Electronic copy available at: http://ssrn.com/abstract=2002004Electronic copy available at: http://ssrn.com/abstract=2002004
Financial sector regulation for
growth, equity and stability
Proceedings of a conference organised by the
BIS and CAFRAL in M um bai,
15–16 Novem ber 2011
Monetary and Econom ic Departm ent
Electronic copy available at: http://ssrn.com/abstract=2002004Electronic copy available at: http://ssrn.com/abstract=2002004
Papers in this volume were prepared for a conference organised by the BIS and the Centre
for Advanced Financial Research and Learning (CAFRAL) in Mumbai on 15–16 November
2011. The views expressed are those of the authors and do not necessarily reflect the views
of the BIS or the institutions represented at the meeting. Individual papers (or excerpts
thereof) may be reproduced or translated with the authorisation of the authors concerned.
This publication is available on the BIS website (www.bis.org) and the CAFRAL website
© Bank for International Settlements and CAFRAL 2012. All rights reserved. Brief excerpts
may be reproduced or translated provided the source is stated.
ISSN 1609-0381 (print)
ISBN 92-9131-088-3 (print)
ISSN 1682-7651 (online)
ISBN 92-9197-088-3 (online)
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BIS Papers No 62
The failure of regulation and the short-sightedness of the private sector were the root causes
of the crisis. The balance of emphasis has shifted from encouraging innovation designed to
yield short-term gains for a few to ensuring sustainable financial sector development that
helps many. How can we make this new orientation operational? What does this enhanced
regulation mean for growth and for equity? Are the implications of regulatory reforms different
for emerging market economies (EMEs) whose growth momentum was dented by the crisis?
In tailoring regulatory reforms, how can we harmonise the interests of the advanced and
emerging economies? Addressing these questions was the main thrust of CAFRAL’s
inaugural international conference, organised jointly with BIS, on "Financial Sector
Regulation for Growth, Equity and Stability in the Post Crisis World" on 15–16 November
2011 in Mumbai.
The conference provided a forum for central bankers, financial sector regulators, academics
and practitioners from both developed and emerging markets to deliberate on several
dimensions of these issues. There was much discussion on some controversial questions.
The discussions illuminated not only the multidimensional linkages between the financial
sector and the sovereign but also the influence of the international financial architecture on
global financial stability. We need to work hard to better understand these connections.
The key message that emerged from the discussions is that the costs of financial instability in
terms of lost growth and foregone welfare can be huge and that it is therefore right for
regulatory reforms to give primacy to securing financial stability. Banks must serve the real
sector, and not the other way round. Participants also agreed that the financial sector
development which serves the needs of the real sector provides sustainable earnings for
financial firms. Higher capital requirements for financial institutions may raise the cost of
credit in the short-term. But these costs will fall over time: better capitalised banks will find
they can fund themselves more cheaply. They will also be able to increase their market
share at the expense of poorly capitalised banks. The benefits of financial stability will surely
outweigh the loss of short-term gains.
A consensus also developed around the incorporation of equity as an explicit objective of
financial policy, especially in countries with a large population of those without access to
formal financial services. There was, however, a lively debate on how best to achieve this in
practice. Supervisory authorities worldwide have to refine and develop their macroprudential
toolkit. The macroeconomic aspects of systemic risk that arise from global influences require
special attention in EMEs. Pragmatic capital account management will accordingly have to
form an integral part of policy in many countries. But such measures should provide a clear
and predictable framework of rules that help the private sector nurture the more stable forms
of capital movement. International capital mobility offers many gains if the risks are managed
We are indeed happy that the papers presented and the proceedings of the conference are
being made available to a wider audience through this publication.
Reserve Bank of India
Bank for International Settlements
BIS Papers No 62
Particular thanks are due to Louisa Wagner of the BIS and K. Kanakasabapathy (former
Advisor Reserve Bank of India) who co-ordinated the preparation of the papers and
discussion summaries for publication under a very tight deadline. We are also grateful to
Blaise Gadanecz and Nigel Hulbert for editing these papers.
