Global Financial Crisis

The global financial crisis and the ongoing aftershocks of the recession have underscored the need for a robust regulatory and supervisory institutional framework, supported by a sound monetary policy and macroeconomic environment. In a globalizing world, the challenges for central banks across the globe have got accentuated. The desired and intended outcomes of domestic policy actions often carry the risk of getting diluted or distorted through significant ramifications of rapidly evolving external developments in the domestic economy. For the policy makers in developing economies, these challenges get further amplified with varied stages of growth and development of the domestic financial markets. Emerging relatively unscathed from the aftermath of the global financial meltdown, India's recovery has been remarkable. Significantly, India's financial sector, especially the banking sector has remained robust and resilient. The Reserve Bank of India emerges as a central bank that has navigated a volatile and difficult global and domestic environment with a significant degree of success. Within an overall approach of gradualism in the economic policy in India, the calibrated stance adopted by the RBI to reform the external and the financial sector has served well in minimising the collateral damage. The financial crisis exposed the vulnerability of monetary policies designed with a single minded focus on price stability. The aftermath of the crisis revealed that price stability was necessary, but not a sufficient condition and did not ensure financial stability. Thus a new policy framework for central banks that encompassed bank regulation, supervision, prevention of asset price bubbles and financial stability has emerged. For India, this is not new. The monetary policy framework has been continuously evolving. With an increasing market orientated approach the RBI's policies have been governed by a broad set of objectives of maintaining a prudent balance between price stability, economic growth and financial stability. While the underlying thrust has been that of definitive progress in liberalisation of the financial sector, it has been characterised by caution and safeguards against excesses. Financial stability has been the pivotal theme in its reform agenda. The crisis also brought to the fore the downsides arising out of the principle-based regulation adopted by some of the regulators that left too much discretion to the regulated entities to manage their own risks. The regulators concentrated on mitigating the entry-level risks in the individually regulated institutions through micro prudential regulation, rather than risks to the system through macro prudential monitoring. In contrast, in order to safeguard the financial system from such risks, the RBI has maintained a very robust supervision mechanism for banks. The dual supervision of banks in terms of annual on-site inspections and the off-site monitoring process has helped capture systemic issues at the individual bank level and also early warning signals, which have then led to timely action by the RBI. The regulator was early in spotting asset bubbles building up in several sectors including real estate sector, the stock markets and consumer credit, and it imposed increased counter cyclical measures on banks lending to these sectors when the economy was on a strong growth trajectory. This was much before the global crisis engulfed all the economies of the world. The need for counter-cyclicality in regulation that reduced the risks of amplifying the boom and bust cycles was identified early by the RBI to prevent a systemic collapse. RBI's Proactive Stance The global financial crisis also taught us that regulators focused too much on regulating commercial banks, while ignoring the developments in the 'shadow banking system' that later turned out to be the sources of risk. The existence of multiple regulators facilitated regulatory arbitrage by the market participants, thereby exacerbating the risks. Early in detecting such systemic risks, the RBI stipulated tight regulations around Non Banking Financial institutions (NBFCs), specifically deposit taking NBFCs. The regulations ranged from prudential capital requirements, exposure norms, liquidity management, asset liability management, and much more. Systemically, across the globe, banks developed a business model wherein they originated loans but distributed the credit risks inherent in such loans to others. This led to a manifold increase in the leverage. The securitisation was a convenient tool to avoid additional regulatory capital. Excesses of these led to huge increase in the overall leverage in the financial sector. In a proactive stance, the RBI initiated certain regulations and guidance which contained the excessive leverage and off-balance sheet activities by banks. For instance, the RBI initiated amortization of gains from securitisation for the total tenure of the outstanding, there by moderating the incentives of the seller, and by ensuring that only the genuine sellers participated in securitisation. Furthermore, the RBI levied higher capital charges for the originating companies, on account of credit enhancements provided to the pool. In conclusion, the RBI's emphasis on gradualism and calibrated emphasis on multi-indicator approach has benefited the economy. RBI's timely interventions and macro-prudential measures which also put a leash on the shadow banking activities, have also prevented asset price bubbles. These lessons from the crisis and RBI's prudence should surely provide guidance and be relevant yard sticks in future G-20 forums, given RBI's immense intellectual property with its practical outcomes.