Analysis of Financial Stability Report, June 2011

Money Banking & Financial Management

Submitted to Prof. Avinash P.

Ayan Bhatnagar -10214 Hima Sachdeva- 10225 Khushal Puri - 10230

The Financial Stability Report holistically assesses, from a systemic risk perspective, disparate
elements of the financial sector eco-structure the macroeconomic setting, policies, markets, institutions. The FSR states that the Indian financial system remains stable in the face of some fragilities being observed in the global macro-financial environment. Growth is slackening in most parts of the world, even as the risks from global imbalances and sovereign debt crises in Europe continue to hover. The uncertainties in global environment with persistently high energy and commodity prices have contributed to a slight moderation in Indias growth momentum as well. The macroeconomic fundamentals for India, however, continue to stay strong, notwithstanding the prevailing inflationary pressures and concerns on fiscal fronts. The Report recognises that a slowdown in the growth momentum is inevitable as inflation looms large, with the possibility of further upward pressure in the ensuing months. This could affect the quality of assets of the financial sector. The present level of current account deficit is not really a concern, but as demand for funds in the industrial countries gathers momentum, Indian financial institutions could face increased funding costs. The enhanced recourse to external commercial borrowing (ECB) is increasing currency mismatches in Indian corporate balance-sheets. The increase in the non-official sector's net liability position reflects the risks that could arise from depreciation of the rupee. In the analysis of this report, we have tried to critically examine and interpret the facts and data shown in the report. For the purpose of analyzing, we kept the original division of reports into five parts; answer tried to assess each part separately, namely

Macroeconomic Outlook Financial Markets Financial Institutions Financial Sector policies Macro-financial Stress testing

Macroeconomic Outlook
The report states that the improvement in macroeconomic conditions at the global level has contributed to some moderation in risks to global financial stability, But in domestic front the growth is bound to remain moderate because of high inflationary pressures. Even the current account deficit would remain high because of rise in rise in imports resulting from higher oil and commodity prices. According to the data given in the report the macroeconomic outlook would be more dependent on internal issues compared to Global issues. In the first half of this year the signs of recovery in several advanced economies have strengthened. Some concerns regarding sovereign debt risks in the Euro Area, however, have re-emerged. The report shows how factors like high food & commodity prices, slowdown in US, and withdrawal of fiscal stimulus have influenced global growth negatively but a decline in Unemployment rate has provided a silver lining. The report does capture the symptoms faced by the world but it doesnt completely capture the problems underlying. No efforts have been made to delve deeper into the factors written there e.g. the reason for behind those factors like rise in commodity and Food prices etc. The report is also silent on the roles of Central Banks as they would try or are trying to appease these factors. The report has extensively cited Global and domestic reason for change in financial stability. The Imbalance and a high volatility of Balance of trades among largest economies is having a negative effect on the Stabilization process. The sovereign debt crisis in Europe has returned full circle to the problem that started over a year ago. But with that the growth story of Indian Exports reflects diversification of products from labor intensive manufactures to higher valueadded products in engineering and petroleum sectors and to destinations across emerging markets and developing economies. The report also tries to find the impact of changing prices of House property. The data from previous year shows that Credit is growing at its trend rate and the servicing of these assets as reflected in housing NPAs ratio has continued to record improvement. The fiscal consolidation will continue, but the report is silent on the quality and pace of the fiscal consolidations. These two factors in Fiscal Consolidation can either favorably or adversely affect the stabilization process. In nutshell we can interpret that it was more on domestic grounds than global which affected Financial Stability.

