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Financial Sector Assessment. Rakesh Mohan Deputy Governor Reserve Bank of India and Chairman, CFSA. What is an FSAP?. The Financial Sector Assessment Program is an IMF-World Bank initiative A comprehensive health check of the financial system
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Financial Sector Assessment Rakesh Mohan Deputy Governor Reserve Bank of India and Chairman, CFSA
What is an FSAP? • The Financial Sector Assessment Program is an IMF-World Bank initiative • A comprehensive health check of the financial system • A review of strengths, vulnerabilities and weaknesses • Measures compliance with international financial standards and codes • Initiated after the1997 Asian financial crisis
Presentation Outline Part I: The FSAP and Self-Assessment A. Background and Timing B. Macroeconomic Outlook and Vulnerabilities C. Stability Assessment & Stress Testing Part II: Lessons and Issues from the Assessment D-F. Financial Institutions, Markets and Infrastructure G. Transparency and Developmental Issues Part III: Transparent Reporting H. Peer Reviewers’ Comments I. CFSA and Advisory Panels – Some Differences Part IV: Conclusions and Concerns J. Summary of Assessment K. Main Concerns
Part I The FSAP and Self-Assessment
Background and Timing (1)The Story So Far • IMF-WB FSAP in 2001, self-assessment of international standards and codes in 2002, reviewed again in 2005 • Set up CFSA in 2006 • India among the first country to undertake comprehensive and holistic self-assessment of financial sector • Post-crisis, emphasis by the G-20
Background and Timing (2)Overview of Self-Assessment Approach and Methodology Pillar I Macro-prudential surveillance and financial stability analysis Pillar II Legal and institutional frameworks review Pillar III International financial standards and codes: assessment and status of implementation
Background and Timing (3)The Process • Benefits • Composition of CFSA: ownership and commitment • Regulatory cooperation: GoI, RBI, SEBI, IRDA, other agencies • Involvement of experts: advisory panels • Peer reviews: Impartiality • Learning and capacity-building: involvement of professionals • Execution • Complex issues – approach with humility • Broad directions instead of specifics in the current context • Focus on Transparent Reporting : Differing opinions of CFSA and Panels covered in the report
Macroeconomic Outlook and Vulnerabilities (1)The Growth Story • Growth in recent period contributed by several factors • High domestic demand • Productivity • Credit growth • High levels of savings and investment • Current global financial crisis: shift from benign outlook to one of uncertainty • 8 %+ growth sustainable in the medium-term due to high demand; deceleration in the short-term
Macroeconomic Outlook and Vulnerabilities (2)Pressing Challenges • Need for revival of growth in agriculture • Address restoration of the fiscal reform path • Continuation of financial sector consolidation and development • Address the infrastructure deficit • Complement bank financing with bond market development • Insurance and pension reforms • FCAC desirable, but with concomitant macroeconomic and market developments
C. Stability Assessment and Stress Testing
Stability Assessment and Stress Testing (1)Main Findings Financial Institutions • Commercial Banks: financially robust • NBFCs and HFCs: healthy financial indicators • Some financing concerns • UCBs and RRBs: improvements in financials • governance concerns • Rural Co-operative Sector • significant weaknesses
Stability Assessment and Stress Testing (2)Financial Soundness Indicators • Commercial Banks - Broad improvement in the post-reform period
Stability Assessment and Stress Testing (3)Financial Soundness Indicators • Other Institutions - Broad improvement in the post-reform period – Rural Co-operative Sector – some concerns * Ratio to Total Assets
Stability Assessment and Stress Testing (4) Stress Testing • What is Stress Testing • Techniques to assess vulnerability of the financial system in the face of shocks; • identifies how portfolios respond to changes in key economic variables: e.g., interest rates, credit quality • Coverage of stress tests • Credit risk • Market/interest rate risk • Liquidity risk • Open positions in foreign exchange much below regulatory limits – Exchange rate tests not undertaken
Stability Assessment and Stress Testing (5)Credit Risk • Concerns about credit risk remain muted at present • Need for close monitoring of such risks in the current scenario Note: CRAR = credit to risk assets ratio
