## Introduction A short note on this valedictory [address by Dr Duvvuri Subbarao](https://rbi.org.in/scripts/BS_SpeechesView.aspx?Id=438), ex-Governor of the Reserve Bank of India, at the FICCI-IBA Annual Conference on “Global Banking: Paradigm Shift”, organised jointly by FICCI and IBA, Location and Date: Mumbai, 10 September 2009. >[!normal] >The speech is based on the lessons of the global financial crisis, and if there is evidence against the old model of central banking and regulation, and what is the new model and what is the paradigm shift required? Dr. Subbarao examines how and why central banks let financial stability fall through the cracks, and then reviews the international initiatives under way to remedy the system, the Indian approach to financial stability, in particular highlighting the stability-enhancing features of our policy and regulatory framework. Finally, he speaks about some issues and challenges on the way forward. 1. In his 1962 [book](https://www.amazon.in/Structure-Scientific-Revolutions-50th-Anninversary/dp/0226458121), ‘Structure of Scientific Revolutions’, Thomas Kuhn argues that when evidence against a prevailing scientific theory piles up, that theory is jettisoned and a new one is adopted signalling a paradigm shift. 2. The collapse of Lehman Brothers in mid-September 2008 caused financial markets in advanced economies to go into seizure. 1. There was a great deal of uncertainty about the extent of losses, the ability of banks to withstand those losses, the extent of risk in the system, where it lay and how it might spread. 2. It triggered unprecedented panic and almost paralyzed the entire chain of financial intermediation. 1. Banks hoarded liquidity. Credit, bond and equity markets nearly froze. 2. Signalling a massive flight to safety, yields on government securities plunged while spreads over risk free government securities shot up across market segments. 3. Several venerable financial institutions came to the brink of collapse. Massive deleveraging drove down asset prices setting off a vicious cycle. 4. Trust totally dried up with a massive break down of trust across the entire financial system - trust in banks and non-banks, central banks and other regulators, credit rating agencies, investment advisers, brokers, dealers, traders, and trust in the financial markets, if not in the market system itself. 5. It spread from the financial sector to the real sector severely hurting consumption, investment, export and import, in the advanced economies. 6. It then spread geographically from the advanced economies to the emerging market economies (EMEs) and soon engulfed almost the entire world through trade, finance and confidence channels. 7. **In short, financial stability that we had grown to take for granted got impaired.** 3. Hence, the restoration of trust in the financial system is central to the pace and shape of recovery after the global financial crisis (GFC). ### Lessons of the crisis 1. Financial stability cannot be taken for granted, even if there is price stability and macroeconomic stability. 2. A threat to financial stability anywhere in the world is potentially a threat to financial stability everywhere. 3. ==Financial stability has to shift from being an implicit variable to an explicit variable of economic policy.== 4. The damage it can cause in poor and developing economies can be particularly severe, **as people with low levels of income have no headroom to bear downside risks**, and their livelihoods can be disrupted by financial instability ### Role of Central Banks 1. Did central banks fail to see the crisis coming, and neglect financial stability in their zealous pursuit of price stability? 2. If yes, was it because accountability mechanisms were weak? 3. ==The 3 egregious failures attributed to central banks: exclusive Focus on Price Stability, failure to Prevent Asset Price Bubbles and the lightness of Regulation.== 4. Warnings signals: Macro-economic imbalances, asset price build up, credit expansion and depressed risk premia, made many issue alerts and warnings about the impending crisis. 6. But central banks largely refrained from strong corrective action for a variety of reasons: 1. The perceived inefficiency of monetary policy to redress asset price bubbles, 2. Separation of monetary and regulatory policies and ==misplaced faith in the self-correcting forces of financial markets.==, as some central banks actually believed that **the Great Moderation permanently changed the macroeconomic dynamics and that the good times will roll on for ever.**  ## Financial Stability - Indian Approach ### Approach 1. Though India was impacted by the crisis less than most others. 