Financial Markets
The FSR highlights how issues all over the world like the European sovereign crisis, the MENA unrest and the Japan earthquake have affected global financial markets. The MENA crisis has impacted energy markets though the effect is still not fully blown, the risks cannot be under estimated if the bigger oil producers are drawn in. The uncertainty of nuclear energy as a source of energy is also affecting energy markets and might lead to greater inflationary pressures. The Federal Reserve has linked higher employment levels to greater economic stability in the region, which is reflected as the dollar has declined over the past few months in the wake of lower than expected increase in the employment levels. Though the earthquake in Japan had rattled the financial markets, the situation soon stabilized after the BoJ injected 37 trillion yen in the financial markets. But, at the same time the burgeoning debts of the European countries viz. Greece, Ireland and Portugal pose a risk to the bigger economies. The report very well captures the affect of global issues but it has downplayed the effect of the increased financialisation of the Commodity markets in Emerging Economies ,which are indicative of the price volatility and thus crowding out genuine hedgers. Moving to the domestic market, the report highlights the persistent deficit liquidity conditions due to frictional and autonomous factors, which was reflected in high call money market rates, high CP, CD and Treasury bill rates. The rupee has remained in a range against the dollar due to recovery in portfolio flows and narrowing of current account deficit. The report clearly articulates the increase in exposure to foreign currency. Due to interest rate differential in emerging economies and advanced economies there has been a significant increase in External Commercial Borrowings (ECB) which not only increases the currency mismatches in the national balance sheet but also increases the exposure to currency risk. The net liability of the non official sector has risen to US$ 437 billion. Also, CRISIL has estimated that FCCBs worth Rs. 220 to 240 billion may not get converted into equity shares as the current stock prices of issuing companies are significantly below their conversion prices, thus resulting in funding problems for firms.

The report also highlights herd behavior which is prevalent in capital markets especially during periods of stress. It also states that the recent inflows in bond markets are due to expansion of limits for FII investment and has offset the equity markets pull out.

The FSR also has a mention of Smart Order Routing (SOR) which is being implemented by SEBI to help brokers make better deals. In effect, the report captures all aspects of the financial markets, other than downplaying of the effect of financialisation of the commodity markets.

Financial Institutions
While the banking sector, by and large, reflects good health, the robust credit growth points to future vulnerabilities. As deposit growth has been less than credit expansion, there would be increasing maturity mismatches affecting profitability. Periods of high credit expansion give rise to credit booms which are precursors to credit busts and financial crisis. While Indian banks are well capitalised and are above the Basel II norm of 12 per cent, increased provisioning for pension liabilities and increased non-performing assets (NPAs) could erode the capital of banks. The Report further says that the increase in the savings bank deposit rate could affect profitability. The possible deregulation of savings bank deposit rates could increase low-cost deposits rather than longer-term high-cost deposits, and thereby contribute to enhanced profitability. Amendments to the banking sector legislation are on the anvil and the Financial Sector Legislative Reforms Commission (FSLRC) has a mandate to recommend a revamp of financial sector laws. The financial soundness of the co-operative sector remained a matter of concern though consolidation measures continued to progress. The regulation of non banking finance companies has been progressively tightened in order to plug regulatory gaps and dissuade regulatory arbitrage. The penetration of the insurance sector has increased after it was opened up to private players and FDI through joint ventures was permitted. The regulatory framework for insurance in India has ensured a robust and well regulated sector. While the essential structure of the insurance business entails relatively lower systemic risk, the interconnectedness of the sector

with the banking and the rest of the financial system could be a source of disruption which may need careful monitoring.

Financial Sector Policies

Sound regulatory policies are critical for smooth functioning of the financial system. Thus, the financial policies need to be put under the scanner to ensure that there are minimal systemic risks posed by malfunctioning of any financial institution. The major lags which exist are in the following areas a. Regulatory gaps permitting deposit raising activities of cooperative societies without being subject to prudential norms need to be plugged; b. Proliferation of structured products in an unregulated space thus posing systemic concerns; c. Gaps in regulation in the non banking financial sector remain even as the various regulatory bodies continue to be closely interconnected; d. The regulatory framework for wealth management services warrants examination e. Supervisory framework for Financial Conglomerates (FCs) being strengthened issues relating to resolution and interconnectedness remain germane

