Pursuit of financial stability:

The Indian experience

Dimple BhandiaJanuary 15, 2013

Financial Stability – In search of a definitionFinancial Stability – In search of a definition

Financial Stability… Dimensions

Broad, encompassing

And Forward looking

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.

Factors Affecting Financial StabilityFactors 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 StabilityWhy Financial Stability Impact – potentially severe

Especially for emerging markets

Contagion – worldwide tentacles 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 CrisisLessons learnt from the Crisis

Lessons learnt from the CrisisLessons learnt from the Crisis

Recognition of the need to pursue financial stability as an explicit policy objective

The Need to strengthen the macro-prudential framework 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

tools to promote financial stability

Innumerable!

Systemic RisksSystemic RisksSystemic 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 RisksSystemic RisksTime 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 RisksMeasuring 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 ReportsFinancial 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.”

– Lars Svensson (2003), NBER WP 9486

Trends in Reporting Financial Trends in Reporting Financial StabilityStability

Number of countries publishing FSRs

Source: “Financial Stability Reports: What are they good for”, Martin Cihak, et al, World Bank, Dec 2011

Characteristics of FSRsCharacteristics 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 FRSTrends 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 RoleRBI Central Office Building, Mumbai

Financial Stability and the Reserve Bank of IndiaFinancial 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.

Financial Stability and Development CouncilFinancial 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

The responsibility of

FSDC includes

The Financial Stability UnitThe Financial Stability Unit

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

An operationally independent FSU was set up in July 2009 with the following mandate:

The Indian Financial SystemThe Indian Financial System

Percentage Share in total financial assets

Diverse but largely within a defined regulatory perimeter

Financial Network Analysis … (1) 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) Financial Network Analysis …(2)

Tiered structure of the banking system

Financial Network Analysis …(3) Financial Network Analysis …(3)

The network of the financial system

Financial Network Analysis …(4) Financial Network Analysis …(4) Contagion Analysis

Banking Stability Measures 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 Index (BSI) - the expected number of banks under distress if at least one bank is under distress.

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Stress testingStress 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 TestsMacro Stress TestsMacro 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)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 to assess vulnerabilities emanating from Systemic Liquidity conditions Fiscal situation External Sector Housing Prices

Stability Maps and Indicators… (2)Stability Maps and Indicators… (2)Financial Stability Map and Indicator

Financial Stability Indicator **Financial Stability Map *

(*) Away from centre implies higher risk (**) Higher level implies lower stability

Stability Maps and Indicators… (3)Stability Maps and Indicators… (3)

Macro Stability Map

Macroeconomic Stability Map *

(*) Away from centre implies higher risk

Stability Maps and Indicators… (4)Stability Maps and Indicators… (4)

Financial Markets Stability Map and Indicator

Financial Markets Stability Indicator **Financial Markets Stability Map *

(*) Away from centre implies higher risk (**) Higher level implies lower stability

Stability Maps and Indicators… (5)Stability Maps and Indicators… (5)

Banking Stability Map and Indicator

Banking Stability Map * Banking Stability Indicator **

(*) Away from centre implies higher risk (**) Higher level implies lower stability

Assessment of Systemic Risks - ChallengesAssessment 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 - ChallengesPublishing 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

• Regular publications help in preventing “over” interpretation

• Loss of credibility– Crying wolf – Most risks communicated will not materialise

• Data gaps and challenges in systemic risk assessment– Validity of models/conclusions

Public policy?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– The Holy Trinity of price stability, financial stability and growth

Questions?