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Project on Indian Financial Market - Module: 4
Stability of Financial Sector
[Source: RBI Report on Currency and Finance 1999-2000 dated January 29, 2001]
Preface & Introduction - Reinforcing Financial Stability
Financial stability has to be an important goal of public policy, particularly after the experiences of currency and financial crises in the 1990s in Mexico and some of the East Asian countries. Fragilities in the financial system could arise on account of several factors. Financial instability, broadly speaking, could arise due to weak fundamentals, institutional failures resulting in banking panics or information asymmetries (Box VI.1). In some cases, all the factors could be at work, making it difficult to determine in crisis situations, at least in the very short run, as to which factor is the dominant one. As a result, corrective actions often have to be broad-based. Most countries, therefore, take pro-active measures before hand to safeguard financial stability. Cross-country initiatives in this context are instructive. These experiences show the importance that central banks in industrialised countries attach to dissemination of their analyses of developments in the financial sector and assessments of vulnerabilities to market participants (Box VI.2). In order to ensure stability of the financial sector, in India too, a wide array of measures has been undertaken by the Reserve Bank and the Government in close co-ordination with one another. These include prudential norms for banks and other intermediaries, restructuring of banks, enforcement of increased competition in the banking sector and promotion of transparency and good governance in the banking sector that could enhance credibility of the banking policies.
A certain amount of volatility is an integral part of the development and gradual integration of the financial markets, depending upon the nature of trades and extant regulatory and supervisory framework, as reviewed in Module: 2. Excessive volatility, however, could turn out to be destabilising and engender serious risks. At the macro-level, such volatility impacts investment and real activity, through a variety of channels - wealth, bank lending and balance sheet channels. Of these, the wealth effect is fairly straightforward. Asset holders gain or lose in terms of wealth due to volatility of asset prices and would, depending on the outcome, revise their consumption-saving plans. The other two channels emerge mainly due to information problems in credit markets. In the bank lending channel, expansionary monetary policy increases the quantity of bank loans available. Given banks' special role as lenders to various classes of borrowers, this leads to rise in investment and possibly consumption spending. In case of the balance sheet channel, expansionary monetary policy causes a rise in equity prices and raises the net worth of firms, which reduces the adverse selection problem (since, in effect, lenders have greater collateral for their loans). This leads to higher investment spending and therefore, raises aggregate demand. If the transmission channel does not function efficiently, there would arise a need for not only maintaining orderly conditions in the asset markets but also ensuring financial stability in the form of smooth functioning of institutions, markets and infrastructure that comprise the building blocks of the financial system. While the external issues in financial stability, inter alia, relate to the appropriateness of the exchange rate regime and the optimum levels of foreign exchange reserves and external debt, the domestic issues pertain to the strengthening of the financial system, through institution of prudential norms and transparent observance of internationally accepted standards and codes.
Box VI.1
Theories of Financial Stability
The occurrence of periodic episodes of financial turmoil has often been attributed to external shocks or various forms of aberrant behaviour. However, recent interest in financial stability has been driven by two major considerations. Recent advances in finance have provided a coherent macroeconomic foundation about the observed phenomena of financial instability. From the policy perspective, the growth and integration of world financial markets and the systemic repercussions that failures might engender, have increased the importance of policy actions to safeguard financial stability.
Theories emphasising debt and financial fragility consider financial crises to be a key feature of the turning-point of many business cycles, as response to previous 'excesses' of borrowings that can occur in financial markets. This explanation is based largely on observations of periods of financial instability up to and including the Great Depression. These theories pinpoint the concept of 'displacement' - an exogenous event leading to improved opportunities for profitable investments, which triggers the cyclical upturn. Second, they highlight financial innovations (e.g., new forms of bank liability).
The monetarist approach emphasises contagious banking panics, which may cause monetary contraction. Banking panics arise from a public loss of confidence in banks' ability to convert deposits into currency. This may be caused by failure of an important institution, which may, in turn, arise from failure of the authorities to pursue a predictable monetary policy.
Bank runs may be seen in terms of the 'liquidity insurance' that banks provide to depositors by pooling risks; banks' assets are mainly long-term and illiquid, and so banks engage in maturity transformation. This feature gives an incentive for panic runs on banks even if they are solvent, because of imperfect information regarding the banks' assets and the inability of banks to sell or cash illiquid assets (i.e., loans) at par. The risk that other depositors may withdraw can cause a panic regardless of the underlying financial position of the bank, and may affect both other banks (via contagion) and borrowers without access to other sources of funds.
There are, on the other hand, theories of crisis which focus on uncertainty. Responses to uncertainty may be to apply subjective probabilities to uncertain events (such as the occurrence of a policy regime shift). But agents often tend to judge such probabilities by the action of others ('herd behaviour') that can collectively lead to systemic financial instability. In presence of such uncertainties, adverse surprises can trigger shifts in confidence, affecting markets more than what seems to be warranted by their intrinsic significance; and therefore, lead to crisis situations.
