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Regulating 'too big to fail' banks

The global economic and financial crisis of 2008 brought to the fore the lacunae in the regulatory framework and disproved the myth of 'too big to fail', gearing the regulators into action.

Regulating 'Too big to fail'

(Illustration: Raj Verma)

Growth in the real sector of an economy typically cannot happen in isolation from the financial sector. Likewise, the financial sector cannot grow in isolation from the real sector, as there is a high correlation and interdependence between the two. In fact, the global economic and financial crisis of 2008 exemplifies this correlation and interlinkages, with its genesis lying in the housing and banking sectors , which ultimately engulfed the real sector as well. It also brought to the fore the lacunae in the regulatory framework and disproved the myth of 'too big to fail', gearing the regulators into action.

Successively, measures have been undertaken both to define these 'too big to fail' or global systemically important banks (G-SIBs) and to introduce the required regulatory changes to minimise the risk arising from these banks in case of an economic downturn. The Bank for International Settlements has listed five parameters to identify G-SIBs, which has been accepted by several countries. After the identification of these banks, various measures have been announced for limiting risks from them, such as:

>> Higher capital surcharge levied in proportion to the risk posed by a bank

>> Greater disclosures

>> Enhanced supervision

>> Country-specific reforms

>> Separation of core and non-core banking activities

>> Addressing risk from interconnectedness

>> Planning recoveries, among others

While the US Federal Reserve, the European Central Bank and The People's Bank of China have increased capital buffers, they have also announced additional measures. The Fed stipulated SIBs to hold increased equity capital in proportion to short-term funds held by them; EU and China mandated higher financial disclosures.

In its quest to minimise risks from SIBs, the Financial Stability Board (FSB) has announced new 'bail-in' rules that require total loss absorbing capacity of at least 16 to 20 per cent of risk weighted assets. This implies conversion of debt into shares of creditors' money in case of bank failure to avoid bailing out banks from government coffers.

Regulatory measures in these countries/regions are important as they account for the bulk of 30 G-SIBs identified by the FSB. But, this raises questions such as how relevant is the concept of SIB to the Indian banking system? And, how big are the big Indian banks to raise risks on failure?

While it can be debated that the Indian banking sector is well regulated, fairly capitalised, relatively less complex and has smaller banks compared to its peers, the concept of SIBs may not gain much precedence. But this may not be entirely true. First, the exposure (defined by its loans and advances) of Indian banks as a percentage of the country's GDP has been found to be quite significant, when compared to their US and Chinese counterparts, exposing the economy to significant risks if adequate mitigation measures are not undertaken. Further, these banks dominate the banking sector on account of their large size (an important indicator of an SIB), which is bound to grow in the event of a possible merger or consolidation, especially in case of the State Bank of India and its subsidiaries.

With only three large banks, the percentage of loans and advances in India's GDP is more than 30 per cent. This is bound to rise on inclusion of more banks. Thus, the concept of SIBs gains precedence in India. However, as the business model of Indian banks varies from its overseas counterparts, the banking regulator in India, the Reserve Bank of India (RBI), has adopted the global definition of an SIB with a few modifications to better suit the domestic environment.

The RBI has set a two per cent criteria (individual bank assets as percentage of GDP) to commence Domestic SIB (DSIB) identification, and will also take into consideration other operations such as derivatives trading and specialised services, relevant in case of foreign banks. Based on its assessment, the central bank is expected to declare the first set of five to six SIBs by August 2015, which will then be required to maintain higher capital buffers and exposed to stricter supervision, similar to international practice. Last year, the RBI also made it compulsory for all banks to undertake stress tests for identification of possible risks and their ability to withstand shocks to safeguard the interest of all stakeholders: households, industry, and the government.

Further, smooth operation of these bigger banks is important as they are key lenders in the economy - a fact due to which they have attained this big size. Continued availability of funds to various sectors and entities is particularly important for India at this juncture as the government is expending great efforts in placing the economy back on the high growth path and luring investors to the country.

However, from the bank's perspective, these measures can imply reduced autonomy on one hand and some sacrifice on growth due to risk calibration. In case the RBI adopts the bail-in strategy, it will likely entail a change in the funding pattern of banks and may bring in additional cost in case long-term debt instruments are issued. In addition, it may call for additional manpower and IT systems to facilitate information availability.

Similar to banks, the concept of systemically important is also applicable to other financial institutions such as the non-bank finance companies (NBFCs). Though the RBI has classified non-deposit taking NBFCs with an asset size of more than Rs 5 billion as systemically important, it is worth noting that most NBFCs are of small size when compared to banks and may not truly be in a position to trigger an economic downturn. However, as a pre-emptive measure, the RBI has increased the core capital requirement for these NBFCs from 7.5 per cent to 10 per cent .

Thus, it is evident that minimising the risk emanating from SIBs has become a key area of concern for regulators. In India, too, though the definition has been adopted with some variance, adequate safeguards are being placed to ensure smooth operation of the financial system and the economy at large, as any imbalance or disruption in one is bound to hamper the other.

(The author is Partner at KPMG in India. Views expressed are personal.)

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