A response to Dr. Subbarao's comments on systemic risk regulation in the draft Indian Financial Code

by Sowmya Rao.

At a recent conference organised by the Indian Merchants Chamber, the Reserve Bank of India (RBI) Governor, Mr. Duvvuri Subbarao, shared his views on lessons learnt from the global financial crisis. The full text of his speech is available here. While discussing financial stability, Mr. Subbarao discussed the recommendations of the Financial Sector Legislative Reforms Commission (FSLRC) on the Financial Stability and Development Council (FSDC). This post is a pointwise response to his text.

The big picture of FSLRC

The draft Indian Financial Code deals with all aspects of financial law, including consumer protection, microprudential regulation, resolution, systemic risk, and monetary policy. Accountability mechanisms and clarity of regulatory objectives are key themes of the recommendations.

The recommended regulatory architecture consists of a Resolution Corporation which will manage the resolution of failing firms, while regulators (RBI and the proposed Unified Financial Agency (UFA)) will pursue consumer protection and microprudential regulation. RBI (as the central bank) will perform monetary policy functions.

Since the legislative mandate of regulators will define their perspective and information access, an individual regulator dealing with say, banking, is likely to focus its operations on banking alone, and not the entire financial system. Systemic risk analysis, in contrast, requires a bird's eye view of the entire financial system, especially to identify interconnections or trace interdependencies. The heart of systemic risk thinking is to look at the woods and not the trees, while the instinct of micro-prudential regulation is to look at trees.

Hence, FSLRC recommended that systemic risk oversight was best executed by a council of regulatory agencies - the FSDC - assisted by a technical secretariat. The board of the FSDC comprises the Minister of Finance (Chairman), the Chairman of RBI, the Chairman of the UFA, the Chairman of the Resolution Corporation, the Chief Executive of the FSDC and an Administrative Law Member of FSDC.

Responses to Dr. D. Subbarao

What are the relative roles of monetary policy and macroprudential policies?

While terms such as financial stability, macroprudential regulation and systemic risk oversight are often used synonymously, the most technically sound term is 'systemic risk'.

FSLRC views monetary policy and systemic oversight as distinct, to be employed by relevant agencies best suited for each. The draft Indian Financial Code (IFC) clearly lays out the process of defining monetary policy objectives alongside quantified medium-term targets (government's responsibility), as well as that of implementing the objectives (RBI's responsibility). This would create accountability in monetary policy, which can then make possible monetary policy independence.

Similarly, the IFC also clearly defines the scope and extent of systemic oversight which is the responsibility of the FSDC. The FSLRC recommendations specifically note that there ought to be strict separation between microprudential regulation (the domain of regulators alone) and systemic oversight.

Under what circumstances should one, rather than the other, be invoked? How do these policies interact with each other?

If institutional synergy between monetary policy and systemic risk is emphasised, this leads to a blurring of accountability. Instead of placing multiple objectives within the same institution, which could cause a conflict of interest, FSLRC has recommended that there be clear regulatory objectives assigned to separate institutions that best serve the issue at hand. There must be no impediment to holding a body accountable for lapses; multiple objectives only serve to reduce such accountability.

In furtherance of this, FSLRC has carefully carved out the contours of these two roles, with monetary policy implemented by RBI and systemic risk oversight carried out by FSDC. These agencies will invoke their enumerated powers when the situations call for it as specified by the IFC.

When these agencies follow their mandates as defined under the IFC, an overlap of these roles is unlikely. To the extent that decisions taken under the rubric of monetary policy may affect systemic risk and vice versa, RBI's presence on the FSDC table should ensure that open conversations about such intersections take place.

If they are handled by different agencies, is it possible that they can work at cross purposes? Is there an inevitable political dimension to macroprudential policies?

Within microprudential regulation, there is little need for any authority other than the regulator to exist. However, the presence of the political dimension takes on particular relevance in systemic risk. When there is a threat of an imminent systemic crisis, many actions that are required must have the authorisation of the political executive. Such actions cannot be taken by any technically ground and non-political and independent regulatory agency. The Finance Minister's leadership of the board of the FSDC reflects India's experience with the role of ministers such as P. Chidambaram and Yashwant Sinha -- and the role of finance ministers worldwide in the global crisis -- in dealing with systemic crises.