BIS Papers No 62
Preface .................................................................................................................................. iii
Acknowledgements ................................................................................................................ iv
Programme ........................................................................................................................... vii
List of participants .................................................................................................................. ix
Financial Sector Regulation for Growth, Equity and Stability in the Post Crisis World
Duvvuri Subbarao ......................................................................................................... 1
Jaime Caruana ............................................................................................................. 9
Usha Thorat ................................................................................................................ 21
Special address: Financial sector regulation and macroeconomic policy
YV Reddy .................................................................................................................. 29
Summary of the discussion .................................................................................................. 39
Financial Sector Regulation for Growth
Chair’s initial remarks
Andrew Sheng ............................................................................................................ 41
Implications for Growth and Financial Sector Regulation
Anand Sinha ............................................................................................................... 45
Summary of the discussion .................................................................................................. 85
Financial Sector Regulation for Equity
Chair’s initial remarks
Stephany Griffith-Jones .............................................................................................. 89
Too big to fail vs Too small to be counted
M S Sriram, Vaibhav Chaturvedi and Annapurna Neti ................................................ 93
Summary of the discussion ................................................................................................ 119
Financial Sector Regulation for Stability
Chair’s initial remarks
John Lipsky ............................................................................................................... 123
Macroprudential policies in EMEs: theory and practice
Philip Turner ............................................................................................................. 125
Summary of the discussion ................................................................................................ 141
BIS Papers No 62
“Financial Sector Regulation for Growth, Equity and
Stability in the Post Crisis World”
15–16 November 2011, Mumbai
Day 1 – 15 November 2011
11.45–12.45 Inaugural session - Addresses by D. Subbarao, Governor, RBI and
Jaime Caruana, General Manager, BIS
14.00–16.00 Session I on “Financial Sector Regulation and implications for
Growth in the Post Crisis World”
Chair: Andrew Sheng, Chief Adviser to the China Banking Regulatory
Background paper presented by : Anand Sinha, DG, RBI
In developing economies, financial sector policies are expected to be
tuned to sub-serve the broad objective of ensuring growth with equity.
This session will discuss the regulatory philosophy in relation to growth
and development in the pre-crisis, mid-crisis and post-crisis periods with
a focus on emerging market economies (EMEs). Beginning with a review
of studies regarding macro-economic impact of Basel III capital and
liquidity regulations, the background paper will explore a model for India
for the assessment of macro-economic impact of these measures.
Specific questions that could be explored in this session are :
• Will the new regulatory approaches and measures impinge and run
counter to the growth objective?
• The needs of the trade and the infrastructure sector being so vital to
growth what are the implications of the capital leverage and liquidity
requirements for these sectors? What are the specific factors that
would weigh in the calibration of macro prudential measures for
• What are the specific difficulties that are likely to be faced by EMEs in
the implementation of Basel 3?
16.30–18.30 Session II on “Implications of the Evolving Regulatory Framework
for Equity in the post crisis World”
Chair: Stephany Griffith-Jones, Financial Markets Programme
Director, Columbia University
Background paper presented by Prof. M S Sriram, IIM, Ahmd.
The regulation of the financial sector is embedded in the larger economy
and has implications on the economic behaviour. In general we find
regulation to be re-active rather than pro-active.
BIS Papers No 62
Specific questions that could be explored in this session are:
• Why are equity and inclusion important and are these objectives at
cross purposes with regulation?
• Can an inclusive regulatory philosophy minimize the risks of a crisis
and soften the impact of cyclical behavior?
• How do other elements of the eco-system – the public policy,
markets, and regulations - that are outside the purview of the
regulator /central bank treat inclusiveness, thereby impinging the
behavior of the financial sector?
• How does the regulatory system develop a longer-term horizon to
stay invested in the “poor”?
