Financial Sector Assessment RAKESH MOHAN DEPUTY GOVERNOR RESERVE

Financial Sector Assessment RAKESH MOHAN DEPUTY GOVERNOR RESERVE BANK OF INDIA AND CHAIRMAN, CFSA 1

What is an FSAP? v. The Financial Sector Assessment Program is an IMF-World Bank initiative A comprehensive health check of the financial system v A review of strengths, vulnerabilities and weaknesses v Measures compliance with international financial standards and codes v Initiated after the 1997 Asian financial crisis v 2

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 3

Part I The FSAP and Self-Assessment 4

A. Background and Timing 5

Background and Timing (1) The Story So Far v. IMF-WB FSAP in 2001, self-assessment of international standards and codes in 2002, reviewed again in 2005 v. Set up CFSA in 2006 v. India among the first country to undertake comprehensive and holistic self-assessment of financial sector v. Post-crisis, emphasis by the G-20 6

Background and Timing (2) Overview of Self-Assessment v. Approach and Methodology v Pillar I Macro-prudential surveillance and financial stability analysis v Pillar II Legal and institutional frameworks review v Pillar III International financial standards and codes: assessment and status of implementation 7

Background and Timing (3) The Process v Benefits v Composition of CFSA: ownership and commitment v Regulatory cooperation: Go. I, RBI, SEBI, IRDA, other agencies v Involvement of experts: advisory panels v Peer reviews: Impartiality v Learning and capacity-building: involvement of professionals v Execution v Complex issues – approach with humility v Broad directions instead of specifics in the current context v Focus on Transparent Reporting : Differing opinions of CFSA and Panels covered in the report 8

B. Macroeconomic Outlook and Vulnerabilities 9

Macroeconomic Outlook and Vulnerabilities (1) The Growth Story v Growth in recent period contributed by several factors v High domestic demand v Productivity v Credit growth v High levels of savings and investment v Current global financial crisis: shift from benign outlook to one of uncertainty v 8 %+ growth sustainable in the medium-term due to high demand; deceleration in the short-term 10

Macroeconomic Outlook and Vulnerabilities (2) Pressing Challenges v. Need for revival of growth in agriculture v. Address restoration of the fiscal reform path v. Continuation of financial sector consolidation and development v. Address the infrastructure deficit v Complement bank financing with bond market development v Insurance and pension reforms v. FCAC desirable, but with concomitant macroeconomic and market developments 11

C. Stability Assessment and Stress Testing 12

Stability Assessment and Stress Testing (1) Main Findings Financial Institutions v Commercial Banks: financially robust v NBFCs and HFCs: healthy financial indicators v. Some financing concerns v UCBs and RRBs: improvements in financials vgovernance concerns v Rural Co-operative Sector vsignificant weaknesses 13

Stability Assessment and Stress Testing (2) Financial Soundness Indicators v Commercial Banks - Broad improvement in the postreform period Financial Soundness Indicators 2000 2008 CRAR 11. 1 13. 0 Gross NPAs to Gross Advances 13. 1 2. 4 Net NPAs to Net Advances 7. 1 1. 1 Return on Total Assets 0. 7 1. 0 Return on Equity 12. 7 12. 5 Efficiency (Cost Income) Ratio 61. 2 48. 9 14

Stability Assessment and Stress Testing (3) Financial Soundness Indicators v Other Institutions - Broad improvement in the postreform period – Rural Co-operative Sector – some concerns NBFCs D 200 4 CRAR Gross NPAs Ratio Ro. A* Scheduled HFCs UCBs RRBs 2008 2004 2008 2005 2007 26. 8 22. 4 15. 0 18. 1 12. 7 11. 9 ---8. 2 2. 5 St. CBs/ DCCBs 1. 5 2. 9 3. 6 ---- ---16. 3 14. 2 24. 8 14. 2 8. 5* 5. 9* 19. 9 18. 5 1. 9 0. 4 0. 3 0. 7 0. 02 2. 2 0. 3 0. 7 1. 0 ---- 1. 1 * Ratio to Total Assets 15

