Pursuit of financial financial stability: stability: The Indian experience
Dimple Bhandia January 15, 2013
Financial Stability – Stability – In In search of a definition There is no universally accepted definition of financial stability. Definitions by various experts abound but most definitions are not amenable to quantification. Financial system functioning without disruption and return to steady state after periods of volatility/vulnerability without significant impairment to longer term prospects, is generally considered an indicator of stability. Volatilities within an acceptable/tolerable range can represent a state of financial stability.
Financial Stability… Dimensions
Broad, encompassing
And Forward looking
Factors Affecting Financial Stability
Vulnerabilities in the real economy Global imbalances and rapid capital flows Complex financial products and rapid technological development Asset price bubbles Shadow banking system Light touch regulation Contagion Interconnected markets Too big to fail counterparties Well….. Virtually anything…. Anywhere!!!
Why Financial Stability
Impact – potentially severe
Especially markets
Contagion tentacles
for
–
emerging
worldwide
Financial instability anywhere can be a threat to financial stability everywhere…
Theory of decoupling weaker than accepted
Sectors
Real and financial sectors through feedback loops
Lessons learnt from the Crisis
Lessons learnt from the Crisis Innumerable!
Recognition of the need to pursue financial stability as an explicit policy objective
The Need framework
to
strengthen
the
macro-prudential
To see both the forest and the trees!!
The need to better identify, assess and manage the systemic risks prevailing in the financial sector.
Renewed policymaker interest in developing and improving
Systemic Risks Systemic events •
Can be broadly understood broadly as financial instabilities spreading to the extent that the financial intermediation process is impaired and economic growth and welfare suffer materially
Systemic risks •
Risk of occurrence of a systemic event
Systemic Risks Time dimension:
Financial imbalances that build up gradually over time may unravel suddenly.
Cross sectional dimensions:
Contagion risk - an initially idiosyncratic problem that becomes more widespread, often in a sequential fashion.
Shared exposure to financial market shocks or adverse macroeconomic developments that affect a range of financial intermediaries and markets at the same time
Measuring Systemic Risks •
•
•
Identification of systemic risks is far from straightforward given that systemic risks per se are complex and multifaceted. There is a need to have a wide range of measures and tools covering different aspects of systemic risks. A host of new quantification measures have, post the crisis, emerged in academic literature, while central banks are developing tools and techniques which will help identify and measure systemic risks.
Measures of systemic risk contribution •
•
•
Treat systemic risk as the extent to which individual financial institution pollutes the “public good” of overall financial stability Focus on the systemic risk contribution of individual institutions In principle, such measures, if accurate, could be used for Pigouvian taxes, levies or other regulatory interventions aimed at internalizing the negative externalities –
The additional capital surcharge proposed to be levied on Globally Systemically Important Banks
Modeling Risks of Aggregate Shocks •
•
Focus on the impact of macroeconomic shocks on the financial system –
Adverse macroeconomic scenarios used in stress testing
–
To assess resilience of financial institutions
Macroeconomic shocks matter for financial stability! –
–
•
They tend to affect all firms in an economy, financial and nonfinancial, at least to some extent. A macro shock causes an increase in correlated default losses, with detrimental effects on financial stability.
Stress-testing models are designed to map adverse macro-financial scenarios into losses in shared credit and asset exposures.
Financial Stability Reports •
Role of FSRs •
•
Limiting instability by pointing out key risks and vulnerabilities to policy makers, market participants and the public at large
A part of the macroprudential toolkit “These reports serve to assure the public and economic agents that everything is well in the financial sector when this is the case. They also serve as early warnings when problems show up at the horizon. Early action can then prevent any financial instability to materialise.”