• How do we look at exotic financial instrument innovations that are
built on the portfolios of the poor and its relation to the real economy?
What should be a stable regulatory approach and philosophy be given
the learning from the crises of the past?
Day 2 – 16 November 2011
10.00–10.45 Special address by Y.V. Reddy, Former Governor, RBI
Topic: “Regulation of Financial Sector in the Macro Policy Context”
11.00–13.00 Session III on “Macro perspectives on Financial Stability in EMEs"?
Chair: John Lipsky, First Deputy Managing Director, IMF
Background paper presented by: Philip Turner, Head, Monetary &
Economic Dept., BIS
The risks affecting the financial system are not simply aggregations of the
risks of individual institutions. This so-called “systemic” aspect of risk has
at least three dimensions viz. macroeconomic variables beyond the
control of domestic monetary or fiscal policies, externalities and pro-
cyclicality. The financial system may amplify macroeconomic or global
financial system shocks.
Specific questions relevant to EMEs that could be explored in this session
• What are the policy targets considering that volatile capital flows and
currency mismatches are forces that are of special importance for
• What are the policy instruments that work best for macro prudential
objectives? How should adjustment in such instruments be
coordinated with monetary policy?
• How interventionist should the authorities be? Do less developed
financial systems require more intervention?
• Which body should be at the controls for macro prudential policies
(central bank, bank regulator, ministry of finance)?
• How to arrange the oversight of those responsible for macro
BIS Papers No 62
List of participants
Cleofas Salviano Junior
Consultant of the Department of Norms of the
Robert, Andre OPHELE
Director General of Operations
Deputy Chief Manager
S C Dhall
Deputy General Manager
Senior Economic Adviser
Mr Hiroto Uehara,
Director, International Department
Assistant Director, Supervision Department
Director, Office of Bank Analysis
Aznan Abdul Aziz
Director of Financial Intelligence Unit
Marjorie Marie-Agnes Heerah Pampusa
Head – Economic Analysis Division
Maha Prasad Adhikari
M S Blackbeard
Head, Bank Supervision Department and
Registrar of banks
Director of Financial Stability
Additional Director of Bank Supervision
Banco Central Do Brasil
Bank of Canada
Bank of France
Bank of Ghana
Reserve Bank of India
Bank of Japan
Central Bank of Kenya
Bank of Korea
Bank Negara, Malaysia
Central Bank of Mauritius
Central Bank of Nepal
South African Reserve Bank
Bank of Spain
Central Bank of Sri Lanka
BIS Papers No 62
Swiss Financial Markets Supervisory
Central Bank of Chinese Taipei
Anne Heritier Lachat
Chair of the Board of Directors
Dou Ming Su
Assistant Director General / Department of
Deputy Executive Director
Banking and Financial Institutions Department
Head of Audit II Department
Nader Rashma AlAnsari
Saleh Allaw Al Teniaji
Senior Associate Director, Division of
Member of the Basel Committee,
Central Bank of Turkey
Banking Regulation and Supervision
Central Bank of United Arab Emirates
Board of Governors of the Federal
Bank for International Settlements
Chairs and Paper presenters
Governor, Reserve Bank of India
General Manager, Bank for International
Professor Emeritus, University of Hyderabad
Chief Adviser to the China Banking Regulatory
Financial Markets Director at the initiative for
policy dialogue, Columbia University
Special Adviser to the Managing Director,
International Monetary Fund
Y V Reddy
Deputy Governor, Reserve Bank of India
Deputy Head of the Monetary and Economic
Department and Director of Policy, Coordination
Fellow, Institute for Development of Research in
Banking Technology [IDRBT], Hyderabad
Fellow Indian Institute
M S Sriram
BIS Papers No 62
Financial regulation for growth, equity and stability in the post-
Let me start by telling you about the motivation for the conference theme.