Asymmetric information and agency cost theory suggest that the well-known problems of debt contract, viz., moral hazard and adverse selection arising from the informational asymmetry between the borrower and the lender, can also account for sharp contractions of credit, engendering financial instability. For example, if interest rates rise, there may be a sharp increase in adverse selection (only the low-quality borrowers would be willing to borrow), thereby leading to a decline in the supply of credit. Higher uncertainty (by making screening of borrowers by lenders more difficult) increases adverse selection, and may reduce supply of credit. And borrowers with low net worth (due to the asset price collapse) present greater moral hazard to lenders, as they have less to lose by default. |
Box VI.2
Financial Stability: Cross-Country Experiences
United Kingdom: Under the 1997 Memorandum of Understanding between the United Kingdom treasury, the Bank of England (BoE) and the Financial Services Authority (FSA), the Bank of England is responsible for the stability of the financial system as a whole. A Standing Committee of the Treasury, the BoE and the FSA meets monthly to discuss developments relevant to financial stability. One of the tasks that the BoE undertakes to discharge its responsibility is the surveillance of financial stability conditions, including the assessment of actual or potential shocks and of the system's capacity to absorb shocks. The Financial Stability Area of the Bank of England undertakes a monthly assessment of financial stability and produces a variety of focused notes. A detailed review of the financial stability conjecture and outlook is undertaken every six months and an abridged version is published in the Bank of England's Financial Stability Review. As stated, the aim of the Review is (i) to encourage informed debate on financial stability issues, domestically and internationally, (ii) to survey potential risks to financial stability and (iii) to analyse ways of promoting and maintaining a stable financial system.
United States: The three institutions that have responsibility for different aspects of banking supervision - Federal Deposit Insurance Corporation (FDIC), the Federal Reserve (Fed) and the Office of the Comptroller of Currency (OCC) -have, over time, developed similar models and indicators aimed at assessing the overall health of individual banks based on summary data submitted by banks as part of their off-site supervision exercises. In general, the variables used in the assessments of the future health of individual banks by the supervisory institutions in the US are proxies for the various factors taken into account when assigning a full ex-post CAMELS rating. As an extension of the assessment of the current health of individual banks, the supervisory authorities have also developed models for assessing the current riskiness of banks, based on which they can generate probabilities of future failure and undertake corrective action in respect of those banks judged to be at the highest risk. The computerised statistical system that supports the work of these three agencies permits joint collection of information on income, operating activity and balance sheet for individual banks so as to discern changes in the health of individual institutions for safeguarding financial stability.
Norway: The Norges Bank produces a report on the situation and outlook for the financial sector since 1995. The work includes analyses of developments in financial institutions, primarily the banking sector and the relationship between financial sector developments and the macro-economy. The approach adopted is to generate an initial assessment of the trends in macroeconomic indicators (MEI) that are of relevance to the financial sector, in general, and to the earnings of financial institutions, in particular. These variables include economic growth, interest rates, credit growth and sectoral debt levels. Following this analysis, a range of aggregated micro-prudential indicators (AMPI) of the banking system are incorporated in the assessment (i.e., capital adequacy ratios, credit growth rate, trends in overdue loans and operating cost). Specific attention is paid to the banks' exposure to the real estate sector and the enterprise sector and the ability of firms in that sector to cope with unexpected deterioration in their financial condition and thereby to stay current with their debt servicing.
Sweden: The surveillance by the Sveriges Riksbank's is directed towards systems and therefore, complements the supervision of the banking system by the Swedish Financial Supervision Authority, which is primarily aimed at individual institutions. The views of the Riksbank on the banking system are published on a semi-annual basis. The major objective of the reports is to raise the financial sector's awareness of vulnerability issues. The method is to assess risks to aggregate banking sector profits based on information from the markets, on a sector-by-sector basis. The assessments are carried out by looking at three categories of risks that impact bank's abilities to generate profits: (i) strategic risks, or factors affecting profits in the medium-term, (ii) credit risks, or risks to profits over the medium-term, and, (iii) counter-party and settlement risk, or risks that impinge upon profits in the short-run. In addition, a range of MEI, including growth rate of aggregate lending, inflation rate, inflationary expectations, and the real interest rate as well as several banking sector variables (profits, loan performance by sector, bankruptcies, etc.) are also used for the assessment purpose.
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Box VI.3
Macro-prudential Indicators and Financial System Surveillance
Macro-prudential indicators (MPIs) comprise macroeconomic indicators (MEIs) and aggregated micro-prudential indicators (AMPIs). MEIs include sets of indicators, on the real economy, fiscal and monetary sectors, the external sector and some asset prices. AMPIs include indicators on capital adequacy, asset quality of lending and borrowing entities, management soundness, liquidity, sensitivity to market risk and some market-based indicators.
