financial system evolves over time.
- Source is the pro-cyclicality of financial system. The
dynamics of the financial system and macroeconomy
intereact with each other increasing the amplitude of booms
and busts.
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B. HOW DOES SYSTEMIC RISK BUILD UP
 Systemic risk builds up through
– Contagion (inter-connectedness) and common exposures
– Procyclical nature of financial system and prudential
regulations –Leverage and Maturity Mismatches
– Regulatory arbitrage due to limited perimeter of
regulation
» Complex Products
» Institutions
» Markets
 financial innovation – opaque and poorly understood
products
 OTC Derivatives –Inadequate infrastructure
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• Procyclical nature of financial system
amplifies the business cycles which are
further amplified with the inter play of
prudential regulations relating to –
Capital
Provisioning
Fair value & VaR
• Pro-cyclicality is also aided by rules relating
to margins/haircuts and triggers and
compensation policies.
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Procyclical Nature of Financial System
• Financial factors can be a powerful amplifier of the
business cycle – Financial Accelerator (FA) at work
 FA Mechanism is procyclical.
 Asset Prices( )
Collateral ( ) Availability
of credit ( )
Consumption & Investment ( )
 Reverse Process in a downturn
• Financial firms themselves act procyclically.
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→ Nature of Systemic Risk: Asset Prices-Balance SheetLeverage Effect
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Procyclical Nature of Prudential Regulation
• During upswing, PD is low (lower capital requirement under
IRB), credit losses are low (lower provisioning), asset values
are high and market liquidity volumes rise with narrow bidask spreads.
• Build up of high leverage
• Conditions reverse in downturn.
• From 2003, onwards significant increase in leverage of many
commercial and investment banks though banks remained
adequately capitalised. Two large Swiss banks were among
best capitalised large international banks and on simple
leverage were among the worst capitalised.
• In retrospect conclusion is that capital estimated from risk
models particularly for trading book was grossly inadequate.
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• During downturn process reverses. Larger the leverage built
up during upturn, more severe would be the deleveraging
during downturn.
•
When risks are perceived to be low during upturn, systemic
risks are increasing and building up.
Fair Value and VaR
• In the trading book, application of fair value and use of VaR
results in procyclical behaviour, high asset values and low
VaR leading to build up of risk positions and leverage and
accentuates a downward price spiral triggering a vicious
cycle of asset sales and further price decline in downturn.
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• In the initial phase of current crisis- severe losses from
trading book positions – several times what VaR models
would have predicted.
Margins/Haircuts/Triggers
• Margins/haircuts in derivatives and securities transactions –
lower in upswing (liquid markets, low volatility) – higher
leverage and are higher during downturn (illiquid markets,
high volatility) exhibiting procyclical behaviour as defense
against counterparty risk.
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• Ratings/Market Value based triggers in OTC derivatives
contracts- requirement to post collateral when rating goes
below a trigger large liquidity shock – Procyclical e.g.
→ AIG – Protection seller (CDS) on higher tranches of exotic
products like CDOs and CLOs– obligations $ 400 billion –
rating downgrade –collateral calls-possibility of bankruptcysystemic risk due to threat to protection buyers-could result
in massive write offs /sales-received $ 85 billion loan
secured against all assets.
Compensation Policies
•
Compensation schemes tied to short-term profits and no
link to risk lead to misalignment of incentives and
encourage excessive risk-taking in upswing.
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Maturity Mismatches
• Asset-liability maturity mismatch exposes firms to funding
liquidity risk.
• Funding liquidity risk shoots up if funding liquidity dries up
liquidity freeze or high credit risk
high margins/ haircuts, restrained lending
forced liquidation of assets
Fire sale discounts- lossesmarket liquidity evaporates
• Large maturity mismatches in the system
Acute funding liquidity risk
aggravates maturity mismatches
liquidity spiral.
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• With the above sequence affecting many market players,
booms and busts amplified
• Current crisis – large aggregate maturity transformation by
banks, investment banks and shadow banking sector:
 SIVs, Conduits funded long term investments with short
term notes.
 Investment banks - value of outstanding Repos tripled
between 2001 and 2007 with particular rapid growth of
overnight repos.
 Mutual funds, particularly in USA held long term credit
assets against on demand, at par (implicit/explicit)
redemption of liabilities to investors.
