Pursuit of financial stability:The Indian experienceDimple BhandiaJanuary 15, 2013

Financial 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 StabilityVulnerabilities in the real economyGlobal imbalances and rapid capital flowsComplex financial products and rapid technological developmentAsset price bubblesShadow banking systemLight touch regulationContagionInterconnected marketsToo big to fail counterparties

Well.. Virtually anything. Anywhere!!!

Why Financial StabilityImpact potentially severeEspecially for emerging marketsContagion worldwide tentaclesFinancial instability anywhere can be a threat to financial stability everywhereTheory of decoupling weaker than acceptedSectorsReal and financial sectors through feedback loops

Lessons learnt from the Crisis

Lessons learnt from the CrisisRecognition of the need to pursue financial stability as an explicit policy objectiveThe Need to strengthen the macro-prudential frameworkTo 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 stabilityInnumerable!

Systemic RisksSystemic eventsCan 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 risksRisk of occurrence of a systemic event

Systemic 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 RisksIdentification 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 externalitiesThe additional capital surcharge proposed to be levied on Globally Systemically Important Banks

Modeling Risks of Aggregate ShocksFocus on the impact of macroeconomic shocks on the financial system Adverse macroeconomic scenarios used in stress testingTo assess resilience of financial institutionsMacroeconomic 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 ReportsRole of FSRsLimiting instability by pointing out key risks and vulnerabilities to policy makers, market participants and the public at large

A part of the macroprudential toolkitThese 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 StabilityNumber of countries publishing FSRsSource: Financial Stability Reports: What are they good for, Martin Cihak, et al, World Bank, Dec 2011

Characteristics of FSRsStandalone document

Generally central bank oriented

Focus on risks and exposures of the financial systemSystemic riskForward looking perspectiveAnalysis of financial interconnectedness

Regularly published

Trends in contents of FRSOf lateUse 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 stabilityPrior to the crisisExclusive (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 stabilityPost the crisisRecognition of the need to pursue financial stability as an explicit policy objectiveWidespread 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 IndiaRaison d'tre

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 advantageThe Preamble of the Reserve Bank of India Act, 1934

First RBI Building 1935, Kolkata

Now A full services central bankMonetary AuthorityIssuer of CurrencyBanker and Debt Manager to GovernmentBanker to banksRegulator of the Banking System Manager of Foreign ExchangeRegulatory of Payment and settlement systemsMaintaining Financial StabilityDevelopment RoleRBI Central Office Building, Mumbai

Financial Stability and the Reserve Bank of IndiaMaintaining 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 CouncilThe 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 MinisterThe responsibility of FSDC includes

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

The Indian Financial SystemPercentage Share in total financial assetsDiverse but largely within a defined regulatory perimeter

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 banksJoint 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.

Stress testingMacro financial stress testsTesting the resilience of financial institutions to adverse movements in macroeconomic variablesSensitivity AnalysisSupplement to macro stress testsAssessing resilience of financial institutions to adverse movements in a range of risk factors covering foreign exchange, liquidity, interest rate and credit risksBoth top down and bottom up stress testing deployedStress 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 IndicatorsMacroeconomic Stability assesses risk conditions in the macroeconomyFinancial Markets Stability assesses stability of financial marketsBanking Stability assesses changes in underlying conditions/risk factors affecting the banking sectors stability Financial Stability assesses overall stability conditions in the Indian financial systemSupplementary Indicators to assess vulnerabilities emanating fromSystemic Liquidity conditionsFiscal situation External SectorHousing Prices

Stability Maps and Indicators (2)Financial Stability Map and IndicatorFinancial Stability Indicator **Financial Stability Map *(*) Away from centre implies higher risk (**) Higher level implies lower stability

Stability Maps and Indicators (3)Macro Stability MapMacroeconomic Stability Map *(*) Away from centre implies higher risk

Stability Maps and Indicators (4)Financial Markets Stability Map and IndicatorFinancial Markets Stability Indicator **Financial Markets Stability Map *(*) Away from centre implies higher risk (**) Higher level implies lower stability

Stability Maps and Indicators (5)Banking Stability Map and IndicatorBanking Stability Map *Banking Stability Indicator **(*) Away from centre implies higher risk (**) Higher level implies lower stability

Assessment of Systemic Risks - ChallengesComplex and opaque - Difficult to MeasureNo universally accepted definition Risk factors are generally not observable hence difficult to quantifyLarge mass of uncertainties known and unknownEffectiveness and appropriateness of tools is not easily measurableSignificant data gaps Challenges in connecting the dots

Assessment a best estimateType I and Type II errorsThe Learning curve is steep!

Publishing of FSRs - ChallengesSome financial stability issues too sensitive to be discussed publiclyCould trigger behaviour likely to provoke a crisis, especially in times when the financial system is already disturbedExist real, inherent constraints in communicating tail risksRegular publications help in preventing over interpretation

Loss of credibilityCrying wolf Most risks communicated will not materialise

Data gaps and challenges in systemic risk assessmentValidity of models/conclusions

Public policy?Financial stability and growth two sides of the same coin?Conventional wisdom says: financial stability promotes and stimulates growthA 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 trilemmaThe Holy Trinity of price stability, financial stability and growth

Questions?