Failure of regulation, by wide agreement, was one of the main causes of the 2008 global
financial crisis. It is unsurprising therefore that reforming regulation has come centre stage
post-crisis. The progress in regulatory reforms over the last two years has been impressive,
but the agenda ahead remains formidable. Regulation will bring in benefits by way of
financial stability, but it also imposes costs. There are some ball park numbers for what the
Basel III package might entail in terms of growth, but there has been no rigorous thinking on
what the whole gamut of regulatory reforms currently on the agenda might mean for growth,
equity and stability in terms of costs and benefits over time and in different regions of the
world. Thinking through these vital and complex issues is the main motivation for the theme
of this conference – Financial sector regulation – equity, stability and growth in the post-crisis
There was another strong motivation for the choice of the conference theme. The crisis, as
we all know, was brewed in the advanced economies, and much of the post-crisis reforms
are accordingly driven by the need to fix what went wrong there. The reform proposals were
discussed at international forums like the FSB and the BCBS. What has struck me though is
that the agenda and the deliberations have been dominated by advanced economy
concerns. As emerging economies, we have had a seat at the table in these international
forums, but we haven’t been able to engage meaningfully in the debate as we have not
related to the issues. The stability of the advanced economy financial sectors is, of course,
important to us. After all we live in a globalizing world, and what happens anywhere has
impact everywhere. What concerns us, though, is that these global standards are going to be
applied uniformly but their implications for EMEs will be different given the different stages of
our financial sector development and our varied macroeconomic circumstances. We hope
that this conference will provide a forum for generating an emerging economy perspective on
issues of growth, equity and stability in the context of the post-crisis thinking on financial
I have great pleasure in welcoming all the delegates to this first CAFRAL-BIS international
conference. You have travelled from around the country and across the world to be present
here, and we value your participation in this conference. I would like to acknowledge, in
particular, the presence here of Mr. Jaime Caruana, General Manager of BIS and the co-host
of this conference, Mr. Andrew Sheng, Ms. Stephanie Griffith Jones and Mr. John Lipsky, all
three eminent thought leaders, who will be chairing the various sessions, and my
predecessor at the Reserve Bank, Dr. Y.V. Reddy who, during his term in office, earned a
formidable reputation as a zealous guardian of financial stability.
I struggled to determine what I should say in this inaugural address. One option would be to
attempt a comprehensive overview of all the issues that might come up in the subject
1 Inaugural address by Dr Duvvuri Subbarao, Governor, Reserve Bank of India at the First CAFRAL-BIS
international conference on “Financial sector regulation for growth, equity and stability in the post-crisis world”,
Mumbai, 15 November, 2011.
BIS Papers No 62
sessions. Such double guessing would clearly be presumptuous on my part given the depth
and breadth of experience you bring to this forum. I will attempt something less ambitious.
What I will do is raise five questions straddling the three dimensions of the conference theme
– growth, equity and stability in the context of financial regulation – and sketch out an answer
to each of them in the hope that we will get more informed answers by the end of the
conference. I will fall back on the Indian experience, which I know best, to illustrate some of
what I say. I believe our experience will be relevant and applicable across a broad swathe of
emerging and developing economies.
Question 1: If financial sector development is good, is more of it better?
Development experience evidences a strong correlation between financial sector
development and economic growth, with the causation possibly running both ways.
Economic growth generates demand for financial services and spurs financial sector
development. In the reverse direction, the more developed the financial sector, the better it is
able to allocate resources and thereby promote economic development.
In India, we have experienced causation in both directions. We embarked on wide ranging
economic reforms following a balance of payment crisis in 1991. Very soon we realized that
the growth impulses generated by the liberalizing regime could not be sustained unless we
also undertook financial sector reforms. That is an illustration of growth triggering financial
sector development. For an example of the causation in the reverse direction, we have to
look no further than India’s remarkable growth acceleration in the period 2003–08 when we
clocked growth of 9+ per cent. Many factors have been cited as being responsible for this –
higher savings rates, improved productivity, growing entrepreneurism and external sector
stability. But one of the unacknowledged drivers of that growth acceleration has been the
impressive improvement in the quality and quantum of financial intermediation in India,
evidencing how financial sector can spur growth.