Stability Assessment and Stress Testing (6)Interest rate risk • Higher the DoE (duration of equity), greater the sensitivity of banks capital to interest rate shocks • Calculates the erosion in accounting capital due to unit increase in interest rate The annualised yield volatility is estimated at 244 bps Given a DoE of 8.1 years, a 244 bps shock implies an erosion of 20 per cent of capital and reserves. => Better management of interest rate risk by commercial banks over time
Stability Assessment and Stress Testing (7)An Overview of Liquidity Ratios
Stability Assessment and Stress Testing (8)Liquidity Risk Management • Gradual, growing dependence on purchased liquidity • Increase in illiquid parts of banks’ balance sheets • Greater reliance on volatile liabilities for asset growth
Stability Assessment and Stress Testing (9)The Way Forward • In Sum: • Commercial Banking System – Broadly Sound • Can withstand significant shocks from large potential changes • Possible Next Steps: • Need to strengthen liquidity management • Stress Testing by individual banks • Periodic scenario testing by RBI • Setting up of a Financial Stability Unit
Part II Lessons and Issues From the Assessment
Financial Institutions (1)Regulation and Supervision • Inherent linkages across institutions • Inter-bank • Bank and non-banks • Basel Core Principles not applicable to: • Co-operative Sector; Regional Rural Banks; • NBFCs; HFCs • But, Assessment done for health check • Results: Generally satisfactory
Financial Institutions (2)Basel Core Principles: A Compliance Summary
Financial Institutions (3)Basel Core Principles: A Compliance Summary Major Gaps: All Institutions: Risk management (for commercial banks the level of compliance is comparatively lower in respect of banking groups); home-host country regulation Commercial Banks: Exposure to related parties; non-compliance in respect to interest rate risk in banking book for which guidelines have since been issued Rural & Co-operative Banks: Dual Control; internal control; corporate governance NBFCs: Major acquisitions, transfer of significant ownership, internal control HFCs: Permissible activities; internal control
Financial Institutions (4)Commercial Banks Oversight • Government ownership poses dilemmas • Possibility of conflicts of interest minimised through even-handed regulation • Capital augmentation of PSBs is a challenge, but could be managed through a variety of ways • Amalgamation where commercial synergies exist • Newer instruments • Through selective dilution of government equity
Financial Institutions (5)Banking For The 21st Century • Capacity Building: • Training • Succession Planning • Lateral Recruitment • Improved remuneration – but discourage excessive risk taking • Corporate Governance: • Improve governance inPSBs • Roadmap for foreign banks – • A well-considered approach within the WTO norms
Financial Institutions (6)New Competition Act: Some Issues Power of Competition Commission to regulate combination Any combination required to be notified to Commission Maximum period of wait 210 days RBI may be able to give sanction only after getting order of Commission or wait for 210 days Delays the process Possibility of regulatory conflict as order of any statutory authority not binding on Commission Could lead to regulatory overlap and conflict Central Government could give necessary exemption under Section 54 of the Competition (Amendment) Act 2007
Financial Institutions (7)Risk Management and Governance Conservative risk management matters Counter-cyclical prudential measures by RBI Off-balance sheet items: Better accounting, disclosure Capital charge if reliance on purchased liquidity beyond a threshold Consolidation Encourage market-based consolidation Co-operative and rural banks need better governance Dual control: improve corporate governance Regulation and supervision of rural financial sector: role for RBI and NABARD
Financial Institutions (8)Non-Bank Financial Services • NBFCs are key players in financial markets • Corporate bond market development would ease funding constraints • Development of regulatory structure for financial conglomerates • Prudential regulations of NBFCs strengthened – some way to go • Housing finance: growing and important segment • National Housing Price Index, Housing Starts Index a priority • Regulation of HFCs should be entrusted to RBI – Government’s stance – status quo
Financial Institutions (9)An Assessment of Insurance The level of compliance of the Insurance Sector to IAIS Core Principles
Significant growth in size, penetration and diversified products Comfortable solvency and capital adequacy But gaps/issues remain Increase supervisory powers of IRDA Group-wide supervision – effective policy to be put in place Risk Management Further requirement of skilled professionals – actuaries, treasury managers Financial Institutions (10)An Assessment of Insurance