Stability Assessment and Stress Testing (4) Stress Testing v What is Stress Testing v Techniques to assess vulnerability of the financial system in the face of shocks; v identifies how portfolios respond to changes in key economic variables: e. g. , interest rates, credit quality v Coverage of stress tests v Credit risk v Market/interest rate risk v Liquidity risk v Open positions in foreign exchange much below regulatory limits – Exchange rate tests not undertaken 16

Stability Assessment and Stress Testing (5) Credit Risk v. Concerns about credit risk remain muted at present v. Need for close monitoring of such risks in the current scenario Scenario - increase in NPA by: Without Stress 100 per cent 150 per cent CRAR (%) 13. 0 11. 6 11. 0 Sept– 12. 5 Note: CRAR = credit to risk assets ratio 08 11. 1 10. 6 Mar-08 17

Stability Assessment and Stress Testing (6) Interest rate risk v Higher the Do. E (duration of equity), greater the sensitivity of banks capital to interest rate shocks v Calculates the erosion in accounting capital due to unit increase in interest rate Period Do. E (yrs) Mar-06 Mar-07 Mar-08 Sep-08 14. 1 12. 0 8. 1 The annualised yield volatility is estimated at 244 bps Given a Do. E 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 18 commercial banks over time

Stability Assessment and Stress Testing (7) An Overview of Liquidity Ratios Ratio Mar-05 Mar-08 Sep-08 (Volatile Liabilities –Temporary Assets) / 34. 7 (Earning Assets –Temporary Assets) (per cent) (High and positive number implies some risk of funding liquidity. ) 43. 9 49. 3 (Core Deposits) / Total Assets (per cent) - 53. 8 (Extent to which assets are funded through stable deposit base) 49. 3 47. 7 (Loans + Mandatory CRR + Mandatory 75. 0 SLR + Fixed Assets) / Total Assets (per cent) – (Embedded illiquidity in the balance sheet) 86. 3 86. 5 (Loans + Mandatory CRR + Mandatory 1. 4 SLR + Fixed Assets) / Core Deposits – (Dependence on purchased liquidity) 1. 8 19

Stability Assessment and Stress Testing (8) Liquidity Risk Management v. Gradual, growing dependence on purchased liquidity v. Increase in illiquid parts of banks’ balance sheets v. Greater reliance on volatile liabilities for asset growth 20

Stability Assessment and Stress Testing (9) The Way Forward v. In Sum: v Commercial Banking System – Broadly Sound v Can withstand significant shocks from large potential changes v. Possible Next Steps: v Need to strengthen liquidity management v Stress Testing by individual banks v Periodic scenario testing by RBI v Setting up of a Financial Stability Unit 21

Part II Lessons and Issues From the Assessment 22

D. Financial Institutions 23

Financial Institutions (1) Regulation and Supervision v. Inherent linkages across institutions v Inter-bank v Bank and non-banks v. Basel Core Principles not applicable to: v Co-operative Sector; Regional Rural Banks; v NBFCs; HFCs v But, Assessment done for health check v. Results: Generally satisfactory 24

Financial Institutions (2) Basel Core Principles: A Compliance Summary Assessment CB UCB St. CB/ DCCB RRB NBFC HFC Compliant 7 4 3 4 1 2 Largely Compliant 11 11 10 8 13 10 6 4 6 6 2 5 Non-compliant 1 2 2 2 8 8 Not applicable - 4 4 5 1 - Materially Noncompliant 25

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); homehost 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 26

Financial Institutions (4) Commercial Banks Oversight v. Government ownership poses dilemmas v Possibility of conflicts of interest minimised through even-handed regulation v. Capital augmentation of PSBs is a challenge, but could be managed through a variety of ways v Amalgamation where commercial synergies exist v Newer instruments v Through selective dilution of government equity 27

