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PRMIA- HYDERABAD CHAPTER

1

Financial Stability

B. YERRAM RAJUB. YERRAM RAJUREGIONAL DIRECTORREGIONAL DIRECTOR

This presentation is based on the RBI Report on Financial Stability enclosed to the RBI Bulletin April 2010.

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When and Why think of Stability?- The Crisis and Consequential instability?

•The crisis started in summer 2007 with lightning failure of Lehman Brothers, Washington Mutual Funds and 3 Iceland Banks.

•Mistrust and fear spread among Banks.•Four Risk environmental factors still being

probed:

– Financial Risk valuation models/methods

– Risk Control Functions– Risk limiting strategies and– Bonus Culture.

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A Perspective on the Indian Approach on the Financial Policy Making

•Prudential policy framework for banks addressing:– Leverage, liquidity, and counterparty concentration– Recognition of NBFCs as systemically important and

extension of regulatory perimeter– An Active Capital Account management framework– Explicit regulation of key OTC derivative markets.

•Despite relatively low exposure to global markets, the contagion impact of any global shocks not ruled out.

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Healthy Banking sector

•Tighter regulatory standards on capital, liquidity and leverage for banks;

•Unregulated systematically important financial entities (NBFCs, Coops) brought under regulatory oversight

•Addressing systemic risks arising from interconnectedness among financial sector entities

•Regulating financial markets from a systemic risk perspective.

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Key underpinnings

•Ensuring that – the process of being away from disintermediation is

genuine– A clear, transparent capture of the risks within the

prudential framework exists in the treatment of NBFCs•Credit quality robust•Share of low cost current and savings account deposits (CASA) is high

•Banks are required to hold a minimum percentage of their liabilities in risk free government securities.

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•“Maintenance of financial stability involves trade-offs and raises a number of challenges.” (Financial Stability Report, RBI, April 2010)

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What is Financial Stability

•It is “a situation in which the financial sector provides critical services to the real economy without any discontinuity.”

•Absence of financial instability: ‘containment of the likelihood of failure of individual financial firms or any systemic stress and thereby limiting the associated costs to the economy.’

•Arresting the possible consequence of ‘unknown unknowns’ and realising the limitations of modeling apparatus and stress testing exercises.

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Financial Stability Board

• Set up by G-20 in the aftermath of recession.• Mandated to

– Assess vulnerabilities affecting the global financial system– Identify and review the regulatory, supervisory and related actions needed

to address them and their outcomes;– Promote coordination and information exchange among the authorities

responsible for FS– Monitor and advise market development and their implications for

regulatory policy;– Advise and monitor best practices– Undertake joint strategic reviews of policy development work on developing

international standards – Set guidelines for and support establishment of supervisory colleges– Support contingency planning for cross-border crisis management– Collaborate with the IMF to conduct Early Warning System– Undertake any other tasks members may seek to perform.

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Central Banks and FS-Key Aspects

•Supervision of individual firms from a systemic perspective

•Greater involvement of central banks where it is found wanting in supervision of systemically important entities

•A collegial body of government/central bank/regulators

•Reorientation of regulatory mandates of all regulators to also take into account a systemic perspective.

•Monetary stability supports sound investment and sustainable growth leading to FS

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Principal Perspectives of FS

•FS has critical influence on price stability and sustained growth

•FS facilitates efficient transmission of monetary policy actions

•From the regulatory and supervisory angle, FS safeguards the depositors’ interests and ensures stability of the financial system.

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Capital Account

Buttressed through the imposition of prudential safeguards in respect of access of foreign entities to the domestic debt markets and on forex borrowings by domestic corporates. (Cap on FII investments in Corporate (US$15bn) and Government (US$5bn) bonds.

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Liquidity Management

Exposure Norms for Commercial Banks

Exposure to Limit

1, Single borrower

2. Group Borrowers

3. NBFC

4. NBFC-AFC

5. Indian Joint venture /wholly owned subsidiaries abroad/overseas step down subsidiaries of Indian corporates

15% of capital fund (Additional 5% on infrastructural component)

40% of capital fund (Additional 10% on infrastructure exposure)

10% on capital fund

15% on capital fund

20% on capital fund

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Liquidity Management (contd)Exposure Norms for Commercial Banks

Exposure to Limit

6. Capital Market Exposure

(a) Banks holding shares in any Co.

(b) Banks’ aggregate exposure (solo basis)

(c) Group basis

(d) Banks’ direct exposure (solo)

(e) Banks’ direct exposure (group)

(f) Gross holding of capital among banks/FIIs

The lesser of 30% of paid up share capital of the Co., or 30% of the paid up cap of banks

40% of its net worth

40% of its consolidated net worth

20% of net worth

20% of net worth

10% of capital fund

Source: RBI FSR-2010 p 813

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What made us distinct?