Financial Markets (1)Regulation and Supervision Systemic stability Importance of markets other than equity market IOSCO Principles extended to: G-Sec markets; Forex Markets; Money Markets Results: Generally satisfactory
Financial Markets (2)Foreign Exchange Market • Fastest growing market globally • Total annual turnover increased from USD 1.3 trillion during 1997-98 to USD 12.3 trillion during 2007-08 • Derivatives: • High growth in forward market • Forex futures introduced in 2008 • Need for monitoring and regulation • Customer appropriateness and product suitability
Financial Markets (3)Sovereign Debt Market • Significant growth in volume and liquidity • Further diversification of investor base needed • Foreign investor participation: proceed with care • Increase in tradable assets desirable • Large proportion parked in HTM category
Financial Markets (4)Equity Market • Significant improvement in market and settlement infrastructure • Functions in robust regulatory environment • Very high compliance with IOSCO Principles • Risk management by market participants • Strengthening of inter-exchange surveillance • Need to improve IPO processes • Setting up of Central Integrated Platform
Financial Markets (5)Money Market • Liquid market • Increased share of repo and CBLO • Need for active interest rate futures market • Being re-introduced • Development of term money market • Development of short-end yield curve necessary • Under examination in TAC Group • Development of the repo market
Financial Markets (6)Other Market Segments • Need to develop corporate bond market • Develop credit risk transfer mechanism • But with appropriate checks and balances • Capacity building in financial institutions with regard to securitisation and credit derivatives
Financial Markets (8) Compliance With IOSCO • Despite high compliance, some gaps remain • Equities Market: Responsibilities and operational independence of regulator; inspection and surveillance powers; capital and prudential requirements for market intermediaries • Foreign Exchange Market: Operational independence and accountability of regulator; co-operation and detection of manipulation and unfair trading practices • G-Sec markets: Operational independence and accountability of regulator; home-host co-operation; disclosure of financial results • Money markets: Operational independence; regulatory co-operation with foreign regulator
Financial Infrastructure (1)Regulatory Infrastructure • Multiple roles of regulators • Consistent with financial development • Needs effective coordination • Principles vs. Rules-based: complementary • Develop supervision of financial conglomerates • Legislation, a new Act? • Develop Self -Regulatory Organisations? • Regulatory independence • Panels have raised some issues • But CFSA considered adequate
Financial Infrastructure (2)Markets and Liquidity • Large capital movements • Volatility in overnight rates • Strengthen government cash management • Asset liability management of banks • Issues related to market integrity—participatory notes • Term liquidity facility not required at this stage
Financial Infrastructure (3)Accounting and Auditing • More autonomy for Accounting Standards Board • Need to develop sector-specific guidance • Issues in auditing about convergence with ISAs • Need to give functional independence to AASB
Financial Infrastructure (4)Payment and Settlement • Payment & Settlement Act of 2007 fills a major gap • Sub-optimal utilisation of electronic payment infrastructure • Delays in collection of outstation cheques • Financial resources with CCIL need strengthening
Financial Infrastructure (5)Business Continuity Management Ease of operations during crises Areas for strengthening Human Resources management Business continuity processes of vendors Outsourcing risk Succession planning
Financial Infrastructure (6)Assessment of Bankruptcy Law Principles Major Gaps: Implementation of bankruptcy laws – poor- average 10 years to complete liquidation proceedings – ‘Doing Business Report’- World Bank Amendment to the Companies Act still pending – Setting up of NCLT Issues relating to Competition Amendment Act, 2007 Lack of a Central Registry for recording security interests
Financial Infrastructure (7)Depositor Protection • Independence of Deposit Insurance and Credit Guarantee Corporation (DICGC) (recommended by Advisory Panel) • Increase flat-rate premium • Involvement of DICGC in resolution process- delink settlement of DICGC claims from liquidation process