Financial Stability

PRMIA- HYDERABAD CHAPTER : 

PRMIA- HYDERABAD CHAPTER 1 Financial Stability B. YERRAM RAJU REGIONAL DIRECTOR This presentation is based on the RBI Report on Financial Stability enclosed to the RBI Bulletin April 2010.

When and Why think of Stability?- The Crisis and Consequential instability? : 

When and Why think of Stability?- The Crisis and Consequential instability? The crisis started in summer 2007 with lightning failure of Lehman Brothers, Washington Mutual Funds and 3 Iceland Banks. Mistrust and fear spread among Banks. Four Risk environmental factors still being probed: Financial Risk valuation models/methods Risk Control Functions Risk limiting strategies and Bonus Culture.

A Perspective on the Indian Approach on the Financial Policy Making : 

A Perspective on the Indian Approach on the Financial Policy Making Prudential policy framework for banks addressing: Leverage, liquidity, and counterparty concentration Recognition of NBFCs as systemically important and extension of regulatory perimeter An Active Capital Account management framework Explicit regulation of key OTC derivative markets. Despite relatively low exposure to global markets, the contagion impact of any global shocks not ruled out. 3

Healthy Banking sector : 

Healthy Banking sector Tighter regulatory standards on capital, liquidity and leverage for banks; Unregulated systematically important financial entities (NBFCs, Coops) brought under regulatory oversight Addressing systemic risks arising from interconnectedness among financial sector entities Regulating financial markets from a systemic risk perspective. 4

Key underpinnings : 

Key underpinnings Ensuring that the process of being away from disintermediation is genuine A clear, transparent capture of the risks within the prudential framework exists in the treatment of NBFCs Credit quality robust Share of low cost current and savings account deposits (CASA) is high Banks are required to hold a minimum percentage of their liabilities in risk free government securities. 5

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“Maintenance of financial stability involves trade-offs and raises a number of challenges.” (Financial Stability Report, RBI, April 2010) 6

What is Financial Stability : 

What is Financial Stability It is “a situation in which the financial sector provides critical services to the real economy without any discontinuity.” Absence of financial instability: ‘containment of the likelihood of failure of individual financial firms or any systemic stress and thereby limiting the associated costs to the economy.’ Arresting the possible consequence of ‘unknown unknowns’ and realising the limitations of modeling apparatus and stress testing exercises. 7

Financial Stability Board : 

Financial Stability Board Set up by G-20 in the aftermath of recession. Mandated to Assess vulnerabilities affecting the global financial system Identify and review the regulatory, supervisory and related actions needed to address them and their outcomes; Promote coordination and information exchange among the authorities responsible for FS Monitor and advise market development and their implications for regulatory policy; Advise and monitor best practices Undertake joint strategic reviews of policy development work on developing international standards Set guidelines for and support establishment of supervisory colleges Support contingency planning for cross-border crisis management Collaborate with the IMF to conduct Early Warning System Undertake any other tasks members may seek to perform. 8

Central Banks and FS-Key Aspects : 

Central Banks and FS-Key Aspects Supervision of individual firms from a systemic perspective Greater involvement of central banks where it is found wanting in supervision of systemically important entities A collegial body of government/central bank/regulators Reorientation of regulatory mandates of all regulators to also take into account a systemic perspective. Monetary stability supports sound investment and sustainable growth leading to FS 9

Principal Perspectives of FS : 

Principal Perspectives of FS FS has critical influence on price stability and sustained growth FS facilitates efficient transmission of monetary policy actions From the regulatory and supervisory angle, FS safeguards the depositors’ interests and ensures stability of the financial system. 10

Capital Account : 

Capital Account Buttressed through the imposition of prudential safeguards in respect of access of foreign entities to the domestic debt markets and on forex borrowings by domestic corporates. (Cap on FII investments in Corporate (US$15bn) and Government (US$5bn) bonds. 11

Liquidity Management : 

Liquidity Management 12

Liquidity Management (contd) : 

Liquidity Management (contd) Source: RBI FSR-2010 p 8 13

What made us distinct? : 

What made us distinct? The counter-cyclical regulations applied ahead of the global crisis helped us cushion against systemic instability. Significant reduction in risk and rebound in market activity Pressures on banking sector liquidity during the crisis together with extraordinary measures taken led to shortening of the maturity profile of bank liabilities Banks facing large refinancing needs in the following years Management of funding risks skillfully More stable customer deposits Sovereign and corporate CDS spreads broadly stabilised in Q2-2009 Corrections in equity prices in Emerging Market economies witnessed largely declines in the range of 30-67 percent. Gains started only in the Q3-2009 Stimulus measures significantly increased global liquidity. Forex markets – RBI’s presence in the market helped manage volatility –Forward Premia in Indian forex markets lower than the rate dictated by interest differential.