Financial Institutions (5) Banking For The 21 st Century v. Capacity Building: v Training v Succession Planning v Lateral Recruitment v Improved remuneration – but discourage excessive risk taking v. Corporate Governance: v Improve governance in PSBs v. Roadmap foreign banks – v A well-considered approach within the WTO norms 28

Financial Institutions (6) New Competition Act: Some Issues v Power of Competition Commission to regulate combination v v 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 v Possibility of regulatory conflict as order of any statutory authority not binding on Commission v Could lead to regulatory overlap and conflict v Central Government could give necessary exemption under Section 54 of the Competition (Amendment) Act 2007 29

Financial Institutions (7) Risk Management and Governance v Conservative risk management matters v v v Counter-cyclical prudential measures by RBI Off-balance sheet items: Better accounting, disclosure Capital charge if reliance on purchased liquidity beyond a threshold v Consolidation v Encourage market-based consolidation v Co-operative and rural banks need better governance v v Dual control: improve corporate governance Regulation and supervision of rural financial sector: role for RBI and NABARD 30

Financial Institutions (8) Non-Bank Financial Services v NBFCs are key players in financial markets v Corporate bond market development would ease funding constraints v Development of regulatory structure for financial conglomerates v Prudential regulations of NBFCs strengthened – some way to go v Housing finance: growing and important segment v National Housing Price Index, Housing Starts Index a priority v Regulation of HFCs should be entrusted to RBI – 31 Government’s stance – status quo

Financial Institutions (9) An Assessment of Insurance The level of compliance of the Insurance Sector to IAIS Core Principles Assessment Number of Principles Observed 5 Largely Observed 13 Partly Observed 10 Not Observed 32

Financial Institutions (10) An Assessment of Insurance v Significant growth in size, penetration and diversified products v Comfortable solvency and capital adequacy v But gaps/issues remain v v 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 33

E. Financial Markets 34

Financial Markets (1) Regulation and Supervision v. Systemic stability v Importance of markets other than equity market v. IOSCO Principles extended to: v G-Sec markets; Forex Markets; Money Markets v. Results: Generally satisfactory 35

Financial Markets (2) Foreign Exchange Market v Fastest growing market globally Ø Total annual turnover increased from USD 1. 3 trillion during 1997 -98 to USD 12. 3 trillion during 2007 -08 v Derivatives: v High growth in forward market v Forex futures introduced in 2008 v Need for monitoring and regulation v Customer appropriateness and product suitability 36

Financial Markets (3) Sovereign Debt Market v. Significant growth in volume and liquidity v. Further diversification of investor base needed v. Foreign investor participation: proceed with care v. Increase in tradable assets desirable v Large proportion parked in HTM category 37

Financial Markets (4) Equity Market v. Significant improvement in market and settlement infrastructure v. Functions in robust regulatory environment v Very high compliance with IOSCO Principles v. Risk management by market participants v Strengthening of inter-exchange surveillance v. Need to improve IPO processes v Setting up of Central Integrated Platform 38

Financial Markets (5) Money Market v. Liquid market v Increased share of repo and CBLO v. Need for active interest rate futures market v Being re-introduced v. Development of term money market v Development of short-end yield curve necessary v Under examination in TAC Group v. Development of the repo market 39

Financial Markets (6) Other Market Segments v. Need to develop corporate bond market v. Develop credit risk transfer mechanism v But with appropriate checks and balances v. Capacity building in financial institutions with regard to securitisation and credit derivatives 40

Financial Markets (7) Compliance With IOSCO Markets/ Assessment Fully Implemented Broadly Implemented Partly Implemented Not applicable Equities Foreign exchange Govt. securities Money market 20 16 19 19 8 - 2 4 2 5 5 5 - 9 4 2 41

Financial Markets (8) Compliance With IOSCO v Despite high compliance, some gaps remain v Equities Market: Responsibilities and operational independence of regulator; inspection and surveillance powers; capital and prudential requirements for market intermediaries v Foreign Exchange Market: Operational independence and accountability of regulator; co-operation and detection of manipulation and unfair trading practices v G-Sec markets: Operational independence and accountability of regulator; home-host co-operation; disclosure of financial results v Money markets: Operational independence; regulatory cooperation with foreign regulator 42