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Limited Perimeter of Regulation- Shadow Banking
• Emergence of highly leveraged non-deposit taking bank-like
entities performing bank like functions
 lending long (holding poor quality illiquid long term
securities) funded by short term borrowings with little
capital and governance standards
 Assumed significant credit and liquidity risks
 Outside regulatory perimeter and without LOLR support
• SIVs, Conduits, Money Market Funds, Hedge Funds, PEFs,
other off-balance sheet vehicles.
• Total assets of shadow banking sector in USA estimated
at USD $ 10 trillion in late 2007, about the same size as
those of the banking system.
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• When liquidity froze on credit risk and valuation concerns of
toxic assets held, the entire shadow banking system
collapsed due to very high funding liquidity risk transferring
risks to the regulated banking system in many cases where
credit enhancement and contingent liquidity lines had been
provided and/ or on reputation concerns i.e. run on SIVs,
conduits
• Failure of Lehman Brothers, insolvency early in the crisis of
two Bear Sterns managed hedge funds.
• Regulation was institution specific (Microprudential). Did
not take adequate account of systemic risk posed by
interconnectedness, activities and markets despite some
steps taken (consolidated supervision, oversight of fund
managers (hedge funds), supporting codes of conduct for
private equity, etc.)
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• Misplaced approach – fallacy of composition. In reality
the risk of distress to financial system as a whole
(systemic risk) is larger than the sum of risks of individual
components.
• Action of individual entities impose negative externality
(spillover risk) to the rest of the system.
Financial Innovation
Limited scope of regulation, along with ineffective market
discipline fostered innovation of opaque and poorly
understood products which increased systemic risk –
investors relied on credit ratings when conflict of interest
was growing in the rating of structured products
• Securitisation of large part of exposures remained within the
banking system.
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C. ENHANCING REGULATORY FRAMEWORK TO
ADDRESS SYSTEMIC RISK
• A fundamental lesson from the current crisis is: effective
supervision at the individual firm level, while necessary, is
not sufficient
• Supplement strong microprudential regulation and effective
supervision with a macroprudential policy overlay
• Strengthening of Microprudential regulation (Basel III)
- Enhancement in quantity and quality of capital
- Raising of risk weight of instruments in the trading book
- Liquidity buffers
- Leverage ratio, etc.
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Macroprudential Policy and Tools are:
• Prudential (regulatory and supervisory)
policies and tools for efffectively monitoring
and addressing the build-up of systemic risks
for pursuing systemwide stability.
• Even a well developed macroprudential
approach is not a panacea.
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Policies and Tools for addressing time
dimension of systemic risk (Procyclicality)
• Basic idea is to build up capital buffer and provisions in good
times that can be drawn down in bad times so as to enable
banks to continue to lend and support the economy.
• Reducing/ eliminating the procyclicality of the minimum
capital requirement
• Capital conservation buffer (2.5% of common equity)
• Countercyclical capital requirement
• Countercyclical provisioning i.e. forward looking provisioning
• Compensation policies.
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Other measures used by Asian
countries
• Higher provisioning and/ or Risk Weights for rapidly
growing sectors
• LTV ratios
• Direct controls on lending to specific sectors
• Capital surcharges for systemically important banks
• Liquidity requirements
• Limits on currency mismatches
• Loan to deposit ratios.
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Policies and Tools for addressing crosssectional dimension of systemic risk
• Principle is to calibrate prudential tools based
on individual institutions’ contribution to the
systemic risk – Continuous approach
• In practice, the approach is to identify
Systemically Important Financial Institutions
(SIFIs) based on size, interconnectedness,
substitutability and other critieria and
calibrate prudential tools (capital, liquidity,
leverage, etc.) for them.
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Main features of the policy framework being
developed by BCBS and FSB are :
•
A resolution framework and other measures to ensure
that all financial institutions can be resolved safely,
quickly and without destabilising the financial system
and exposing the taxpayer to the risk of loss
A requirement that SIFIs and initially in particuar global
SIFIs (G-SIFIs) have higher loss absorbency capacity to
reflect the greater risks that these institutions pose to
the global financial system
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More intensive supervisory oversight for
financial institutions which may pose
systemic risk
Other supplementary prudential and other
requirements as determined by the national
authorities.
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Strengthening core financial infrastructure to
reduce contagious risk from failure of
individual institutions
• All standardised OTC derivatives contracts
should be traded on exchanges or electronic
trading platforms and cleared through Central
Counterparties (CCPs)
• OTC derivative contracts to be reported to
trade repositories.
