Systems beyond silos
Financial Express, 11 February 2012
Central banks in advanced countries have been held accountable for price stability. The job of maintaining financial stability is a new focus that has been entrusted to many central banks, finance ministries and financial sector regulators since the 2008 crisis, when it was realised that no one was adequately looking at systemic risk in the financial sector.
Systemic risk thinking is about the scenario where an entire financial market ceases to function. As an example, during the 1991/1992 crisis, the bond market and the stock market essentially ceased to function. Similarly, in late 2007, the money market in London stopped functioning (well before Lehman died). The collapse of market liquidity can arise from several directions. A very big firm can collapse, and this can set off a domino effect. Or, a large number of small firms can behave in correlated ways and collapse together. Or, deeper problems in market liquidity can arise which kill off the liquidity.
The critical feature of systemic risk thinking is to look beyond silos, to look at the financial system as a whole. This is something very new to us in India, where finance has been partitioned up into silos each governed by one financial regulatory agency. Modern finance is inevitably evolving towards large, complex financial firms that do business in all sectors. Sectoral regulation is ill-equipped to understand the map of risk in this world.
In a systemic perspective, when regulations are restrictive in one sector, business tends to migrate to another sector. for this reason, there is now an even stronger case to move towards a single regulator for all finance. but even when there is a single regulator for finance, the systemic risk perspective encourages skepticism: risk tends to move towards unregulated firms.
Conventional financial regulators tend to think of one financial firm at a time. This is called `micro-prudential regulation'. This is a poor tool for thinking about systemic risk since the whole is bigger than the sum of the parts. Very careful analysis of one firm at a time does not guide the analysis of collapses of market liquidity.
This is not to say that micro-prudential regulation is not worth doing. It is an important element of financial regulation. The micro-prudential regulator should be looking keenly inside the books of each firm (and all its subsidiaries), worrying about the failure probability. If the firm starts taking too much risk, then it is the job of the supervisor to speak to the managers and get them to reduce that risk. While he tries to do such a thing, the highly incentivised employees of the firm would betrying to increase risk in ways that he does not see. This is gritty, detailed, transaction intensive work. An agency which has a strong organisational culture for doing this will find it hard to see the woods for the trees, to shift gears from details to understand the overall financial system. Hence, it is important to separate systemic risk (termed "macro-prudential regulation") from conventional financial regulation and supervision (termed "micro-prudential regulation").
Risks to financial stability can arise at any time, both during a recession and during a boom. These could be, say, excessive lending to housing in the middle of a property boom. These risks cannot be countered by fiscal or monetary policy. A separate set of instruments is required. These instruments, known as instruments for macroprudential regulation include loan to value ratios, risk weights, provisioning norms and margin requirements on stock exchanges.
The world is, as of now, at the early stages of figuring out what these instruments are, and how best they should be utilised. The field of macro-prudential regulation today is much like central banking pre-1980 : governments created central banks before the knowledge was in place. Unsurprisingly, in the pre-1980 period, central banks in first world countries made many mistakes. It is likely that the field of macro-prudential regulation is going to fumble along similarly, given the lack of data and scientific knowledge. The top priority right now should be on improved data collection and on research. Attempts at data collection and analysis are being put together, such as at the US Treasury's new `Office of Financial Research'.
In any country, there will necessarily be a constellation of players: a Treasury (which controls all use of public resources), a central bank (which is the utility that produces emergency liquidity when required), a micro-prudential regulator (which understands whether a firm is solvent or illiquid) and a macro-prudential agency (which has the big picture of what is going on in the system). All these need to talk to each other and coordinate strategies. For this, better coordination mechanisms are required. In most countries, the picture is not so clean: there are multiple agencies and/or agencies combine multiple conflicting functions. This makes coordination even more difficult.
RBI Governor Subbarao has made an important speech in a recent RBI conference. The speech emphasises that the RBI is being asked to do too much, and there are conflicts in delivering the various objectives placed on the RBI. Financial stability cannot, and should not be the sole responsibility of RBI, for which, as the Governor points out, the RBI has no mandate.
Internationally, one concern on this issue is not to place all three crucial functions of monetary policy, microprudential regulation and macroprudential regulation, in one institution. Along with the concentration of risk this reduces accountability of the institution. It would become impossible for the government to give such an institution independence as should be given for the conduct of monetary policy or financial regulation.
In India, the government has set up the Financial Stability and Development Council whose task would be to look at the big picture (macro-prudential regulation) and to perform coordination. Once this is put into place as a technically sound team, the remaining questions that follow are: How do we establish sound coordination mechanisms? How do we move towards a unified micro-prudential regulator? What would be the role of the RBI? Many countries are undergoing an overhaul of their regulatory structure in the light of these questions. India, too, needs to find well thought out answers to them.
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