F. Financial Infrastructure 43

Financial Infrastructure (1) Regulatory Infrastructure v Multiple roles of regulators v Consistent with financial development v Needs effective coordination v Principles vs. Rules-based: complementary v Develop supervision of financial conglomerates v Legislation, a new Act? v Develop Self -Regulatory Organisations? v Regulatory independence v Panels have raised some issues v But CFSA considered adequate 44

Financial Infrastructure (2) Markets and Liquidity v. Large capital movements v. Volatility in overnight rates v Strengthen government cash management v Asset liability management of banks v. Issues related to market integrity— participatory notes v. Term liquidity facility not required at this stage 45

Financial Infrastructure (3) Accounting and Auditing v. More autonomy for Accounting Standards Board v. Need to develop sector-specific guidance v. Issues in auditing about convergence with ISAs v. Need to give functional independence to AASB 46

Financial Infrastructure (4) Payment and Settlement v. Payment & Settlement Act of 2007 fills a major gap v. Sub-optimal utilisation of electronic payment infrastructure v Delays in collection of outstation cheques v. Financial resources with CCIL need strengthening 47

Financial Infrastructure (5) Business Continuity Management v. Ease of operations during crises v. Areas for strengthening v Human Resources management v Business continuity processes of vendors v Outsourcing risk v Succession planning 48

Financial Infrastructure (6) Assessment of Bankruptcy Law Principles Assessment Observed Broadly Observed Partly Observed Number 38 24 12 Total 74 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 49 Lack of a Central Registry for recording security interests

Financial Infrastructure (7) Depositor Protection v. Independence of Deposit Insurance and Credit Guarantee Corporation (DICGC) (recommended by Advisory Panel) v. Increase flat-rate premium v. Involvement of DICGC in resolution processdelink settlement of DICGC claims from liquidation process 50

G. Transparency and Development Issues 51

Transparency and Development Issues (1) Assessment of Transparency in Monetary and Financial Policies Assessment Transparency in Monetary Policy Transparency in Financial Policies RBI SEBI IRDA Observed 40 32 33 29 Broadly Observed 1 - - - Partly Observed 3 4 - - Not Observed - - - 1 Not Applicable 2 - 3 6 Major Gaps/Issues: §Need for review of legislations- overhaul of legislations not required §Operational independence of RBI §Strengthening TACMP – requires ongoing review §Separation of debt management from monetary management – Chairman’s dissent §Price index for measuring inflation – WPI/CPI debate 52

Transparency and Development Issues (2) Assessment of Fiscal Transparency Assessment Centre States Observed 36 22 Broadly Observed 4 6 Partly Observed 5 15 Not Observed - 2 §Significant Legislations improvement following FRBM Act and Fiscal Responsibility Major Gaps/Issues: §Functional overlap by Central Government on issues relating to State Government like health and agriculture §Mode of calculating FD does not capture off-budget items separately –augmented FD required §Need for accrual-based accounting – guarded approach 53

Transparency and Development Issues (3) Assessment of Data Dissemination Standards Assessment National Accounts WPI CPI-IW Government Finance Statistics Monetary Statistics Balance of Payments Observed 6 15 18 9 22 19 Largely Observed 13 6 3 10 - 3 Largely Not Observed 3 1 1 3 - - Not Observed - - - Major Gaps: §Need for proper legal and institutional support for CSO §IIP data - need to adjust basket of commodities and weights assigned §Multiple agencies in collection of labour data §WPI – outdated weights 54

Transparency and Development Issues (4) Making Financial Inclusion Work v Rangarajan Committee on financial inclusion v Exploit synergies between local and national level financial institutions v Finance consumption and household expenditure v Scale-up IT initiatives v Biometric smart cards in rural areas v Development of mobile banking v Incentivise BCs v Urban poor v Dilute KYC norms 55

