Macroprudential Policies: Indian Experience
(Address by Mr. Anand Sinha, Deputy Governor, Reserve Bank of India, at Eleventh Annual International Seminar on Policy Challenges for the Financial Sector on “Seeing both the Forest and the Trees- Supervising Systemic Risk” co-hosted by The Board of Governors of the Federal Reserve System, The International Monetary Fund, and The World Bank at Washington, D.C, June 1-3, 2011)
Introduction
1. Good Morning. It gives me great pleasure to share with you our experience in implementing macroprudential policies in India. The current global financial crisis has brought to fore serious lacunae in the approach to regulation and supervision and put the issue of systemic risk on to the regulatory agenda. A comprehensive definition of systemic risk is, “The risk of disruptions to financial services that is caused by an impairment of all or parts of the financial system, and can have serious negative consequences for the real economy.”1
2. There are two facets to systemic risk. One is in terms of its distribution within the system at any given point in time and another is its evolution with time. The cross-sectional dimension is how risk is distributed within the system at any given point in time. Systemic risk in this dimension arises due to the inter-connectedness of institutions, balance sheet entanglements, common exposures and, sometimes, even common business models of financial institutions. The time dimension on the other hand deals with how aggregate risks in the financial system evolve over time – the procyclicality issues in the financial system. The dynamics of the financial system and the macroeconomy interact with each other increasing the amplitude of booms and busts. The larger is the boom, the larger is the bust and larger is the damage to the economy.
Systemic Risk Management and Macro Prudential Policy
3. The set of policies which deal with managing the downside of systemic risk is known as macro prudential policy. Macroprudential policies primarily use prudential tools to limit systemic risk and thereby minimize disruptions in the provision of key financial services that can have serious consequences for the economy by (i) dampening the buildup of financial imbalances; (ii) building defenses that contain the speed and sharpness of subsequent downswings and their effects on the economy; and (iii) identifying and addressing common exposures, risk concentrations, linkages and inter-dependencies that are sources of contagion and spillover risks that may jeopardize the functioning of the system as a whole2. While the third objective of macroprudential policy [(iii) above] is concerned with the cross-sectional dimension, the first two objectives [(i) and (ii) above] are concerned with the procyclicality issues. The second objective of building defenses, i.e., increasing the resilience of the financial system is viewed as a narrow objective and is attained by build-up of buffers during boom times which can be used when risks materialize during busts. The first objective of dampening the buildup of financial imbalances is considered a broader objective and is essentially “leaning against the wind” aspect during the boom phase for dampening the credit and asset price boom. The buildup of buffers should achieve this objective by affecting the cost of credit, though evidence is not unequivocal in this regard. A more ambitious interpretation of the first objective would be moderation of credit supply through both booms and busts i.e. ensuring stable credit supply. While the objective of dampening the credit exuberance during boom and, thereby, moderate credit supply looks plausible, increasing credit supply during busts by leaning against the wind i.e. by releasing buffers, does not seem as plausible because of risk aversion that is likely to set in among banks and other economic agents as well as the market pressure and expectation from banks to maintain high levels of capital when risks are apparently highest. Thus macroprudential policy is likely to have asymmetric impact from “leaning against the wind” during booms and busts. BCBS and FSB are currently involved in developing a range of macroprudential policies to deal with the procyclicality issues as also with systemically important financial institutions and other aspects of systemic risk on account of inter-connectedness and common exposures.
4. Reserve Bank of India (RBI) has been using macroprudential polices, more notably the countercyclical policies, since 2004 as a toolkit for ensuring financial stability though it had used them sporadically even earlier. It would be useful to describe the broad structure of the Indian financial system and the linkages between the monetary policy and financial stability in India, to provide a backdrop for discussing the implementation of polices.
Structure of the Indian financial system
5. The Indian financial system is heavily dominated by commercial banks. Within the banking system, public sector banks (majority shareholding held by the Government of India) account for nearly 70 per cent of the banking system assets.
6. RBI regulates banking sector, non-banking financial companies (NBFCs), as also the money, forex and Government securities markets which are dominated by banks. Thus, the interconnectedness channels, both from the institutional and market perspectives, come within the regulatory ambit of RBI. There are separate regulators for capital markets, insurance sector and pension funds. With many Indian banks having expanded into the above mentioned activities through subsidiaries, associates or otherwise, there has been a need for coordination among sectoral regulators which has been ensured through inter-regulatory bodies within the umbrella of a high level committee chaired by the Governor, RBI and with representatives from Ministry of Finance. This institutional arrangement has recently undergone a change with the establishment of the Financial Sector Development Council (FSDC) chaired by the Finance Minister.
Role of RBI in maintaining financial stability
7. The Reserve Bank of India Act, 1934 provides a broad legal mandate to RBI to secure monetary stability and generally to operate the currency and credit system of the country to its advantage. In practice this meant the dual objective of growth and price stability, the relative emphasis being dependent on the context. Since 2004, RBI has added financial stability as an additional objective in view of the fast growing size and importance of the Indian financial sector3. It is in this setting that RBI has been using macroprudential framework in both time and cross-sectional dimensions for quite long without christening these policies as macroprudential policies as is the case with some other countries, notably some Asian countries. Operationally, while pursuing multiple objectives, multiple indicators, including growth in credit and money, are used to track the macroeconomic conditions. India being a bank-dominated economy, the bank credit becomes a key monetary policy transmission channel. Thus, the aggregate bank credit growth has always formed an important variable in the conduct of monetary and countercyclical policies.
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