Pursuit of financial stability:

The Indian experience

Dimple Bhandia
January 15, 2013
Financial Stability In search of a definition












Financial Stability Dimensions

Broad, encompassing

And Forward looking

There is no universally accepted definition of financial stability. Definitions by
various experts abound but most definitions are not amenable to quantification.
Financial system functioning without disruption and return to steady state after
periods of volatility/vulnerability without significant impairment to longer term
prospects, is generally considered an indicator of stability.
Volatilities within an acceptable/tolerable
range can represent a state of financial
stability.
Factors Affecting Financial Stability
Vulnerabilities in the real
economy
Global imbalances and rapid
capital flows
Complex financial products and
rapid technological development
Asset price bubbles
Shadow banking system
Light touch regulation
Contagion
Interconnected markets
Too big to fail counterparties

Well.. Virtually anything.
Anywhere!!!

Why Financial Stability
Impact potentially severe
Especially for emerging
markets
Contagion worldwide
tentacles
Financial instability anywhere
can be a threat to financial
stability everywhere
Theory of decoupling weaker
than accepted
Sectors
Real and financial sectors
through feedback loops
Lessons learnt from the Crisis
Lessons learnt from the Crisis
Recognition of the need to pursue financial stability as
an explicit policy objective
The Need to strengthen the macro-prudential
framework
To see both the forest and the trees!!
The need to better identify, assess and manage the systemic
risks prevailing in the financial sector.
Renewed policymaker interest in developing and improving
tools to promote financial stability
Innumerable!

Systemic Risks
Systemic events
Can be broadly understood broadly as financial
instabilities spreading to the extent that the
financial intermediation process is impaired and
economic growth and welfare suffer materially

Systemic risks
Risk of occurrence of a
systemic event

Systemic Risks
Time dimension:
Financial imbalances that build up
gradually over time may unravel
suddenly.
Cross sectional dimensions:
Contagion risk - an initially
idiosyncratic problem that becomes
more widespread, often in a
sequential fashion.
Shared exposure to financial
market shocks or adverse
macroeconomic developments that
affect a range of financial
intermediaries and markets at the
same time
Measuring Systemic Risks
Identification of systemic risks is
far from straightforward given
that systemic risks per se are
complex and multifaceted.
There is a need to have a wide
range of measures and tools
covering different aspects of
systemic risks.
A host of new quantification
measures have, post the crisis,
emerged in academic literature,
while central banks are
developing tools and techniques
which will help identify and
measure systemic risks.
Measures of systemic risk contribution

Treat systemic risk as the extent to which individual
financial institution pollutes the public good of overall
financial stability

Focus on the systemic risk contribution of individual
institutions

In principle, such measures, if accurate, could be used for
Pigouvian taxes, levies or other regulatory interventions
aimed at internalizing the negative externalities
The additional capital surcharge proposed to be levied on
Globally Systemically Important Banks

Modeling Risks of Aggregate Shocks
Focus on the impact of macroeconomic shocks on the
financial system
Adverse macroeconomic scenarios used in stress testing
To assess resilience of financial institutions
Macroeconomic shocks matter for financial stability!
They tend to affect all firms in an economy, financial and
nonfinancial, at least to some extent.
A macro shock causes an increase in correlated default losses,
with detrimental effects on financial stability.
Stress-testing models are designed to map adverse
macro-financial scenarios into losses in shared credit
and asset exposures.
Financial Stability Reports
Role of FSRs
Limiting instability by pointing out key risks and
vulnerabilities to policy makers, market participants and
the public at large

A part of the macroprudential toolkit

These reports serve to assure the public and economic
agents that everything is well in the financial sector
when this is the case. They also serve as early warnings
when problems show up at the horizon. Early action can
then prevent any financial instability to materialise.
Lars Svensson (2003), NBER WP 9486
Trends in Reporting Financial Stability
Number of countries publishing FSRs
Source: Financial Stability Reports: What are they good for,
Martin Cihak, et al, World Bank, Dec 2011
Characteristics of FSRs
Standalone document

Generally central bank oriented

Focus on risks and exposures of the financial
system
Systemic risk
Forward looking perspective
Analysis of financial interconnectedness

Regularly published
Trends in contents of FRS
Of late
Use of more sophisticated market based
indicators

Use of stress testing

Presenting results of early warning systems

Extensive use of disaggregated data

Extensive use of modelling


Central banks and financial stability
Prior to the crisis
Exclusive (excessive?) focus
on price stability
Asset price bubbles
central banking function?
Greenspan orthodoxy