Part III Transparent Reporting 56

H. Peer Reviewers’ Comments 57

Peer Reviewers’ Comments (1) Financial Stability Assessment and Stress Testing V. Sundararajan v Plausible shocks and vulnerabilities arising out of domestic macroeconomic and external sectors should be systemically linked to stress scenarios v Growing use of purchased funds need analysis of second round contagion effects Andrew Sheng v Creation of secondary mortgage market v Setting up of Government sponsored secondary mortgage vehicles v On-site examination process should be supplemented by a forensic “follow the evolution of the product” approach. 58

Peer Reviewers’ Comments (2) Assessment of BCP Eric Rosengren v Urgent need to improve co-ordination between regulatory agencies v Lo. LR should have the ability to assess solvency and liquidity risks facing institutions v Report should elaborate on aspects relating to Central Government’s role in operation of PSBs – whether it interferes with the regulatory role of RBI Corporate Governance and Transparency in Monetary Policy Sir Andrew Large v Higher corporate governance standards for the unlisted sector v Mechanism to enable central bank to be adequately informed to handle liquidity related events v Improvements in transparency would enhance central bank independence 59

Peer Reviewers’ Comments (3) Bankruptcy Laws Thomas Baxter v Indian insolvency regime remains an enigma v Special Insolvency regime for banks complement access to credit facilities of central bank and deposit insurance Fiscal Transparency Vito Tanzi v Better classification of expenditure central to fiscal policy v Relevant fiscal target should be GFD and not revenue deficit v Relatively few countries have made a transition to accrual based accounting 60

Peer Reviewers’ Comments (4) Accounting and Auditing Ian Mackintosh v Exercise caution while developing country specific and sector specific accounting standards v Important to give functional independence to AASB N. P. Sarda v Determining the role of the Quality Review Board to review and improve the quality of audit service is required 61

I. CFSA and Advisory Panels – Some Differences 62

CFSA and Advisory Panels – Some Differences Regulatory Independence n n Panel view : Issues regarding independence of SEBI and IRDA CFSA view: Regulatory independence adequate Review of Legislation n n Panel view : Review of RBI Act needed CFSA view : Requires to be viewed in a more comprehensive manner Role of HLCCFM n n Panel view : Further formalisation and institutionalisation CFSA view: Not consistent with regulators’ autonomy Prompt Corrective Action n n Panel view : Appropriate time-frame required CFSA view: Any rigidity in timeline unduly restrictive 63

Part IV Conclusions and Concerns 64

Conclusions and Concerns (1) Summary of Assessment v. Financial Sector – Has expanded; acquired greater depth and vibrancy v. Macro economy – Short-term - Uncertainty; Medium-term - high growth sustainable v. Banks – Healthy and Robust v. Financial Markets – Resilient and fairly liquid v. Financial Infrastructure – Robust v. Transparency – Significant improvements 65

Conclusions and Concerns (2) Main Concerns v Macro economy – v Fiscal Deficit v Agricultural Growth v Susceptibility to international commodity price movements v Institutions – v Emerging liquidity concerns v Corporate governance in co-operative sector v Health of rural co-operatives v Funding constraints for NBFCs v Lack of timely data to gauge household indebtedness v Stress Testing v Lack of database, techniques and capacity to conduct appropriate systemic stress tests taking into account sectoral interlinkages as also contagion risk 66

Conclusions and Concerns (3) Main Concerns v. Financial Markets – v Risk of contagion v Development of an appropriate risk free yield curve v Corporate bond markets v Issues relating to derivatives – knowledge concentration and capacity building v. Transparency – v Some issues in fiscal transparency; Need to strengthen data collection agencies 67

Conclusions and Concerns (4) Main Concerns v v v Delay in bankruptcy proceedings and credit dispute resolution v Time taken for winding up proceedings is highest in the world v Improvement in effective enforcement of creditor rights required v Faster resolution of stressed assets of financial intermediaries Regulation of financial conglomerates and holding companies Role of SROs Regulatory co-operation – particularly cross border Management of capital account Deficiency in retail payment systems 68