Available literature on leading indicators of crises as well as country experiences suggest that information on a core set of MEIs could provide early warning signals and thereby help in identifying vulnerabilities in pursuing forward looking policies to attain the objective of financial stability. Since MEIs alone cannot fully capture the strengths and weaknesses of the financial system, MEIs need to be monitored along with AMPIs. Unlike MEIs, academic research on AMPIs are limited (largely due to non-availability of long time-series information) and the recent initiatives focus only on developing a core set of AMPIs which appear to be relevant when seen in the context of the recent episodes of financial crises. One commonly used framework for analyzing the financial health of an individual institution is the CAMELS. AMPIs represent aggregation across all banks/financial institutions comprising the financial system and include such indicators as capital ratios, sectoral credit concentration, non-performing loans and provisions, connected lending, leverage ratios, return on assets, expense ratios, the maturity structure of assets and liabilities, liquid asset ratios, sensitivity to market risk, foreign-currency denominated lending, etc. Besides AMPIs and MEIs, MPIs also include market-based indicators like credit ratings, sovereign yield spreads and market prices of financial instruments.
The key challenge for developing an MPI based surveillance of the financial system is to compile a reasonably long time series database on AMPIs, which alone can help in evaluating how developments in AMPIs over time can be related to the developments in the MEIs. Furthermore, in the case of macroeconomic indicators, the linkages based on economic theory help in sound application of judgment, while operating with a multiple indicator based surveillance system. The lack of any established theoretical/empirical framework to explain the interactions between AMPIs and MEIs, as also the range of webs through which financial system instability impinge upon the macro-economy suggest that the internal surveillance process based on MPIs would take time to stabilise. To begin with, establishing the right link between AMPIs and MEIs may be difficult. For example, deterioration in the capital adequacy position of the banking system could be a sign of vulnerability; but to know as to how exactly that could affect the macro-economic variables is important from the standpoint of country surveillance. Similarly, increase in the leverage (debt/equity ratio) of the corporate sector as a whole is an early indication of vulnerability; but again how exactly that could affect the macroeconomic variables is not clearly known. A MPI based surveillance system, therefore, could evolve only over time, more from experience than any theoretical underpinnings.
Like the causal linkages running from AMPIs to MEIs, it is also important to identify the linkages running from MEIs to AMPIs. Changes in the exchange rate or interest rates could affect the balance sheets of banks, which in turn, may get reflected in AMPIs. (Stress tests could help in identifying such impact resulting from any policy/market shock). Similarly, during economic booms, bank profitability may increase and NPAs may decline. The reverse may happen during recessions. Moreover, solvency and the liquidity position of a bank could be comfortable during a particular macro-economic condition but may prove inadequate in another macro-economic scenario.
Despite the importance of a framework to study the interactions between AMPIs and MEIs, switching over to a model-based surveillance mechanism is fraught with the danger of sending wrong signals because, firstly, the interactions between AMPIs and MEIs are yet to be properly studied by the international community and hence not very clear, and secondly, model-based analyses of MEIs that occasionally guide conventional macro-monitoring are not very reliable, even after the proliferation in both theoretical and empirical research helping in continuous refinements. The key findings of such research, as documented in Berg et al. (1999), show that: (a) models perform much better in-sample than out-of-sample, (b) most of the models signal vulnerabilities but they often provide false alarms, (c) timing of a crisis is much harder to predict, (d) the determinants of crisis episodes vary significantly over time and across countries, (e) models could be useful in identifying countries which are more vulnerable in a period of international financial turmoil than others, (f) signals from the early warning models should be calibrated with sound judgment to minimize the costs associated with any policy action guided by false signals, (g) sound fundamentals may not be enough to avoid a self-fulfilling or contagion driven crisis, but they are essential to ensure success in defending an attack and in achieving a faster restoration of normalcy after the attack and (h) since the indicators with varying degrees of predictive abilities could be many, at least the important indicators must be monitored constantly.
Due to the nascent stage of current initiatives on MPIs, most of the central banks have preferred constituting separate working groups to study the relevance of MPIs and to suggest measures to establish a system for collecting timely information on such indicators. The European Central Bank has instituted a working group on Macro-prudential analysis and has recently completed a "gap-exercise" helping it in identifying the existing data gaps constraining compilation of information on MPIs. The Bank of Finland has put in place a framework for forecasting banking sector developments and with improved availability of desirable information on MPIs which would be linked to their macro-forecasting model. The Bank of England now regularly publishes a Financial Stability Review, based on indicators (and not a model) and aims at placing greater emphasis on AMPIs in such reviews. The variables used by the Federal Reserve's Financial Institutions Monitoring System to assess the health of banks resemble AMPIs. Norway's present assessments of its MPIs are mostly for internal use. Aggregation across a number of banks/financial institutions may fail to capture the structural weakness of individual banks/institutions. But at the macro-level, formulation of policies may require aggregated information on the financial sector, leaving the institution- wise details to the supervisors. Preventing failure of each bank/ institution in the system should be the objective, and hence monitoring of individual institutions is essential. But for identifying vulnerability of the financial systems as a whole and also to enable inter-country comparability, developing a system to collect information on AMPIs may be warranted.
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The macroeconomic consequences of excessive volatility and financial stability are interlinked in many ways and fragilities in either of the two feed into the other. On these considerations, India has been pursuing the twin-pronged strategy of ensuring price stability as well as financial stability. Safeguarding financial stability, in the Indian context, is based on three inter-related strategies of improving the robustness of the linkages across institutions and markets (macro-prudential level), promoting soundness of institutions through prudential regulation and supervision (micro-prudential level) and also ensuring the overall macroeconomic balance.
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