Trends in Reporting Financial Stability Number of countries publishing FSRs
Source: “Financial Stability Reports: What are they good for”,
Characteristics of FSRs •
Standalone document
•
Generally central bank oriented
•
•
Focus on risks and exposures of the financial system •
Systemic risk
•
Forward looking perspective
•
Analysis of financial interconnectedness
Regularly published
Trends in contents of FRS •
Of late •
Use of more sophisticated market based indicators
•
Use of stress testing
•
Presenting results of early warning systems
•
Extensive use of disaggregated data
•
Extensive use of modelling
Central banks and financial stability •
Prior to the crisis –
–
Exclusive (excessive?) focus on price stability Asset price bubbles – central banking function? •
–
–
Greenspan orthodoxy
Light touch regulation Risks identified – but no action taken
Central banks and financial stability •
Post the crisis –
–
•
Recognition of the need to pursue financial stability as an explicit policy objective Widespread amendments to regulatory infrastructure (national and international) and legislations to pursue financial stability
THE HOLY TRINITY! –
Price Stability, Financial Stability and Sovereign Debt Sustainability
The Reserve Bank of India Raison d'être –
……to regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage The Preamble of the Reserve Bank of India Act, 1934
First RBI Building 1935, Kolkata
Now… “A full services central bank” •
Monetary Authority
•
Issuer of Currency
•
Banker and Debt Manager to Government
•
Banker to banks
•
Regulator of the Banking System
•
Manager of Foreign Exchange
•
Regulatory of Payment and settlement systems
•
Maintaining Financial Stability
•
Development Role
Financial Stability and the Reserve Bank of India Maintaining financial stability has been an explicit objective of the Reserve Bank since 2004.
The Reserve Bank has, over the years, attempted to address both aspects of systemic risks – the time dimension (procyclicality) and the cross sectional dimension (interconnectedness) within a macroprudential framework, without christening these policies as macroprudential policies.
Board for Financial Supervision
Board for Payment and Settlement Systems
Separate committees of RBI Central Board responsible for focussed regulation and supervision of institutions and system
Financial Stability and Development Council The FSDC, set up in 2010, is a body consisting all regulators and the Ministry of Finance. It is the highest forum in matters relating to financial stability. The Council is chaired by the Union Finance Minister
Financial Stability Interregulatory coordination
Financial literacy and financial inclusion
The responsibility of FSDC includes
Financial Sector Development
Macro prudential surveillance of the
The Financial Stability Unit An operationally independent FSU was set up in July 2009 with the following mandate:
Conduct of macro-prudential surveillance of the financial system on an ongoing basis.
Developing models for assessing financial stability
Conduct of systemic stress tests to assess resilience
Communicating risks to financial stability
Latest tools and techniques - Macro-financial stress testing - Network Analysis
Study of international best practices in systemic risk assessment
Systemic Risk Assessment Process In house econometric research and statistical studies to support assertions in the FSR
Robust and extensive analysis of a database of - Off site Banking and non banking sector supervisory returns - Ad hoc data requests from financial institutions
The Indian Financial System Diverse but largely within a defined regulatory perimeter 6
Scheduled Commercial Banks and LABs
4.1
Urban Cooperative Banks 13.5
Rural Cooperative Credit Institutions and RRBs NBFCs
2.4
Development Financial Institutions 6.5
59.3
Insurance Companies Provident and Pension Funds
5.8 2.3
Mutual Funds
Percentage Share in total financial assets
Financial Network Analysis … (1)
Network analysis is a tool which seeks to explore how systemic risks are affected by the structure of the financial system …
How does the size and distribution of exposures between banks determine the resilience of the system as a whole?
How does the potential for interbank exposures to transmit shocks from one bank to another inter relate with the aggregate amount of capital available to cushion shocks?
Are more concentrated banking systems with a small number of large banks, more or less susceptible systemic breakdown than systems that comprise a large number of small banks?
Are ‘tiered’ systems, where a small number of ‘core’ banks
coexist with a fringe of smaller banks in the ‘periphery’ more or less susceptible to systemic breakdowns than less tiered or more uniform systems?
Financial Network Analysis …(2)
Tiered structure of the banking system
Financial Network Analysis …(3)
The network of the financial system
Financial Network Analysis …(4) Contagion Analysis
Banking Stability Measures Modeling Distress dependencies among banks Probability of Distress based on equity prices of select banks Joint Probability of Distress
(JPoD) - probability that all banks in the system experience large losses simultaneously.
