Systemic risks – Macro prudential regulation

Dimple BhandiaSeptember 20, 2013

Outline

• Theoretical Underpinnings

– Financial Stability

– Systemic risks

– Macro-prudential regulation

• Indian experience

– Macroprudential regulation

– Assessing systemic risks

• Challenges

Financial Instability

Between May 22 and September 5 Emerging market equities were down 11 per

cent Emerging market currencies were down 7 per

cent Emerging market bonds were down 8 per cent

In India,

The currency depreciated by over 17 per cent

Equities markets fell by 8 per cent

10 year interest rates jumped 123 basis points

Why Financial Stability

Impact – potentially severe

Especially for emerging markets

Contagion – worldwide tentacles

Financial instability anywhere can be a threat tofinancial stability everywher

Theory of decoupling weaker than accepted

Sectors

Real and financial sectors through feedback loops

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/tolerablerange can represent a state of financialstability.

Factors Affecting Financial Stability

Vulnerabilities in the real economy

Global imbalances and rapid capital flows

Complex financial products and rapid technologicaldevelopment

Asset price bubbles

Shadow banking system

Light touch regulation

Contagion

Interconnected markets

Too big to fail counterparties

Well….. Virtually anything…. Anywhere!!!

Lessons learnt from the Crisis

Recognition of the need to pursue financialstability as an explicit policy objective

The Need to strengthen the macro-prudentialframework

To see both the forest and the trees!!

The need to better identify, assess and manage thesystemic risks prevailing in the financial sector.

Renewed policymaker interest in developing andimproving tools to promote financial stability

Innumerable!

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

Macro-prudential policy

The set of policies which deal with managing the downside of systemic risks

Using prudential tools to limit systemic risks

Dampening the build up of financial imbalances

Building defences that contain the speed and sharpness of subsequent downswings and their impact on the economy

Identifying and addressing common exposures, risk concentrations, linkages and inter-dependencies that are sources of contagion and spillovers

Implementing macroprudential policy Why?

To what extent are vulnerabilities building up?

Where? In which sectors are the vulnerabilities building up?

When? Are the vulnerabilities likely to crystallise?

How? How much? Which are the instruments to be used? What is the optimal mix of tools to address the risks?

Risks How (un)certain is the risk assessment? Rules vs. Discretion? What are the costs of applying the policy?

Post mortem How (un)certain are the effects of applying the instrument?

Implementing macroprudentialpolicy: Indicators

CGFS, 2012

Implementing macroprudentialpolicy: Instruments

CGFS, 2010

Implementing macroprudentialpolicy: Coordination

Microprudential policy

Monetary policy

Fiscal Policy

Capital account management, etc.

Balancing policy objectives

Synergies and trade offs

Implementing macroprudentialpolicy: Timing

CGFS, 2012

Macroprudential regulation to address both dimensions of systemic risk

Time and Cross-Sectional Dimensions

Largely based on discretion

Select quantitative and qualitative indicators guide policy action

Applied primarily on banks as they are central to Indian financial system

Shadow banking is relatively small and within a regulated space

Macroprudential Regulation in India

Investment Fluctuation Reserves (IFR)

To address impact of interest rate volatility by appropriation of bank profits, below the line

Use of time-varying risk weights and provisioning

Especially identified as sensitive sectors

Provision Coverage Ratio and countercyclical provisioning buffer

Addressing Time Dimensions of Systemic Risks

IFR and Profits

IFR introduced as a counter-cyclical measure enabled

banks to absorb losses when interest rates rose

beginning late-2004. Withdrawn once market risk

capital charge was applied.

IFR and CRAR

CRAR remained stable despite introduction of capital charge

for market risk and falling income due to rise in yields

TI: Total Income

Time-Varying Risk weights and Provisioning

Source: Address by Mr. Anand Sinha, Deputy Governor, RBI on “Seeing both the Forest

and the Trees- Supervising Systemic Risk” , June 2011

Time-varying Risk Weights and Provisioning for Commercial Real Estate

Policy Response

Teaser loans - Standard asset provisioning on the outstanding amount increased

Restriction of Loan to Value ratio of housing loans

Increase in the risk weights on large housing loans

Addressing excessive leverage in Housing Sector

Stipulation of Provisioning Coverage Ratio in December 2009 70% of gross NPAs as on a particular date

Excess of provisions for PCR over that required under prudential norms segregated into a “countercyclical provisioning buffer”

This buffer to be used for making specific provisions for NPAs during periods of system wide downturn, with the prior approval of RBI

More recently, draft dynamic provisioning norms introduced

Countercyclical Provisioning Buffer

Pre-Crisis Limits on interbank liabilities Restricted access to un-collateralised funding market Limits on banks’ investments in capital instruments

issued by other banks Limits on banks’ exposure to NBFCs Systemically important NBFCs are closely monitored

Post-Crisis Cap on banks investments in Debt-oriented Mutual

Funds Restrictions on lending to gold loan NBFCs

Cross-sectional Dimension of Systemic Risk

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.

Contagion risks / Measures of systemicrisk contribution

Addressing “too big to fail”/ “too connected to fail” issues

Measuring systemiticity

• Measuring the systemic risk of financial system

• Attributing systemic risks to individual financial entities

• Measuring interconnectedness and contagion risks

• Balance Sheet based models

• Market price based models

– Econometrics analysis using the Principal Component Analysis

– Merton model

– Multivariate

– Traditional risk management tools – VaR and expected shortfall

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.

The Financial Stability Unit

Conduct of macro-prudentialsurveillance of the financial systemon an ongoing basis.

Developing models for assessingfinancial stability

Conduct of systemic stress tests toassess resilience

Communicating risks to financialstability

An operationally independent FSU was set up in July2009 with the following mandate:

Systemic Risk

Assessment Process

Study of international best practices in systemic

risk assessment

Robust and extensive analysis of a database

of

- Off site Banking and non banking sector supervisory returns

- Ad hoc data requests from financial

institutionsIn house econometric research and

statistical studies to support

assertions in the FSR

Latest tools and techniques

- Macro-financial stress testing

- Network Analysis

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 inthe system experience large losses simultaneously.

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

Stress testing

Macro financial stress tests

Testing the resilience of financial institutions to adversemovements in macroeconomic variables

Sensitivity Analysis

Supplement to macro stress tests

Assessing resilience of financial institutions to adversemovements in a range of risk factors covering foreignexchange, 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.

Expected loss estimation

Scenario assumptions

Stability Maps and Indicators… (1)

Maps and Indicators

Macroeconomic Stability – assesses risk conditions in themacroeconomy

Financial Markets Stability – assesses stability of financialmarkets

Banking Stability – assesses changes in underlyingconditions/risk factors affecting the banking sector’s stability

Financial Stability – assesses overall stability conditions inthe Indian financial system

Supplementary Indicators to assess vulnerabilitiesemanating from Systemic Liquidity conditions Fiscal situation External Sector Housing Prices

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 - Challenges• Complex and opaque - Difficult to Measure

No universally accepted definition

Risk factors are generally not observable – hence difficult toquantify

Large mass of uncertainties – “known” and unknown”

Effectiveness and appropriateness of tools is not easilymeasurable

Significant data gaps

Challenges in “connecting the dots”

• Assessment – a “best estimate”

• Type I and Type II errors

• The Learning curve is steep!

Questions?