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D. REVIEW OF INDIAN EXPERIENCE IN
ADDRESSING SYSTEMIC RISK
REGULATORY ARCHITECTURE
• Key segments of Indian financial system
( money market, Government securities
market, forex market and commercial
and cooperative banks, NBFCs) fall
within the regulatory jurisdiction of RBI.
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• The channels of interconnectedness between
banks and other financial sector entities are
within the regulatory purview of RBI.
• Coordination among RBI, Securities and
Exchange Board of India and Insurance
Regulatory and Development Authority is
ensured through the forum of - High Level
Coordination Committee on Financial
Markets
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EXPANDING SCOPE OF REGULATION
• Regulation of non-banking entities is being progressively
strengthened by the respective regulators.
• NBFCs owned by foreign banks, and regulated by RBI
brought under the Group concept with the foreign bank
branches to contain the regulatory arbitrage though legally
they do not form a Group.
• An elaborate prudential framework put in place for
systemically important non-deposit taking NBFCs.
• Consolidated supervision of banking groups introduced in
2003 and constantly strengthened thereafter.
• RBI has become the regulator of Payment and Settlement
Systems.
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RESTRICTIONS ON NON-BANKING ACTIVITIES OF
BANKS
• Limits on Banks’ equity investment in individual
financial subsidiaries/ affiliates.
• Banks not permitted activities not incidental to
banking and also not allowed to set up subsidiaries
for activities which banks are not permitted.
• Capital requirements for banks’ sponsoring of
private pools of capital on reputational risk
considerations.
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PRUDENTIAL MEASURES
• Basel-II implemented prudential limits on capital
market exposure
Monitoring of sensitive sector exposure
Securitisation guidelines
Prudential limits on bank exposures (funded and
non-funded) to non-bank finance companies individual as well as aggregate.
Lending and borrowing in call money market
limited to a percentage of capital funds of the
lending/borrowing bank.
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Call money market made a pure inter-bank
market.
Limits on inter-bank liabilities equal to
200% of net worth
Limit on Non- Government unlisted
securities
Investment in unrated debt securities not
permitted.
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OTHER MEASURES
• Quality of regulatory capital: Tier I capital of
banks should be at least 6% of RWA by March
31, 2010.
• Tier III capital for market risk not introduced,
as it is short term.
• Higher RW and/ or provisioning requirement
for exposure to sectors showing high credit
growth.
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ENSURING ADEQUATE LIQUIDITY
WITH INDIVIDUAL BANKS
BUFFERS
• SLR requirements
• Improvement in the framework for
monitoring and reporting of liquidity position
of individual banks - introduction of more
liquidity buckets within the 1-14 segment ( 1
day, 1-7 days, 8-14 days).
• Guidelines on Liquidity Risk Management
being upgraded.
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E. Institutional Framework of Systemic
Regulation
.
.
One single macroprudential regulator – control over
macroprudential tools, well formulated mandate,
sufficient authority and resources, professional
independence with accountability.
Large body of view favours Central Bank as
macroprudential regulator – expertise, reputational
authority, deep knowledge of financial markets (and
institutions where it is macroprudential regulator),
handling of monetary policy and experience in
handling financial stability issues
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• Lost of experiementation underway
• USA – Financial Stability Oversight Council
(FSOC) under Dodd Frank Act headed by
Treasury Secretary. FED has substantial role to
impose methods to lower systemic risk
• UK – BOE is the assigned body
• Eurozone – European System Risk Board
(ESRB) outside ECB
• India – Financial Stability Development
Council (FSDC)
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F. Open Issues & Challenges
• Framework in formative stage. Modelling of contribution to
systemic risk or for measuring systemic instability are in
infancy.
• Difficult to assess the impact of tools in reducing systemic risk
as no prior experience.
• Filling data gaps
• Those in charge of policy coordination with monetary policy,
fiscal policy and microprudential policies essential.
• Communication with markets essential for success of
macroprudential policies
• Communication with markets essential for success of
macroprudential policies
• Global coordination for international consistency of
macroprudential policies to minimise regulatory arbitrage. 36
• Consistency in implementation – peer group review
process
• Rules vs. discretion
• Setting up adequate resolution regimes – complex
legal issues, cost sharing issues
• All efforts focussed on banks – advantage to nonbanking financial firms. Perimeter of regulation will
have to expand and greater consistency in prudential
treatment will be essential
• Challenging task coping with the profileration of new
instituions and activities – boundary problem
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THANK YOU
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