Light touch regulation

Risks identified but no
action taken

Central banks and financial stability
Post the crisis
Recognition of the need to pursue financial stability as an
explicit policy objective
Widespread amendments to regulatory infrastructure
(national and international) and legislations to pursue
financial stability
THE HOLY TRINITY!
Price Stability, Financial Stability and Sovereign Debt
Sustainability
The Reserve Bank of India
Raison d'tre

to regulate the issue of
Bank notes and the keeping
of reserves with a view to
securing monetary stability in
India and generally to
operate the currency and
credit system of the country
to its advantage

The Preamble of the Reserve
Bank of India Act, 1934

First RBI Building 1935, Kolkata
Now A full services central bank
Monetary Authority
Issuer of Currency
Banker and Debt Manager to
Government
Banker to banks
Regulator of the Banking System
Manager of Foreign Exchange
Regulatory of Payment and
settlement systems
Maintaining Financial Stability
Development Role
RBI Central Office Building, Mumbai
Financial Stability and the Reserve Bank of India
Maintaining financial stability has been an explicit objective of the
Reserve Bank since 2004.
The Reserve Bank has, over the
years, attempted to address both
aspects of systemic risks the
time dimension (procyclicality)
and the cross sectional
dimension (interconnectedness)
within a macroprudential
framework, without christening
these policies as macroprudential
policies.
Board for
Financial
Supervision
Board for
Payment
and
Settlement
Systems
Separate
committees
of RBI Central
Board
responsible
for focussed
regulation
and
supervision of
institutions
and system
Financial Stability and Development Council
The FSDC, set up in 2010, is a body consisting all regulators and
the Ministry of Finance. It is the highest forum in matters
relating to financial stability. The Council is chaired by the
Union Finance Minister
Financial
Stability
Financial Sector
Development
Macro
prudential
surveillance
of the
economy
Financial
literacy and
financial
inclusion
Inter-
regulatory
coordination
The
responsibility of
FSDC includes
The Financial Stability Unit

Conduct of macro-prudential
surveillance of the financial system
on an ongoing basis.

Developing models for assessing
financial stability

Conduct of systemic stress tests to
assess resilience

Communicating risks to financial
stability
An operationally independent FSU was set up in July
2009 with the following mandate:
Systemic
Risk
Assessment
Process
Study of
international
best practices
in systemic
risk
assessment
Robust and extensive
analysis of a database
of
- Off site Banking and
non banking sector
supervisory returns
- Ad hoc data requests
from financial
institutions
In house
econometric
research and
statistical studies
to support
assertions in the
FSR
Latest tools and
techniques

- Macro-financial
stress testing

- Network Analysis
The Indian Financial System
Percentage Share in total financial assets
59.3
2.3
5.8
6.5
2.4
13.5
4.1
6
Scheduled Commercial Banks and LABs
Urban Cooperative Banks
Rural Cooperative Credit Institutions
and RRBs
NBFCs
Development Financial Institutions
Insurance Companies
Provident and Pension Funds
Mutual Funds
Diverse but largely within a defined
regulatory perimeter
Financial Network Analysis (1)
Network analysis is a tool which seeks to explore how systemic
risks are affected by the structure of the financial system
How does the size and distribution of exposures between banks
determine the resilience of the system as a whole?
How does the potential for interbank exposures to transmit
shocks from one bank to another inter relate with the aggregate
amount of capital available to cushion shocks?
Are more concentrated banking systems with a small number of
large banks, more or less susceptible systemic breakdown than
systems that comprise a large number of small banks?
Are tiered systems, where a small number of core banks
coexist with a fringe of smaller banks in the periphery more or
less susceptible to systemic breakdowns than less tiered or more
uniform systems?

Financial Network Analysis (2)
Tiered structure of the banking system
Financial Network Analysis (3)
The network of the financial system
Financial Network Analysis (4)
Contagion Analysis
Banking Stability Measures
Modeling Distress dependencies among banks Probability of
Distress based on equity prices of select banks
Joint Probability of Distress (JPoD) - probability that all banks in
the system experience large losses simultaneously.
Banking Stability Index (BSI) - the expected number of banks
under distress if at least one bank is under distress.






0
0.001
0.002
0.003
0.004
0.005
0.006
0
1
2
3
4
5
J
a
n
-
0
8
M
a
y
-
0
8
A
u
g
-
0
8
N
o
v
-
0
8
F
e
b
-
0
9
M
a
y
-
0
9
A
u
g
-
0
9
N
o
v
-
0
9
F
e
b
-
1
0
M
a
y
-
1
0
A
u
g
-
1
0
N
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v
-
1
0
F
e
b
-
1
1
M
a
y
-
1
1
A
u
g
-
1
1
N
o
v
-
1
1
F
e
b
-
1
2
M
a
y
-
1
2
A
u
g
-
1
2
J
P
o
D
B
S
I
BSI JPoD
0
0.0001
Jun-10 Jun-11 Jun-12
Stress testing
Macro financial stress tests
Testing the resilience of financial institutions to adverse
movements in macroeconomic variables
Sensitivity Analysis
Supplement to macro stress tests
Assessing resilience of financial institutions to adverse
movements in a range of risk factors covering foreign
exchange, liquidity, interest rate and credit risks
Both top down and bottom up stress testing deployed
Stress testing the derivative portfolio of banks
Sensitivity and Scenario analysis

Macro Stress Tests
Macro stress testes assess the vulnerability of the banking system to
extreme but plausible adverse macroeconomic shocks.