2. Integration with the rest of the world makes us vulnerable to the forces of globalization. If financial stability anywhere in the world is jeopardized, our financial stability will become vulnerable too. 3. In contrast to the ‘single objective, single instrument’, ==the conduct of monetary policy by the Reserve Bank was guided by several multiple objectives and multiple instruments, where our three main objectives have been price stability, growth and financial stability, with the _inter se_ priority among the objectives shifting from time to time depending on the macroeconomic circumstances. == ### Measures 1. **On financial globalization - our stance has been gradualist - of making haste slowly**. We view capital account liberalisation as a process and not an event. The extent of opening is contingent upon progress in other sectors. 2. Equity flows, especially direct investment flows are preferred over debt flows, which are are subject to restrictions which are reviewed and fine-tuned periodically. 3. Exchange rate is largely [[Managed vs Market-determined rates|market-determined]] and we intervene in the foreign exchange market in times of excessive volatility. 4. Since mid-1990s, RBI has been laying down regulatory framework for banks in India. As of April 2009, all our commercial banks are Basel II compliant. 5. RBI has a ==[board/committee for financial supervision](https://rbi.org.in/commonman/Hindi/scripts/aboutus.aspx) for focussed regulation and supervision of banks and other financial institutions, which are under RBI's jurisdiction. It has departments, viz. Department of Supervision, which was further bifurcated in August 1997, into [Department of Banking Supervision (DBS](https://www.rbi.org.in/commonman/English/scripts/deptofbs.aspx)) and Department of Non-Banking Supervision (DNBS), under its guidance. 1. There are only 2 [central boards](https://www.rbi.org.in/commonman/English/scripts/organisation.aspx#FS) in RBI, and so the other one is [Board for Payment and Settlement Systems](http://rbidocs.rbi.org.in/rdocs/Content/PDFs/BPSBS2012.pdf) 6. RBI may have been cautious or conservative regarding exotic products, but Indian financial markets remain ==sufficiently widened and deepened in terms of instruments, products and participant.== 7. **Few specific features of our system that have contributed to financial stability:** 1. SLR - Banks are required to hold a minimum percentage of their liabilities in risk free government securities under the statutory liquidity ratio ([[SLR - Statutory Liquidity Ratio|SLR - Statutory Liquidity Ratio]]) system. This stipulation ensures that banks are buffered by liquidity in times of stress. 2. Capital accounts - In the face of large capital inflows during 2006-08, we sterilised the resultant excess liquidity through calibrated hikes in the cash reserve ratio ([[Cash Reserve Ratio (CRR)|Cash Reserve Ratio (CRR)]]) and issue of market stabilisation scheme ([[Market Stabilisation Scheme (MSS), 2004|MSS)]] securities. When the flows reversed during the last quarter of 2008, RBI reversed the measures to substitute this source of liquidity injection with a cut in the CRR and buyback of the MSS securities. 1. To contain the ==adverse impact of high credit growth in some sectors and asset price fluctuations on banks’ balance sheets, RBI proactively prescribed a sector-focussed risk weights for various sector, which helped banks to maintain a prudent _minimum capital to risk weighted assets ratio_. It was done preemptively and in a countercyclical way—more provisions during good times when risks appear low, to prepare for potential loan losses during downturns or crises. 3. **Securitization:** To ensure that securitization is value adding, we insist on ‘true sale’, and 1. Any guarantees or financial support provided by the originator to make the securities more attractive are regulated, requiring adequate capital to back such commitments, minimizing risk exposure. 2. The profit from sale of assets to SPVs *to be amortized over the life of the securities issued*. This prevents short-term profit inflation and ensures a steady change in the position. 4. Access to the unsecured [[Call, Notice and Term Money|overnight/notice/term]] market is restricted only to banks and primary dealers. Other entities can access the secured overnight/notice/term market only through collateralized instruments ([[Repos and Tri-Party Repo|repos]] collateralised by govt. securities) which are cleared and settled on a guaranteed basis through a central counterparty. 5. Banks’ exposures to non-bank finance companies are within the prudential framework (limits, capital requirements, etc.). 6. Regulation have been extended to **systemically important non-deposit taking [[NBFCs|NBFCs]], and this has limited leverage and space for regulatory arbitrage. 7. Central counterparty (CCP) clearing and guaranteed settlement is currently operative for government securities transactions and inter-bank spot rupee-USD forex transactions. CCP guaranteed arrangements for forex forwards and **OTC rupee interest rate swaps are underway.