• The counter-cyclical regulations applied ahead of the global crisis helped us cushion against systemic instability.

• Significant reduction in risk and rebound in market activity• Pressures on banking sector liquidity during the crisis together with

extraordinary measures taken led to shortening of the maturity profile of bank liabilities

• Banks facing large refinancing needs in the following years

• Management of funding risks skillfully

• More stable customer deposits

• Sovereign and corporate CDS spreads broadly stabilised in Q2-2009

• Corrections in equity prices in Emerging Market economies witnessed largely declines in the range of 30-67 percent.

• Gains started only in the Q3-2009

• Stimulus measures significantly increased global liquidity.

• Forex markets – RBI’s presence in the market helped manage volatility –Forward Premia in Indian forex markets lower than the rate dictated by interest differential.

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Regulatory Counter-cyclical Measures

Date Capital Mkt Housing Other Retail Comm Real Estate NBFC-ND-SI

Risk wt

Pro- vision

Risk Wt

Pro-vision

Risk Wt

Pro-

vision

Risk wt

Pro-vision

Risk Wt

Pro-vision

Dec 04 100 0.25 75 0.25 125 0.25 100 0.25 100 0.25

Jul 05 125 0.25 75 0.25 125 0.25 125 0.25 100 0.25

Nov 05 125 0.40 75 0.40 125 0.40 125 0.40 100 0.40

May-06 125 1.0 75 1.0 125 1.0 150 1.0 100 0.40

Jan-07 125 2.0 75 1.0 125 2.0 150 2.0 125 2.00

May- 07 125 2.0 50-75 1.0 125 2.0 150 2.0 125 2.00

May-08 125 2.0 50-100

1.0 125 2.0 150 2.0 125 2.00

Nov- 08 125 0.40 50-100

0.40 125 0.40 100 0.40 125 0.40

Nov-09 125 0.40 50-100

0.40 125 0.40 100 1.00 100 0.40

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GDP Outlook

•Increasing business cycle correlation between developed and developing economies that enabled India’s current and capital a/c flows more than doubled from les than half of the country’s GDP in 1991 to over 100% of GDP in the last two years.

•Indian economy continued to be driven largely by domestic demand notwithstanding increasing globalization.

•Overall macro economic conditions affected by adverse shocks in farm sector growth – deficient monsoon;associated drought and flood in certain parts of the country; decline in kharif production of food grains and oil seeds.

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GDP Outlook Contd..

• Tangible recovery since April 2009 in industry and services

• Upward bias strengthened due to – Recovery in industry & core

infrastructure– Upturn in business & consumer

confidence reflected in revival of consumption and investment demand

– Revival in exports and capital flows– Recovery in stock market – Higher resource mobilization thru

public issues and private placements• RBI’s growth forecast revised to 7.5% in 09-10

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Exit Process had begun

•SLR restored to 25% - on May 26 reduced to 24.5% to provide more liquidity in the wake of 3-G cash requirements of Telecom Companies.

•Export Credit refinance back to 15%•Non-standard refinance facilities to commercial banks

discontinued•Jan 2010- CRR hiked by 75 basis points to 5.75%•Repo and Reverse Repo hiked by 25 basis points.

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Key Fiscal Indicators (Centre and States) (per cent to GDP)

Year Primary Deficit

Revenue Deficit

Gross Fiscal

Deficit

OutstandingLiabilities

2003-042004-052005-062006-072007-082008-09 RE2009-10 BE

2.1 1.31.00.0

-1.13.44.3

5.83.52.71.30.24.15.1

8.57.26.55.44.18.59.7

81.178.677.274.372.071.673.2

RE: Revised Estimates. BE: Budget Estimates.NOTE: Negative sign indicates surplus.Source: Budget Documents.

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Movements in Monetary Policy Instruments and BPLRs

Phase Monetary Tightening Phase

Monetary Easing Phase

(Mar 2004 – Sep 2008)

(Sep 2008 – Nov 2009)

CRR 450 (-)400

Repo Rate 300 (-)425

Reverse Repo Rate 150 (-)275

Bench mark Prime Lending rates

Public Sector Banks

325-350 (-)125 – (-)275

Private Banks 225 – 375 (-)100 – (-)125

Foreign Banks 100 – (-)150 (+)50 – 0

Source: RBI Report of the Working Group on Benchmark Prime Lending Rate, October 2009

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Liquidity ratios

Liquidity Ratios Mar-05

Mar-06

Mar-07

Mar-08

Mar-09

Sep-09

Dec-09

1 (Volatile Liabilities – Temporary assets)/ (Earning Assets - Temporary Assets) – (%)

