A decade later, what has changed in the financial regulatory system
A look at some elements of the regulatory framework that emerged in aftermath of the global financial crisis
Mumbai: The global regulatory regime post September 2008 was marked by an extraordinary level of global coordination and rule-making. Here are some elements of the regulatory framework—sourced from speeches delivered by various Reserve Bank of India governors—which emerged in the aftermath of the Lehman Brothers bankruptcy.
Basel-III: These regulations stipulate enhanced quality and quantity of capital. The component of Tier-I capital as part of total capital was raised to 6% (out of total 8% CRAR), requirement of equity capital was raised very substantially to 7 % (including 2.5% of capital conservation buffer) from the earlier 2%.
Capital buffers: Banks are expected to build capital buffers during economic expansion which could then be used during a downturn to maintain their lending activities; this could cushion the impact of a downturn on the economy.
Leverage ratio: Before the crisis, the banking system was characterized by high levels of leverage, even though many banks were well capitalized. Basel-III leverage ratio seeks to address these weaknesses by restricting the build-up of leverage in the banking sector to avoid destabilizing deleveraging processes that can damage the broader financial system and the economy.
Liquidity coverage ratio: Banks can face difficulties despite adequate capital levels if they do not manage their liquidity in a prudent manner. In an economic crisis, liquidity can evaporate quickly due to rapid reversal in market conditions.
The LCR promotes the short-term resilience of banks’ liquidity risk profiles. It ensures that a bank has an adequate stock of unencumbered high quality liquid assets (HQLA) that can be converted into cash at little or no loss of value in private markets, to meet its liquidity needs for a 30-calendar-day liquidity stress scenario. LCR encourages ‘self-insurance’ and discourages dependence on public sector to provide liquidity support in case of stress.
Systemic risk: The most important lesson from the crisis is the recognition of systemic risks and the development of a framework to deal with that. Policies that deal with systemic risk are called macro-prudential policies (as opposed to micro-prudential, which regulates and supervises at the institution level) and this framework includes, among other things, counter-cyclical policies, as well as policies to address interconnectedness and building defences against contagion.
Inter-connectedness: While dealing with the contagion effects of economic crisis, regulators have focused on systemically important financial institutions (SIFIs). Global systemically important financial institutions (G-SIFIs) and domestic systemically important financial institutions (D-SIFIs) are entities that could potentially create larger negative externalities to the financial system if they were to get into trouble and fail. Therefore, it is necessary to stipulate greater loss absorbency for these entities, subject them to more intense supervision. SIFIs are identified based on metrics which takes into account factors such as their global activity, their size, interconnectedness with other segments of the system, their substitutability and the complexity of their operations. G-SIFIs have to maintain additional capital in a range of 1% to 2.5% depending upon the level of their inter-connectedness and systemic criticality.
Transparency in OTC markets: Improving transparency in the over-the-counter (OTC) markets, standardization of OTC products and their migration to central counter parties (CCPs) to contain the risk of interconnectedness were the other major reforms.
Compensation structure: It is now widely acknowledged that the flawed incentive framework underlying the compensation structures in the advanced country banking sectors fuelled the crisis. The performance-based compensation of bank executives is typically justified on the grounds that banks need to acquire and retain talent. The Financial Stability Board has since evolved a set of principles to govern compensation practices and the Basel Committee has developed a methodology for assessing compliance with these principles. The proposed framework involves increasing the proportion of variable pay, aligning it with long-term value creation and instituting deferral and claw-back clauses to offset future losses caused by the executives.
Shadow banking regulation: The need to provide oversight to the shadow banking system—known in India as non-banking finance companies, or NBFCs—is another major lesson from the crisis. The shadow banking system grew phenomenally in the run-up to the crisis and overshadowed the regular banking system in many jurisdictions.
The risks originated in the lightly, or completely, unregulated shadow banking system and then spread to the regular banking system and exacerbated the crisis. Improving the oversight/regulation of the shadow banking system assumed importance with the tightening of banking regulations as the widened regulatory gap between the two systems afforded increased regulatory arbitrage with risks flowing from the more regulated banking system to the less regulated shadow banking system.
Supervision: Post crisis, there has been a shift towards risk based supervision (RBS) away from the erstwhile CAMELS approach. CAMELS—or Capital adequacy, Asset quality, Management, Earnings and Liquidity—is essentially a scorecard based approach, which is more of a backward-looking methodology and transaction testing model operating with a lag.
The RBS, on the other hand, is a forward-looking approach because it tries to assess the risk build-up in banks. RBS also enables conservation of supervisory resources.
Accounting standards: Fair value accounting has come in for criticism for its inadequacy to deal with the typical features of a financial crisis: illiquid markets and distress sale of assets. It is argued that fair value accounting, no matter that it has logical appeal, is too rigid for a crisis situation and that it, in fact, fuels a downturn. The G-20 Working Group on Enhancing Sound Regulation and Strengthening Transparency recommended that the accounting standards-setters and prudential supervisors should work together. Accordingly, the IASB has initiated appropriate modifications to the relevant accounting standards.
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