** 1. *Since March 28, 2014 and November 19, 2018, CCIL offers the guaranteed settlement in interest rate swaps referenced to the O/N MIBOR (now modified MIBOR-MMFOR) and [[Modified MIFOR|MIFOR]] (now modified MIFOR-MMFOR) respectively.* ### Financial Stability Unit in RBI 1. The [Financial Stability Unit](https://www.rbi.org.in/commonman/English/scripts/departments.aspx#FSU1:~:text=Top-,Financial%20Stability%20Department,-Keeping%20in%20view) was set up in July 2009, and is now called the Financial Stability Department (since around June 2023). 1. It is a multi-disciplinary Financial Stability Unit in the Reserve Bank, which prepares and publishes the Financial Stability Report (FSR) twice a year. 2. It is part of the [FSDC](https://dea.gov.in/sites/default/files/StrucFSDC.pdf) forum. 3. Following the formation of the Financial Stability and Development Council (FSDC) in Dec-2010, the Executive Director, RBI (in charge of Financial Stability department) is the Member Secretary and the Financial Stability Department (FSU) of RBI is the Secretariat for the Sub-committee of this council, also called FSDC-SC. 4. The Governor of the RBI is the head/chairman of FSDC-SC. 2. Related Note - [Financial Stability Department](Financial%20Stability%20Department.md) ## Challenges way forward Financial stability comes with trade-offs and have challenges. Here are the 5 challenges: 1. **How to Define and Measure Financial Stability** 1. If it is precisely defined, it can helpful in choosing the agency and the protocol for addressing threats to financial stability. It is similar to the ones we have for managing natural disasters. 2. From a macro-prudential perspective, financial stability can be defined as a situation where the financial sector functions without any discontinuity. 3. But a definition like above can only become useful for policy if it can quantify financial stability like price stability which can be defined and quantified. 4. ==Any precise, measurable and comprehensive definition may require following elements:== 1. Excessive **volatility of macro-variables such as interest rates and exchange rates** which have direct impact on the real economy; 2. Build-up of significant **leverage in financial**, corporate  and household sector balance sheets; 3. The **moral hazard risks posed by institutions** that have become ‘too-big-to-fail’ or too interconnected or complex to resolve; 4. Internal buffers aimed at institution and the entire system, to counter potential shocks to the economy; 5. ==Strong policy and institutional mechanisms to lean against the wind even as “the music is playing”;== 6. Prevalence of unregulated areas in the financial sector which, through their interconnectedness with the formal regulated system, can breed systemic vulnerabilities. 2. **Financial Stability - Exclusive or Shared Responsibility?** 1. There are several regulatory models around including those where the central bank is a pure monetary authority but the bank regulation and supervision vested with another agency. 2. Post-crisis, the emerging view is that the crisis was caused, at least in part, by the lack of coordination and communication between the separate bodies. ==So it is optimal, in the interest of financial stability, to entrust the function of regulation of banks and non-banks also to central banks. The argument is that only the monetary authority, as the lender of last resort, can provide emergency liquidity support. Also, being the regulator, the monetary authority gets a better sense of the market conditions and can therefore manage liquidity more efficiently.== 4. But can the central bank **have exclusive responsibility for financial stability**? Conversely, can the government completely delegate this responsibility to the central bank under a principal-agent model? 1. Consider, for example, a situation where the banking system is under threat of instability, and decisions have to be made on which banks to bail out and how much support to extend. In all this, fiscal support may need to be extended. 2. How should the responsibility (like the protocol for decisions and deadlock) for financial stability be shared between the government (which is democratically elected and accountable to a legislature) and the central bank in this case? 5. In India, as of now, financial institutions are regulated by different bodies. We also have the [financial stability division](https://dea.gov.in/FSDC) under the department of economic affairs, Ministry of finance, is an apex-level body, but not created by statue but acts as a regulatory body. It was suggested in a [report](https://www.jrvarma.in/reports.html) titled 'A Hundred Small Steps' by the [High Level Committee on Financial Sector Reforms (Raghuram Rajan Committee, 2008)](RBI_Report:Committee_20080912_Committee%20on%20Financial%20Sector%20Reforms_2008_A%20Hundred%20Small%20Steps_Chairman-Raghuram%20Rajan.pdf) in 2008 and was set up in 2010. 