34.7 38.4 41.4 43.9 43.9 45.7 45.1

2 Core Deposits/Total Assets – (%)

53.8 53.9 52.2 49.3 48.4 51.0 52.0

3 (Loans + Mandatory CRR + Mandatory SLR + Fixed Assets)/Total Assets – (%)

75.0 79.9 83.4 85.9 79.6 81.4 83.3

4 [Loans +Mandatory CRR + Mandatory SLR + Fixed Assets]/Core Deposits

1.4 1.5 1.6 1.7 1.6 1.6 1.6

5 Temporary Assets/Total Assets –(%)

28.8 30.3 43.4 52.0 47.6 39.9 40.0

6 Temporary Assets/Volatile Liabilities

0.54 0.53 0.65 0.71 0.69 0.61 0.61

Source: RBI Supervisory Returns

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Liquidity Ratios

NO Ratio Components Significance

1 (Volatile liabilities – Temporary Assets)/(Earning Assets – Temporary Assets)

Volatile Liabilities:(Deposits + borrowing bills payable upto 1 year)Letters of credit – full outstanding Component-Wise CCF of other contingent credit and commitments Swap funds (buy/sell) upto one year

As per extant norms, 15 per cent of current deposits (CA) and 10 per cent of savings deposits (SA) are to be treated as volatile and shown in 1-14 days time bucket; remainder in 1-3 years bucket. Hence CASA deposits reported by banks as payable within one year are included under volatile liabilitiesBorrowings include from RBI, call, other institutions and refinanceTemporary assets:CashExcess CRR balances with RBI Balances with banksBills purchased/discounted upto 1 yearInvestments upto one yearSwap funds (sell/buy) upto one yearEarning Assets:Total assets – (Fixed assets + Balances in current accounts with other banks + Other assets excl. leasing + Intangible assets)

Measures the extent to which hot money supports bank’s basic earning assets. Since the numerator represents short-term, interest sensitive funds, a high and positive number implies some risk of illiquidity.

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No Ratio Components Significance

2 Core deposits/Total Assets

Core deposits:All deposits (including CASA) above I year + net worthTotal Assets: Balance sheet footing

Measures the extent to which assets are funded through stable deposit base.

3 (Loans + mandatory SLR + mandatory CRR + Fixed Assets)/Total Assets

Gross AdvancesRequired SLRRequired CRRFixed assets

Loans including mandatory cash reserves and statutory liquidity investments are least liquid and hence a high ratio signifies the degree of ‘illiquidity’ embedded in the balance sheet.

4 (Loans + mandatory SLR + mandatory CRR + Fixed Assets)/Core deposits

AdvancesRequired SLRRequired CRRFixed assets

Measure the extent to which illiquid assets are financed out of core deposits.Greater than 1 (purchased liquidity)Less than 1 (stored liquidity)

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No Ratio Components Significance

5 Temporary Assets/Total Assets

Measures the extent of available liquid assets. A higher ratio could impinge on the asset utilisation of banking system in terms of opportunity cost of holding liquidity

6 Temporary Assets/Volatile Assets

Measures the cover of liquid investments relative to volatile liabilities.

A ratio of less than 1 indicates the possibility of a liquidity problem.

7 Volatile liabilities/Total Assets

Item 5 divided by item 6

Measures the extent to which volatile liabilities fund the balance sheet.

8 (Market value of Non – SLR Securities + Excess SLR Securities) / (Book Value of Non – SLR Securities + Excess SLR Securities)

Measures the market value of non – SLR securities and excess SLR securities relative to their book value. A ratio exceeding 1 reflects that a bank stands to gain if it sells off its saleable portfolio

Source: Report of the Committee on Financial Sector Assessment.

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Rating Outlook of Banks

(Long term Instrument) (hybrid Instruments)

Rating as on March 31,2009

Rating as on

November 30,2009

Rating as on March 31,2009

Rating as on

November 30,2009

No. of Banks assessed

25 26 No. of Banks assessed

25 25

Positive 01 - Positive - 01

Stable 19 25 Stable 18 23

Negative 05 1 Negative 07 1

Source:CRISIL

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Rating as on March 31,2009

Rating as on November

30’2009

Banks assessed Long Term ratingPositiveStableNegative

270

243

283

205

Note: The numbers pertain to long – term instruments only (both national and international), Hybrid ratings where assigned, carry a lower rating but the same outlook as the bank’s long – term rating.Source: Fitch

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Different Regulatory Norms of UCBs

Tier I bank Tier II bank

Definition Deposits less than Rs.100 crore

Other cooperative banks

NPA norm 180 days loan delinquency norm for loan accounts till March 2009

90 days loan delinquency

Asset classification norm

The 12 month period for classification of a substandard asset in doubtful category is effective from April 1, 2009