Bank group level NPA and CRAR are projected using various
econometric tools, like, multivariate regression, panel regression,
logit regression, Vector Autoregression(VAR), Quantile regression, etc.
Projected Gross NPA ratio using Different Models
(FSR June 2012)


Projected CRAR using Different Models
(FSR June 2012)

Stability Maps and Indicators (1)
Maps and Indicators
Macroeconomic Stability assesses risk conditions in the
macroeconomy
Financial Markets Stability assesses stability of financial
markets
Banking Stability assesses changes in underlying
conditions/risk factors affecting the banking sectors stability
Financial Stability assesses overall stability conditions in
the Indian financial system
Supplementary Indicators to assess vulnerabilities
emanating from
Systemic Liquidity conditions
Fiscal situation
External Sector
Housing Prices

Stability Maps and Indicators (2)
Financial Stability Map and Indicator
Financial Stability Indicator ** Financial Stability Map *
(*) Away from centre implies higher risk (**) Higher level implies lower stability
Macro
Stability
Banking
Stability
Financial
Market
Stability
Mar-11 Sep-11 Mar-12
0.0
0.2
0.4
0.6
0.8
1.0
D
e
c
-
0
8

M
a
r
-
0
9

J
u
n
-
0
9

S
e
p
-
0
9

D
e
c
-
0
9

M
a
r
-
1
0

J
u
n
-
1
0

S
e
p
-
1
0

D
e
c
-
1
0

M
a
r
-
1
1

J
u
n
-
1
1

S
e
p
-
1
1

D
e
c
-
1
1

M
a
r
-
1
2

Stability Maps and Indicators (3)
Macro Stability Map
Macroeconomic Stability Map *
(*) Away from centre implies higher risk
Global
Growth
Inflation
External Fiscal Index
Corporate
Household
2010-11:Q4 2011-12:Q2 2011-12:Q4
Stability Maps and Indicators (4)
Financial Markets Stability Map and
Indicator
Financial Markets Stability Indicator **
Financial Markets Stability Map *
(*) Away from centre implies higher risk (**) Higher level implies lower stability
Stability Maps and Indicators (5)
Banking Stability Map and Indicator
Banking Stability Map * Banking Stability Indicator **
(*) Away from centre implies higher risk (**) Higher level implies lower stability
0.0
0.2
0.4
0.6
0.8
1.0
Soundness
Quality
Profitability Liquidity
Efficiency
MAR11 SEP11 MAR12
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
M
A
R
0
1

S
E
P
0
1

M
A
R
0
2

S
E
P
0
2

M
A
R
0
3

S
E
P
0
3

M
A
R
0
4

S
E
P
0
4

M
A
R
0
5

S
E
P
0
5

M
A
R
0
6

S
E
P
0
6

M
A
R
0
7

S
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P
0
7

M
A
R
0
8

S
E
P
0
8

M
A
R
0
9

S
E
P
0
9

M
A
R
1
0

S
E
P
1
0

M
A
R
1
1

S
E
P
1
1

M
A
R
1
2

S
E
P
1
2

Assessment of Systemic Risks - Challenges
Complex and opaque - Difficult to Measure
No universally accepted definition
Risk factors are generally not observable hence difficult to
quantify
Large mass of uncertainties known and unknown
Effectiveness and appropriateness of tools is not easily
measurable
Significant data gaps
Challenges in connecting the dots

Assessment a best estimate
Type I and Type II errors
The Learning curve is steep!
Publishing of FSRs - Challenges
Some financial stability issues too sensitive to be
discussed publicly
Could trigger behaviour likely to provoke a crisis, especially in
times when the financial system is already disturbed
Exist real, inherent constraints in communicating tail risks
Regular publications help in preventing over
interpretation

Loss of credibility
Crying wolf Most risks communicated will not materialise

Data gaps and challenges in systemic risk assessment
Validity of models/conclusions
Public policy?
Financial stability and growth two sides of the same
coin?
Conventional wisdom says: financial stability promotes and
stimulates growth
A stable financial system is a pre-requisite for sustainable economic
growth (William Dudley, New York Fed, 2011)
But evidence scarce!
What about financial instability?
Price stability and financial stability Are there trade offs?
Return of fiscal dominance over monetary policy?
Accountability of central banks

The new trilemma
The Holy Trinity of price stability, financial stability and growth
Questions?