3. **Growth and Financial Stability - Managing the Trade-offs** 1. ==Measures like exposure norms, risk weights (CRAR) and provisioning requirements are not always costless. == 1. For instance, tightening of risk weights arguably tempers the flow of credit to certain sectors, but excessive, premature or unnecessary tightening could blunt growth. 2. Similarly, exposure norms offer protection against concentration risks; however, such limits could restrict the availability of credit for important growth sectors. This is a live issue in our country in the context of the immense needs of infrastructure financing. 2. As in case of price stability, central banks face the challenge of managing the trade off between financial stability and growth. 2. After a crisis, all conservative policies appear safe. But excessive conservatism in order to be prepared to ride out a potential crisis ==could thwart growth and financial innovation.== 3. Experience shows that managing this challenge, that is to determine how much to tighten and when, is more a question of good judgement rather than analytical skill, and this judgement skill can be honed over a period of time as the central bank pursues the dual objectives of growth and financial stability. **The question is what price are we willing to pay, in other words, what potential benefits are we willing to give up, in order to prevent a black swan event?** 4. **Reforming Regulatory Architecture** 1. Two key lessons are driving central banks to review their regulations: 1. The responsibility for financial stability cannot be fragmented across several regulators; it has to rest unambiguously with a single regulator, and ==that one single regulator optimally is the central bank. == 2. There is need for coordination across regulators on a regular basis and for developing a protocol for responding to a crisis situation. 3. **But there are 3 issues in the area of regulatory architecture.** 1. **Regulatory coordination:** In India, we have a host of regulators in the financial sector - RBI, SEBI, IRDA and PFRDA. 1. In order to facilitate coordination between them, there is a High Level Coordination Committee on Financial Markets (HLCC-FM) comprising all the regulators and the Finance Secretary. *FSDC has replace the High-Level Coordination Committee on Financial Markets*. A formal structure of such committees leads to accountability, but can also make the forum excessively bureaucratic and detract from its other value adding features. A clear defined role is very helpful. 2. **Regulation of financial markets:** Two reports, Percy Mistry on Mumbai as an International Financial Centre and the other by Raghuram Rajan on Financial Sector Reforms, had recommended that regulation of all trading of financial products and instruments be brought under SEBI. 1. _Will such unification help?_ 1. ==Apart from banks, NBFCs and other financial institutions, RBI regulates the money market, the government securities market, the credit market and the foreign exchange market and the derivatives thereon. 2. *In respect of OTC derivatives, only those derivatives where one party to the transaction is an RBI regulated entity have legal validity whereas SEBI regulated the products traded on the exchanges. Therefore, unlike many countries, India has had established procedures for regulation of OTC derivatives.    2. _Why such unification will not help?_ 1. It helps to preserving financial stability.   2. ==Unlike equity prices, interest rates and exchange rate are key macroeconomic variables with implications for monetary policy and overall macroeconomic stability. In addition, banks dominate the interest and exchange rate markets. By also being the regulator of these markets, the Reserve Bank is in a position to exercise oversight of institutions, markets and products, to monitor market developments, sense impending developments, take advance action, prevent excessive volatility and maintain financial stability at the systemic level. 3. This is an arrangement that has stood to the test of time, has protected our financial stability even in the face of some severe onslaughts, and should not be jettisoned lightly in quest of a unified market regulator. 3. **Should central bank should also be a banking/financial sector regulator?:** 1. Pre-crisis, there was a dominant argument for separation of the **monetary and regulatory functions** premised on a possible conflict of interest. 1. If financial stability becomes the dominant concern of a central bank, banks may very likely take excessive risks in the full confidence that the central bank, being also the regulator, will ease policy and extend regulatory benefits to bail them out in a crisis. But paradoxically, this very aggressive pursuit of financial stability can itself threaten financial stability over the long horizon. 