The 12 month period for classification of a substandard asset in doubtful category has been effective from April 1, 2005

Provisioning Norms Standard Assets:0.25% Standard Asset: 0.25% to 0.40%depending on loan category. Fresh accretion Doubtful Asset for more than three yearsMarch 31,2007 – 50%March 31,2008 – 60%March 31,2009 – 75%March 31,2010 – 100%Doubtful assets outstanding for more than three years 100% from March 31,2007

Source: Reserve Bank of India

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Deposits Advances and Investments of SUCBs (Growth per cent)

Mar 2008 over Mar 2007

Sep 2008 overSep 2007

Mar 2009 over Mar 2008

Total AssetsCapital &ReservesDepositsBorrowingsSLR InvestmentsNon SLR InvestmentsGross loans & Advances

17.229.819.77.9

17.039.516.1

14.917.516.6-2.512.823.918.8

13.225.913.615.213.319.913.7

Source: RBI on Trends and Progress

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Major Sources of Funds of NBFCs – ND - SI

Source of Fund March 2008(Percentage

to total liabilities)

March 2009(Percentage

to total liabilities)

1.2.3.4.5.

DebenturesCommercial PaperBorrowing from Banks and FisInter – corporate LoansOthers

21.74.9

19.85.4

14.1

28.34.5

18.52.8

15.2

Source: RBI Report on Trend & Progress of Banks.

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S.No

Approach The earliest date of making

application by banks to

the RBI

Likely date of approval by the RBI

a.b.c.d.

Internal Models Approach (IMA) for Market RiskThe Standardised Approach (TSA) for Operational RiskAdvanced Measurement Approach (AMA) for Operational RiskInternal Ratings – Based (IRB) Approaches for Credit Risk(Foundation – as well as Advanced IRB)

April 1, 2010April 1, 2010April 1, 2012April 1, 2012

March 31, 2011

September 30, 2010

March 31, 2014

March 31, 2014

Source: Reserve Bank of India

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Macro Economic Environment

•Global activity contraction of 0.8% in 2009 expected to recover by about 3.9% in 2010 (IMF-World Economic Outlook Jan)

•Global inflation remained subdued slipped into negative territory

•Anaemic aggregate demand, sharp decline in oil prices since mid 2008

•Major corrections of agricultural commodity prices and metals•Decline in capacity utilization•Transfer of financial risks to sovereign balance sheets and

higher public debt levels added to financial stability risks and complicated the stimulus-exit process

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Soren Ramdhan Research Findings

• Financial Crisis started in summer 2007 with the lightning failure of Lehman Bros and Washington Mutual Funds and 3 Iceland Banks

• It spread mistrust and fear among Banks and FIs• Four Risk Environmental Factors still being probed:

– Financial Risk valuation models/methods– Risk Control Functions– Risk limiting strategies and – Bonus culture

• Empirical evidence shows that financial risk performance was related with the factors: financial risk valuation models/methods and risk control functions. The factor risk control functions with the financial risk performance have a stronger relation than the factor financial risk valuation models/methods with financial risk performance.

• Remarkably, no evidence is found to support the relation between financial risk performance and the factors: risk-limiting strategies and bonus culture.

 • Financial institutions can achieve better financial risk

performance by emphasizing more on the risk environmental conditions related with financial risk valuation models/methods and risk control functions.

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Introduction (1) Background/scope

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Introduction (1)Effective financial risk management in the future. Learning from the past can be a solution for the future

Need

To identify the significant REC’s.Challenge

Opportunity

Risk practitioners, it is their performance.

Perspective

Reason

19-04-23 34

To re-engineer the risk matrix and spread risk culture seamlessly integrating with the Business of the organization

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The dependent variable

The independent variables

The risk environmental factors

Introduction (2)

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Financial risk performance

(Estimated

financial risk)

Financial risk valuation models

and methods

Risk control functions

Risk-limiting strategies

Bonus culture

The research model and questions

To what extent was financial risk performance related with financial risk valuation models/methods?To what extent was financial risk performance related with financial risk valuation models/methods?

To what extent was financial risk performance related with risk control functions?To what extent was financial risk performance related with risk control functions?

To what extent was financial risk performance related with risk-limiting strategies?To what extent was financial risk performance related with risk-limiting strategies?

To what extent was financial risk performance related with bonus culture?To what extent was financial risk performance related with bonus culture?

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Conclusions

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Recommendations (1)

© Soerinder Ramadhin19-04-23 37

Management of Risk Evaluation Controls holds the key

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Thank You Hyderabad@prmia.org