Healthy banks under healthy regulation

B. Yerram Raju PhD.

Dr Yerram Raju is distinguished banker turned economist and management consultant; currently a Director at the Development and Research Services Hyderabad and a consultant to the Govt. of Andhra Pradesh on cooperative reforms in banking and law. His four and half decades of multi-sector experience spans 3 decades with the SBI, with stints with LBSNAA Mussoorie, ASCI, IIPE and the IIE. He was Regional Director, Professional Risk Managers' International Association; Hyderabad Chapter till May 2013. Briefly the editor-in-chief of Asian Economic Review, a visiting Professor at IDRBT Hyderabad and the ISED Cochin. Author and prolific writer, he was a Member of the Jury for the Asia Pacific Bankers' Congress in Manila in 2004 and 2005 and a short term consultant to the World Bank, GTZ, FNF, UNIDO and UNDP.

Post recession 2007, world over there were unsparing attacks on regulatory lapses with India alone being excluded, thanks to the then RBI Governor Y.V.Reddy’s sagacity. Capital account convertibility and derivatives were asked to wait at the gates of the regulator and this measure kept at bay the contagion effect. The trust deficit that has been shaking the foundations of the Indian Government with scandals galore has not touched the portals of the financial sector while in the US and Europe it is the financial sector that had to face the brunt of the crisis. These countries had to rebuild the trust with great effort.

Six years down the line, the US, Europe (post the Libor scandal) and even the UK have been re-engineering their regulatory regimes. The need arose mainly because of the high leverage ratios, limited capital buffers and little attention to operational and reputational risks. The recession shocks created tremors all over the world resulting in NINJAs in the West and Europe and destabilized several Asian economies as never before. The Markets were quick to react with falling indices and devaluation of stocks across the globe. The pension funds and mutual funds were affected. The interest rates were unstable for longer than expected. Several countries reeled under inflationary pressures. Even in USA and Europe with UK being no exception, banks were nationalized to protect the depositors’ interests.

In many countries, there is an outcry that there is an overdose of regulation and this burden could be reflected as red herrings on their balance sheets before long. At a recent conference, at tea time, a few top bankers were wondering whether they should continually review their capital and see how much of it could be put to better use so that the bank progresses. Several bank CEOs confide in private that the regulatory mandates on MIS and Risk management would finally make business opportunities ornamental and customers irrelevant. It is this backdrop that made me choose a review of most of the regulations with a bearing on capital allocation and financial stability across nations.

It is strong regulation followed by effective monitoring and supervision by the Reserve Bank of India (RBI) that saved the Indian banking system from the global financial turmoil in 2007. This is despite the risks arising from the inter-linkages between institutions and markets both in India and abroad! Like elsewhere, the Indian banking system also engages in acceptance of deposits, lending of depositor’s money and investments of funds in Government bonds and other long term securities of corporations. However, the Reserve Bank has laid down certain safety norms as the funds belong to public and banks cannot fritter them away by taking undue risks.

Statutorily, regulation of banking is governed by the Provisions of RBI Act 1934, Banking Regulation Act 1949 and Foreign Exchange Management Act 1999. The Reserve Bank has prescribed certain guidelines keeping in view the economic environment, the need for financial soundness and the risks banks face in the ever increasing integration of international economies and the unending emergence of innovative and exotic financial products. There was neither over-regulation nor any impairment of the freedom of financial institutions to carry on businesses as usual during and after the crisis. While there were political, social and economic pressures to extend finance to seemingly high risk sectors like farming, micro and small enterprises, retailers, exporters, housing, education etc., the regulator’s learning from the failures of international banks enabled adequate firewalls preventing failures of a similar nature. Adequate checks and balances over risky advances have received continual attention by way of certain exposure norms for individual and group borrowers. Bulk of a bank’s investments is in Government securities because of the Governments’ dependence on these funds and for want of a corporate bond market. These investments are guided by certain parameters that factor in market risk in terms of interest and price fluctuations. Equity market exposure is permissible within limits and that too only under close surveillance.

Basel norms viz., capital adequacy, are in place and they are being progressively improved upon, in tune with requirements. Asset liability management has been rigorously pursued and the banking system has developed the skill and expertise to closely monitor the cost of funds, liquidity gaps and maturity mismatches in terms of interest and principal amounts, off balance sheet management with permissible products like derivatives, guarantees etc. The RBI provides liquidity support and influences the market rates of interest through its monetary intervention tools like CRR, REPO and Reverse REPO rates. However, the insulation from the impact of the crisis is not everlasting. India has to keep its eyes and ears open. There are still gaps on the governance front because of the perception that compliance and conformance to regulatory regimes is all that good governance means.

USA had to put in place, the Dodd Frank Act and has brought in new regulations to rein in credit rating institutions and the Volker’s rule. Realizing that these did not take them far, it has been made clear that all banks and financial institutions are to abide by the rigor of Basel III capital allocations, leverage ratios, governance and liquidity norms. ‘SAI Global Compliance’ announced the findings of its 2013 Financial Services Industry Compliance Benchmark Study. As a result of the growing number of new and updated regulations emerging over the past year, firms cited mitigating new risks created by Dodd-Frank and demonstrating compliance effectiveness as their top priorities for 2013. “As individual regulations continue to ensure implementation of the Dodd-Frank legislation, financial services firms are stepping-up their game in terms of compliance and risk management”.

In most nations, measurement and management of the liquidity risk has been a concern for over 20 years. The document of the first ‘Basel Committee on Banking Supervision; (BCBS) on sound practices in liquidity risk management was issued in 1992. It was superseded in 2000 by 14 guiding principles. The crisis of 2007 has increased the regulatory attention to liquidity risk. Consequently, in 2008, the BCBS issued an updated document comprising of 17 guidelines -- but there were still no binding requirements. In December 2010, in response to even more heat generated by the crisis, BCBS unveiled new liquidity rules in a document called "Basel III: International framework for liquidity risk measurement, standards and monitoring." This paper introduced two key minimum reporting standards for liquidity: a 30-day liquidity coverage ratio (LCR) and a longer-term structural ratio called the net stable funding ratio (NSFR). The LCR, from a net cash flow perspective, will force banks to boost their short-term liquidity pool and to hold a minimum liquidity to survive 30 days of stress. The NSFR, on the other hand, is designed to mitigate maturity mismatch, and will serve as an early indicator for regulators to intervene when structural liquidity is insufficient.

In July 2013, barring Argentina, Indonesia, Russia and Turkey the rest of the nations including the US, embraced the Basel III regulation framework with introduction to commencing from April 2013 and the maturity date being April 2018.

Regulation of banking is necessary for supporting the growth of the economy, for ensuring the health of regulated institutions and for insulating nations from the repercussions of any emerging global crisis. From this angle, the warnings that overdoing regulation is no answer to regulatory wrongs are not acceptable. {The Legatum Institute and the Tax Payers’ Alliance cautioned that intensive financial regulation is ‘harmful, costly and potentially dangerous for the growth of world economy.’ (bustle@belfasttelegraph.co.uk)}. Regulatory wrongs are also the lessons from the world financial turmoil and they need to be adequately addressed. Well calculated regulatory risk to prevent/minimize business risks and failures can only be beneficial and any excess can bring in unexpected damage. The new liquidity risk ratios, along with monitoring metrics, are a fundamental part of the Basel III regulation, and represent the first step toward international and globally harmonized liquidity measurement standards. They will also facilitate liquidity comparisons between financial institutions.