2. Post-crisis, this argument has weakened, and rather, some advanced economies are rethinking structure, where regulation and supervision are with an agency other than the central bank 3. **Conclusion:** The crisis has also shown that there are clear synergies between monetary policy management and financial sector regulation. ==In particular, the central bank can perform its lender of last resort function more effectively if it has a clear view of the institution’s current and prospective balance sheet and its liquidity and solvency position.== 5. As it is yeh to be decided which model is the most effective as crisis has proved that none are, he emphasized the fact ==that the lessons of the crisis need to be reflected seriously before implementing regulatory changes.== 6. **Fiscal Policy, Financial Stability and** **Central Bank Independence** 1. Any measure to preserving financial stability will have implication for the prized independence of central banks. 1. Before 1970, it was typical across countries for monetary policy to be hostage to fiscal compulsions. 2. But, following the stagflation of the 1970s and the ascendency of monetary policy thereafter, a neat arrangement started to emerge. Governments started becoming fiscally responsible and monetary policy had started getting independent. 2. But this has become difficult as a result of the crisis. Unnerved by the scale and sweep of the crisis, governments and central banks around the world responded with an unprecedented show of policy force. 1. Central banks cut policy interest rates and have resorted to injecting massive liquidity in the system through a slew of measures variously called quantitative and credit easing. 2. Governments stepped in with fiscal stimulus packages raising fiscal deficits to levels not seen before in peace time. Even as governments and central banks cooperated, ==the familiar tensions between fiscal and monetary policy have started playing up.== 3. It is widely hoped though that once the crisis is behind us, these tensions will melt away and monetary policy will once again be conducted independent of fiscal compulsions. On the other hand, there are apprehensions that this may not ==happen soon because of the expected protracted recovery and also because of structural factors that may keep fiscal deficits at elevated levels into the medium term.== 3. ==Such tensions between fiscal and monetary policies could potentially militate against financial stability. Why?== 1. If governments continue to incur large fiscal deficits, it will be that much more difficult for central banks to maintain price stability. **While the current crisis has shown that price stability is decidedly a necessary though not sufficient condition for financial stability.** 1. Example: Higher inflation could also push the yield curve upwards. This could result in significant mark to market losses for fixed income instruments with potentially adverse implications for banks’ profitability. This again could impair financial stability. 4. In India, various elements of public borrowings by the state and the centre is planned by the RBI, the DEA along with suggestions of the [finance commission](https://fincomindia.nic.in/historical-perspective). 5. It is imperative that both the centre and states in India return to a path of fiscal consolidation, for a number of reasons, including the need to preserve financial stability. ## Conclusion 1. He spoke about the following aspects of financial stability. 1. How financial stability has been affected in the crisis and the role or flaws of central banking in it. 2. The important international initiatives under way to preserve and strengthen financial stability. 3. India's approach to financial stability and the new tools RBI is building for it. 4. The fact that developments elsewhere can impact us as India rapidly integrates with the world. 5. 5 major challenges that the world, India included, will need to address on the way forward. 6. Preserving and strengthening financial stability is a complex challenge. 7. Measures have to be not too benign, and at the same time, not excessive or prematurely tight. 8. It is a misplaced concern in some quarters that the crisis may have dented our enthusiasm for financial sector reforms. 9. RBI, under his leadership, will not slow down on reforms, but will surely rework the road map to reflect the lessons of the crisis. ## Related Notes 1. [Department of Supervision](Department%20of%20Supervision.md) 2. [Department of Regulation (DoR)](Department%20of%20Regulation%20(DoR).md) 3. [Financial Stability Department](Financial%20Stability%20Department.md) 4. [Financial Sector Assessment Program (FSAP)](Financial%20Sector%20Assessment%20Program%20(FSAP).md)