FSDC is a forum for regulatory bodies to discuss their concerns, especially if any one agency (including FSDC itself) appears to be working at cross-purposes with the mandate of any other agency. The possibility that such a concern may arise should not preclude the creation of a body to mitigate systemic risk.

If yes, how does one protect the autonomy of the institution responsible for macroprudential policy?

In an area such as monetary policy or micro-prudential regulation, there is a case for autonomy of the institution. With systemic risk, there is an inescapable role for the political authority in dealing with crises. No RBI Governor could have dealt with the 2008 crisis or the 2001 crisis. These required the authority and decision-making powers of the Minister of Finance.

In its submission to the Commission during the consultative stage, the Reserve Bank argued that the financial stability mandate that the Reserve Bank has been carrying out historically by virtue of its broad mandate should be clearly defined and formalized.

At present, the RBI has no mandate to carry out the function of systemic risk oversight, nor is there a work program of this nature.

In law: The words `systemic risk' or `financial stability' or `macroprudential regulation' do not occur in the RBI Act. That mandate, as well as powers to perform that mandate, are absolutely absent in the RBI Act.

In fact: RBI does not have a database about the overall Indian financial system, nor does it have executive authority over financial firms which are not banks. It has no meaningful way of assessing inter-connectedness or risk in sectors other than banking and payments. As an example, much of the complex dynamics of the crisis of late 2008 took place beyond the information set of the RBI. Further, the RBI does not have powers to do anything about the overall Indian financial system. In terms of financial regulation, RBI is only a sectoral regulator dealing with two sectors (banking and payments).

The Commission has acknowledged comments made by RBI and responded as follows (see FSLRC Report, Volume I, Chapter 9): In the consultative processes of the Commission, the RBI expressed the view that it should be charged with the overall systemic risk oversight function. This view was debated extensively within the meetings of the Commission, however, there were several constraints in pursuing this institutional arrangement. In the architecture proposed by the Commission, the RBI would perform consumer protection and micro-prudential regulation only for the banking and payments sector. This implied that the RBI would be able to generate knowledge in these sectors alone from the viewpoint of the safety and soundness of such financial firms and the protection of the consumer in relation to these firms. This is distinct from the nature of information and access that would be required from the entire financial system for the purpose of addressing systemic risk.

The FSLRC recommendation that the executive responsibility for safeguarding systemic risk should vest with the FSDC Board runs counter to the post-crisis trend around the world of giving the collegial bodies responsibility only for coordination and for making recommendations.

The international experience comprises some important examples which shaped the working of FSLRC.

Financial Stability Oversight Council (FSOC) in the United States: Created post-crisis, this body consists of the US Treasury Secretary and heads of all regulatory bodies. FSOC has powers similar to those envisaged for FSDC, including designating non-bank institutions as Significantly Important Financial Institutions (SIFIs), where designated institutions are subject to heightened prudential and supervisory provisions.

(See Section 113 of the US - Dodd-Frank Wall Street Reform and Consumer Protection Act, 2010. Further, See Section 295 (Functions of the FSDC) and Section 299 (Designation of Systemically Important Financial Institutions) of the IFC.)

The European Systemic Risk Board (ESRB) in the European Union: Consisting of the heads of the European Central Bank, the Governors of the national central banks of the EU member states and the regulatory heads of insurance, pensions and securities, the ESRB has the power to issue recommendations and warnings. These are issued with a specified timeline for the addressee to respond with a relevant policy response. It is crucial to note that addressees of such a recommendation are required to communicate to the ESRB and to the EU Council the actions undertaken in response to the recommendation or justify any inaction on a comply or explain basis.

To date the ESRB has published recommendations touching upon a wide range of issues, namely; lending in foreign currencies; the macro-prudential mandate of national authorities; US dollar denominated funding of credit institutions; money market funds and funding of credit institutions.

(See Regulation (EU) No 1092 /2010 of the European Parliament, para 17)

The Reserve Bank is also of the view that in a bank dominated financial sector like that of India, the synergy between the central bank's monetary policy and its role as a lender of last resort on the one hand, and policies for financial stability on the other, is much greater.

