More prolific and periodically-disseminated data on systemically-important financial institutions can ensure better monitoring and go a long way in containing future crises
The global financial crisis has been a wake-up call to policymakers the world over. The unprecedented scale and complexity of the crisis is such that it is unlikely you will ever find experts agreeing completely either on the factors that led to the crisis or, more importantly, possible safeguards against a future recurrence.
Was it poor regulation? Overly loose US monetary policy? Underlying global imbalances? The use of opaque and complex credit derivatives? Faulty executive remuneration models? Blind faith in market forces, to list just some of the factors touted as responsible for the spectacular meltdown in the global economy witnessed since the Great Depression?
The jury is still out on the precise factors or combination of factors responsible for the crisis. But there is one issue on which there is rare unanimity among the wise men of international finance: the collateral damage caused by poor regulation of systematically-important financial institutions (SIFs). Following from this the next question is, what sort of information do we need about SIFs to ensure proper regulation?
The Bank for International Settlements (BIS) has identified information gaps in five areas as critical for better regulation of SIFs and containing future crises. Regulators, for instance, have little or no information about the consolidated balance sheet of systemically important financial entities, their liabilities, their currency exposures, degree of interconnectedness and about non-bank financial entities such as off-balance sheet special investment vehicles, pension funds, insurance funds, etc.
Yet each of these has a vital bearing on the final outcome of any regulatory effort. For instance, cross holdings between companies are now the norm rather than the exception. However, most of the data collected and monitored by regulators is on individual companies.
The danger in this is that we could end up losing the wood for the trees. Thus, a financial conglomerate with interests in diverse fields such as banking, insurance, pensions, asset management and so on could well be submitting information on different aspects of its business to different regulators.
And while an individual company may not be systemically important, the group as a whole could well be; but since it is not tracked as a conglomerate its importance is not fully appreciated.
Fortunately for us, the RBI, to its credit, has been alive to the dangers of this kind of a disaggregated approach. Hence its insistence on the holding company model for financial institutions; ring-fencing commercial banks to keep them immune from the consequences of the activities of related entities.
However, the importance of consolidated balance sheets is yet to be fully appreciated even by the RBI.
This is relevant since over the years corporate structures have become more complicated. The ramifications of inter-connected dealings can best be assessed from consolidated balance sheets.
As the BIS points out, ‘the inability to “see” the consolidated balance sheet, either at the individual bank level or at the headquarter country level, means that the build-up of stresses at the systemic level cannot be monitored'.
Another information gap the crisis has highlighted relates to the liabilities' side of bank balance sheets. In the past, analysts tracking the health of banks invariably focused only on assets — the quality of loan portfolios, share of NPAs, interest-sensitivity of investment portfolios and so on.
Little or no attention was paid to the liabilities' side of bank balance sheets. Nor was there any appreciation of the difference between banks that depended heavily on inter-bank deposits, non-bank money market funds and wholesale deposits from large companies as distinct from those that depended on retail deposits; until the former collapsed when short-term money markets froze. Northern Rock is a case in point.
Here again, the RBI has been ahead of its counterparts in the developed world in emphasising the need for a good ‘retail deposit base' and frowning on the dependence of foreign banks on the short-term money market. Yet we cannot really “see” any of these markets in our aggregate data.
And when we cannot see them, we cannot assess the degree of maturity mismatch embedded in the system. But the trend in relying on money market liabilities and building a deposit base can be detected through regular off-site monitoring of banks
The exposure of banks to different currencies especially off-balance sheet exposures is another challenge. In the past adventurism often went way beyond the dictates of prudence primarily on account of two factors. One, the pressure on managers to earn their bonuses and two, the fact that much can be hidden in off-balance sheet exposures.
The problem here is that the position is never static, so central banks will have to develop a ‘sixth sense' and learn to recognise warning signals keeping in mind intangible aspects such as the culture of different SIFs. A Citi or ICICI Bank, for instance, is quite different from a State Bank of India and that difference will need to be kept in mind by regulators.
The degree of interconnectedness of SIFs is another key indicator for measuring systemic importance. Bilateral interbank liabilities and system-wide aggregate exposures to particular counterparties are indicators of the inter-connectedness. Collection of such data is a challenge, but realisation by central banks of the importance of this is a first step.
Pre-crisis, off-balance sheet entities such as structured investment vehicles (SIVs) obscured the build-up of stresses in the financial system and exacerbated the problems when they had to be moved back onto banks' balance sheets.
Therefore, non-bank companies particularly, pension funds, insurance companies and large corporates — should not be excluded from systemic monitoring exercises.
NBFCs are now on the RBI's radar and the bank does identify systemically important NBFCs and subject them to closer monitoring. But not large corporates. Is it possible to monitor such companies? Is it necessary to bail out non-banks?
These are issues that are as yet unresolved. In the meanwhile even as central banks fill the information gaps identified by BIS they would do well to develop the skills needed to track and recognise warning signals. No amount of data can fill in for that!
What is true at the level of individual SIFs is also true at the national level. Statistics compiled by national authorities, the IMF, the OECD and the BIS do not provide a complete picture.
For example, the flow of funds statistics, the balance of payments statistics, the IMF's Coordinated Portfolio Investment Survey and the BIS locational banking statistics all rely on residencybased data. Such data are insufficient for identifying vulnerabilities in any particular consolidated national banking system.
Posted by Parthasarathi Kumar | 07 Jun, 2010
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