Banking Stability Ind ex
(BSI) - the expected number of banks under distress if at least one bank is under distress. 5
0.006 0.0001
0.005
0
4
Jun-10
Jun-11
Jun-12
0.004
3
D
I S B
0.003 o
P J
2
0.002
1
0.001
0
0
8 0 n a J
8 8 0 - 0 y g a u M A
8 9 0 - 0 v b o e N F
9 9 0 - 0 y g a u M A
9 0 0 - 1 v b o e N F
BSI
0 0 1 - 1 y g a u M A
0 1 1 - 1 v b o e N F
1 1 1 - 1 y g a u M A
JPoD
1 2 1 - 1 v b o e N F
2 2 1 - 1 y g a u M A
Stress testing
Macro financial stress tests
Testing the resilience of financial institutions to adverse movements in macroeconomic variables
Sensitivity Analysis
Supplement to macro stress tests
Assessing resilience of financial institutions to adverse movements in a range of risk factors covering foreign exchange, liquidity, interest rate and credit risks
Both top down and bottom up stress testing deployed
Stress testing the derivative portfolio of banks
Sensitivity and Scenario analysis
Macro Stress Tests Macro stress testes assess the vulnerability of the banking system to extreme but plausible adverse macroeconomic shocks. Bank group level NPA and CRAR are projected using various econometric tools, like, multivariate regression, panel regression, logit regression, Vector Autoregression(VAR), Quantile regression, etc. Projected Gross NPA ratio using Different Models (FSR June 2012)
Projected CRAR using Different Models (FSR June 2012)
Stability Maps and Indicators… (1) Maps and Indicators Macroeconomic Stability –
assesses risk conditions in the
macroeconomy Financial Markets Stability – assesses stability of financial markets Banking Stability – assesses changes in underlying conditions/risk factors affecting the banking sector’s stability Financial Stability
– assesses overall stability conditions in the Indian financial system
Supplementary Indicators emanating from
Systemic Liquidity conditions Fiscal situation External Sector Housing Prices
to
assess
vulnerabilities
Stability Maps and Indicators… (2)
Financial Stability Map and Indicator
Financial Stability Map *
Financial Stability Indicator **
Macro Stability
1.0
0.8
0.6
0.4
Financial Market Stability
Banking Stability
0.2
0.0
Mar-11
Sep-11
Mar-12
(*) Away from centre implies higher risk
8 0 c e D
9 0 r a M
9 0 n u J
9 0 p e S
9 0 c e D
0 1 r a M
0 1 n u J
0 1 p e S
0 1 c e D
1 1 r a M
1 1 n u J
1 1 p e S
1 2 1 - 1 c r e D
(**) Higher level implies lower stability
Stability Maps and Indicators… (3)
Macro Stability Map Macroeconomic Stability Map * Global
Household
Growth
Corporate
Inflation
Fiscal Index
2010-11:Q4
External
2011-12:Q2
2011-12:Q4
(*) Away from centre implies higher risk
Stability Maps and Indicators… (4)
Financial Markets Stability Map and Indicator Financial Markets Stability Map *
(*) Away from centre implies higher risk
Financial Markets Stability Indicator **
(**) Higher level implies lower stability
Stability Maps and Indicators… (5)
Banking Stability Map and Indicator Banking Stability Map * Soundness 1.0
1.0
0.8
0.9
0.6
0.8
0.4
Efficiency
Banking Stability Indicator **
Quality
0.7
0.2
0.6
0.0
0.5 0.4 0.3 0.2
Liquidity
Profitability
0.1 0.0
MAR11
SEP11
MAR12
(*) Away from centre implies higher risk
1 1 2 2 3 3 0 0 0 0 0 0 E E E S S S
4 5 5 6 6 7 7 8 8 0 0 0 0 0 0 0 0 0 E E E E E S S S S S
(**) Higher level implies lower stability
Assessment of Systemic Risks - Challenges •
•
Complex and opaque - Difficult to Measure
No universally accepted definition
Risk factors are generally not observable – hence difficult to quantify
Large mass of uncertainties – “known” and unknown”
Effectiveness and appropriateness of tools is not easily measurable
Significant data gaps
Challenges in “connecting the dots”
Assessment – a “best estimate” •
•
Type I and Type II errors
The Learning curve is steep!
Publishing of FSRs - Challenges •
Some financial stability issues too sensitive to be discussed publicly –
–
Could trigger behaviour likely to provoke a crisis, especially in times when the financial system is already disturbed Exist real, inherent constraints in communicating tail risks •
•
help
in
preventing
“over”
Loss of credibility –
•
Regular publications interpretation
Crying wolf – Most risks communicated will not materialise
Data gaps and challenges in systemic risk assessment –
Validity of models/conclusions
Public policy? •
Financial stability and growth – two sides of the same coin? •
Conventional wisdom says: financial stability promotes and stimulates growth…… –
“ A stable financial system is a pre-requisite for sustainable economic growth” (William Dudley, New York Fed, 2011)
–
……But evidence scarce!
–
What about financial instability?
•
Price stability and financial stability Are there trade offs?
•
Return of fiscal dominance over monetary policy?
•
Accountability of central banks
•
The new trilemma