Though the report highlights the various loopholes and issues, most of which have also been mentioned in the previous FSR it fails to suggest concrete solutions for these. As the financial system is affected by global upheavals suggestions have been made to seek international cooperation in this regard, by sharing information and adopting internationally agreed standards and reforms, e.g. a central repository that will give a clear picture of the positions and exposures in derivatives. The efficacy of such measures is questionable as there will be a lot of issues relating to the transparency of information by the institutions of various countries. Also, issues regarding governance and power centers are bound to arise. The FSR highlights various tests which have been done to identify system linkages, these show that there is high exposure and dependency among the various entities of the banking sector but

these interactions have not captured the systemic effect the non banking financial institutions can have in case of a failure. The counter cyclical buffer which is used to extend the size of capital conservation during periods of excess credit growth cannot be solely be estimated based on the aggregate private sector credit to GDP gap, but a mix of qualitative and quantitative indicators are required and also a considerable degree of judgment. The qualitative and quantitative indicators are yet to be identified and the extent of effect each one will have on the buffer value is questionable, also this method requires considerable degree of judgment which may not bring in desired results. Internal rating systems require time series data to correctly predict the quantification of default and loss estimates, calibration of the exposure at default, and quantitative modeling of macro and micro level risk factors. But all these exercises are futile unless the underlying data is correct as recently pointed out by RBI when the change in the policy rates failed to bring about the desired effect. The application of Basel III proposals might hit the growth of the country as this call for stringent capital adequacy requirements. These may be in line with the goal of the developed countries but in countries like India where credit demand is expected to pick up, such measures will create a downward effect on the economy. Thus, the central bank and other regulators need to be very vigilant while choosing policies which need to be implemented while making sure that inter sector risks are minimal.

Micro-financial Stress Testing

In this section the RBI has studied impacts of various levels of stress on banking industry. The stability of banks has been studied through the Joint Probability of Distress (JPoD) and the Banking Stability Index (BSI), which takes into account the impact of one bank on others through direct or indirect links. Further, the resilience of the commercial banks in respect of credit, interest rate and liquidity risks were also studied through stress testing by imparting extreme but plausible shocks. The report has duly given importance to significance of measuring Systematic risk and its implication on the economy.

In the report, two indicators, the Joint Probability of Distress (JPoD) and the Banking Stability Index (BSI) have been used. The JPoD represents the probability of all the banks in the system (portfolio) becoming distressed. Whereas, BSI reflects the expected number of banks becoming distressed given that at least one bank has become distressed. It was observed that the expected number of banks (out of the sample of 20) which was under distress was 4 during the crisis has declined to 1 by the last quarter of 2010. But, it has again increased to 2 during the first quarter of 2011. The report has also delved into measuring Credit risk, liquidity risk and interest rate risk. A scenario analysis was undertaken for testing the credit risk using a balance sheet approach. It was found that under the stress conditions, profitability of banks was adversely affected. The Return on Assets (RoA) density function under stress conditions shifted towards negative values indicating more and more banks unable to earn positive returns under the assumed stress conditions. Liquidity stress tests showed that a few banks did not have adequate liquid assets to meet the withdrawals on the first day itself. The number of such banks increased in March 2011 as compared to March 2010. However, the total number of banks unable to withstand the stress scenario at the end of five days was higher in March 2010 indicating a slight improvement of the position under the liquidity stress tests relative to the previous assessment. While analysing the report and various data, we made out that under stress scenarios of lower GDP growth and higher rates of inflation & interest, NPA ratio would increase further. Distress dependence across banks rises during times of crisis, indicating that systemic risks, as implied by the JPoD and the BSI, rise faster than individual risks. The distress dependence across major banks increased substantially during the global crisis period. The vulnerability of banks was high during the recent financial crisis but declined substantially during the subsequent period. The interest rate risk through the Duration of Equity (DoE) method showed that the DoE continued to remain at elevated level, with an improvement in recent quarters, suggesting active involvement of banks in managing interest rate risks. Regarding liquidity stress test, under severe stress situation, when market sentiment is poor, some banks may face extreme liquidity constrains and may show a sign of vulnerability.