Regulatory Counter-cyclical Measures : 

Regulatory Counter-cyclical Measures 15

GDP Outlook : 

GDP Outlook Increasing business cycle correlation between developed and developing economies that enabled India’s current and capital a/c flows more than doubled from les than half of the country’s GDP in 1991 to over 100% of GDP in the last two years. Indian economy continued to be driven largely by domestic demand notwithstanding increasing globalization. Overall macro economic conditions affected by adverse shocks in farm sector growth – deficient monsoon;associated drought and flood in certain parts of the country; decline in kharif production of food grains and oil seeds.

GDP Outlook Contd.. : 

GDP Outlook Contd.. Tangible recovery since April 2009 in industry and services Upward bias strengthened due to Recovery in industry & core infrastructure Upturn in business & consumer confidence reflected in revival of consumption and investment demand Revival in exports and capital flows Recovery in stock market Higher resource mobilization thru public issues and private placements RBI’s growth forecast revised to 7.5% in 09-10

Exit Process had begun : 

Exit Process had begun SLR restored to 25% - on May 26 reduced to 24.5% to provide more liquidity in the wake of 3-G cash requirements of Telecom Companies. Export Credit refinance back to 15% Non-standard refinance facilities to commercial banks discontinued Jan 2010- CRR hiked by 75 basis points to 5.75% Repo and Reverse Repo hiked by 25 basis points. 18

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Liquidity ratios : 

Liquidity ratios 21

Liquidity Ratios : 

Liquidity Ratios 22

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Macro Economic Environment : 

Macro Economic Environment Global activity contraction of 0.8% in 2009 expected to recover by about 3.9% in 2010 (IMF-World Economic Outlook Jan) Global inflation remained subdued slipped into negative territory Anaemic aggregate demand, sharp decline in oil prices since mid 2008 Major corrections of agricultural commodity prices and metals Decline in capacity utilization Transfer of financial risks to sovereign balance sheets and higher public debt levels added to financial stability risks and complicated the stimulus-exit process 31

Soren Ramdhan Research Findings : 

Soren Ramdhan Research Findings Financial Crisis started in summer 2007 with the lightning failure of Lehman Bros and Washington Mutual Funds and 3 Iceland Banks It spread mistrust and fear among Banks and FIs Four Risk Environmental Factors still being probed: Financial Risk valuation models/methods Risk Control Functions Risk limiting strategies and Bonus culture Empirical evidence shows that financial risk performance was related with the factors: financial risk valuation models/methods and risk control functions. The factor risk control functions with the financial risk performance have a stronger relation than the factor financial risk valuation models/methods with financial risk performance. Remarkably, no evidence is found to support the relation between financial risk performance and the factors: risk-limiting strategies and bonus culture.   Financial institutions can achieve better financial risk performance by emphasizing more on the risk environmental conditions related with financial risk valuation models/methods and risk control functions.

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Financial crisis Started in 2007 Introduction (1) Risk environmental conditions Underestimated financial risk Risk environmental conditions Perfectly estimated financial risk Risk environmental factors Financial risk performance Root of the financial crisis Background/scope Scope of the research To identify the relation between financial risk performance of the last years and risk environmental factors influencing the performance. Research objective 13-6-2010 33 What were the risk environmental factors behind the financial risk performance? MRQ1

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Introduction (1) Effective financial risk management in the future. Learning from the past can be a solution for the future Need To identify the significant REC’s. Challenge Opportunity Risk practitioners, it is their performance. Perspective Reason 13-6-2010 34 To re-engineer the risk matrix and spread risk culture seamlessly integrating with the Business of the organization

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The dependent variable The independent variables The risk environmental factors Introduction (2) 13-6-2010 35 Financial risk performance (Estimated financial risk) Financial risk valuation models and methods Risk control functions Risk-limiting strategies Bonus culture The research model and questions To what extent was financial risk performance related with financial risk valuation models/methods? To what extent was financial risk performance related with risk control functions? To what extent was financial risk performance related with risk-limiting strategies? To what extent was financial risk performance related with bonus culture?

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Conclusions FRP was related with risk control functions (highest significant predictor). The beta of 0.381 is the extent of the relation. Financial risk performance (FRP) was related with financial risk valuation models/methods. The beta of 0.331 is the extent of the relation FRP was not related with risk-limiting strategies. FRP was not related with bonus culture 13-6-2010 36 The determinants of FRP are RISK DRIVERS related with the following 13 REC’s: Data, market variables, qualitative valuation methods, tail loss, stress test, and group-wide risk, system risk, solvability and integrity, strategic risk decision, day-to-day operational risk activities, and traders’ risk-awareness. Overall risk management failed due to: 1) Underdeveloped financial risk valuation models/methods, 2) Poor performance of risk control functions

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Recommendations (1) © Soerinder Ramadhin 13-6-2010 37 Financial institutions must emphasize more on the risk drivers related with the (13) REC’s by ensuring proper governance around the risk drivers. Regulators must extend their control activities among the risk drivers related with the (13) REC’s to ensure that a proper governance is applied among FI’s Management of Risk Evaluation Controls holds the key

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Thank You Hyderabad@prmia.org