India is not a bank-dominated financial sector. As an example, the market capitalisation of all listed companies is over twice the size of non-food credit by banks to all companies. A perusal of the aggregative balance sheet of firms in India shows that bank financing is an important, but small, component. This is particularly the case if the balance sheet is re-expressed using market value of equity instead of book value.

The knowledge and expertise required to tackle systemic risk to the entire financial system is unlikely to be located within any one sectoral regulator. The knowledge about the Indian financial system will be dispersed across RBI, UFA, and Resolution Corporation. Hence, it would be inappropriate to place the systemic risk function in any one place.

RBI will only have expertise and information relating to the banking and payments industries. In equal measure, UFA will only have expertise in the non-banking non-payments financial sector, and the Resolution Corporation, will only have knowledge about handling failing firms. Each will be able to bring those respective nuances to the conversations on FSDC's board. Each of these agencies has synergies in its own right with the function of mitigating systemic risk.

The function of being a lender of last resort does not equate with performing systemic risk oversight. The IFC envisages that RBI will continue to provide funds to participants for which the RBI directly operates payment systems. Further, IFC establishes a mechanism through which RBI will also provide emergency liquidity for non-banking financial firms in times of severe or unusual stress in the financial system, on provision of collateral. There is no contradiction between a central bank that is a lender of last resort and a central bank that is not the systemic risk regulator.

We need to think through whether the responsibility of FSDC Board should be extended from being a coordination body to one having authority for executive decisions? What will that imply for the speed of decision making?

The FSLRC envisages two executive functions at FSDC: naming certain financial firms as Systemically Important Financial Institutions (SIFIs), and making decisions on system-wide counter-cyclical capital. Both these decisions will be taken by the board of FSDC, which will include the Chairman of RBI, the Chairman of UFA and the Chairman of the Resolution Corporation. FSDC is a council of regulators.

A loose coalition of regulators that does nothing more than meet has been tried in India. It was called the HLCCFM. It failed to solve problems such as the SEBI/IRDA dispute, and it played little role in the crisis management of 2008. The task ahead in designing sytemic risk regulation is one of understanding how to do things differently.

In the spirit of FSLRC's overall recommendations, establishing FSDC as a statutory body endows it with legal process, transparency and accountability that ought to accompany a financial sector agency. This means that FSDC can be held accountable for lapses, and that the possibility of external influences affecting its functioning is significantly reduced.

The speed of decision-making is enshrined in process, the efficiency of which depends on the stakeholders involved. Acting decisively is of importance where a crisis is at hand, but in a world that seeks to uphold principles of rule of law, there is little value in hasty decisions made by a non-statutory body with no accountability for its actions. A statutory FSDC is more likely to ensure that decisions relating to crisis situations are taken responsibly, and with full disclosures.

During a crisis, we need the executive to lead the fight and stem the sources of systemic risk, and all regulatory bodies will have to work together with the Ministry of Finance. This is what happened everywhere in the world during the financial crisis is the best model for tackling a crisis. FSLRC recommendations have legislated this model to increase accountability for actions taken during a crisis.

Can we clearly define the boundaries between financial stability issues falling within the purview of the FSDC and regulatory issues falling exclusively within the domain of the regulators?

Systemic risk may arise due to various reasons, such as regulatory arbitrage, excessive leverage ratios, or procyclical fluctuations in the economy. None of these issues can be handled exclusively by any one regulator.

IFC has laid down the process of identifying and implementing measures to mitigate or eliminate systemic risk. One measure of counter-cyclical systemic risk regulation, i.e the countercyclical capital buffer to address pro-cyclical effects in the financial system, has been explicitly provided for in the law. The implementation of such measures may commence only at the instruction of FSDC.

Regarding the intersect between the roles of FSDC and the regulators, under the IFC, the FSDC cannot interfere with microprudential regulation or the monetary policy function of the RBI. Any concerns can always be raised at the FSDC table, and discussed in full view of the public and the markets.

The author is grateful to Sumathi Chandrashekaran, Bhavna Jaisingh, Radhika Pandey and Ankur Saxena for useful inputs.