Given the historical experience, it is tempting to believe that if financial sector development
aids growth, more of it must be better. I am afraid that will be misleading. We must look for a
more nuanced response, especially in the light of the lessons of the crisis.
In the world that existed before the crisis – a benign global environment of easy liquidity,
stable growth and low inflation – the financial sector kept delivering profits, and everyone
became enticed by a misleading euphoria that profits would keep rolling in forever. Herb
Stein, an economist, pointed out the truism that “if something cannot go on forever, it will
eventually stop”. But no one paid attention. The financial sector just kept growing out of
alignment with the real world.
It will be useful to put some numbers on how, across rich countries, this misalignment kept
on increasing. Take the case of the United States. Over the last 50 years, the share of value
added from manufacturing in GDP shrank by more than half from around 25 per cent to 12
per cent while the share of financial sector more than doubled from 3.7 per cent to 8.4 per
cent. The same trend is reflected in profits too. Over the last 50 years, the share of
manufacturing sector profits in total profits declined by more than two thirds from 49 per cent
to 15 per cent while the share of profits of the financial sector more than doubled from 17 per
cent to 35 per cent. The large share of the financial sector in profits, when its share of activity
was so much lower, tells a compelling story about the misalignment of the real and financial
The world view before the crisis clearly was that the growth of the financial sector, in and of
itself, was desirable, indeed that real growth can be got by sheer financial engineering. Our
faith in the financial sector grew to such an extent that before the crisis, we believed that for
every real sector problem, no matter how complex, there is a financial sector solution. The
crisis has made us wiser. We now know that for every real sector problem, no matter how
BIS Papers No 62
complex, there is a financial sector solution, which is wrong. In the pre-crisis euphoria of
financial alchemy, we forgot that the goal of all development effort is the growth of the real
economy, and that the financial sector is useful only to the extent it helps deliver stronger
and more secure long term growth.
How does financial sector regulation come into all this? It comes in because the financial
sectors of emerging economies are still under development. How should they respond to the
lessons of the crisis, particularly in reshaping their regulations? Is a larger financial sector
necessarily better for growth? For equity? Is there such a thing as a ‘socially optimal’ size for
the financial sector? What are the weights to be attached to growth and stability in the
objective function of regulation? Are the weights stable over time, or if they should vary, on
what basis? As we seek answers to this long list of questions, the basic tenet that must guide
our thinking is that it is the real sector that must drive the financial sector, not the other way
Question 2: Financial sector regulation, yes, but at what cost?
Even as efficient financial intermediation is necessary for economic growth, the financial
sector cannot be allowed an unfettered rein; it needs to be regulated so as to keep the
system stable. This we knew even before the crisis. What we have learnt after the crisis is
that the quantum and quality of regulation matters much more than we thought.
In the years before the crisis – indeed even before the Great Moderation – a consensus was
building around the view that if the burden of regulation is reduced, the financial sector will
deliver more growth. That consensus has nearly dissolved. We now know that financial
markets do not always self-correct, that signs of instability are difficult to detect in real time,
and that the costs of instability can be huge. Global income, trade and industrial production
fell more sharply in the first twelve months of the Great Recession of 2008/09 than in the first
twelve months of the Great Depression of the 1930s. Three years on, the crisis is still with
us; it has just shifted geography. And there is still enormous uncertainty about when we
might see its end and with what final tally of costs in terms of lost output and foregone
So, the emphasis of post-crisis regulatory reforms on making the financial system stable is
understandable. But a relevant question is, where do we strike the balance between growth
and stability? In other words, how much growth are we willing to sacrifice in order to buy
insurance against financial instability?
For illustrative purposes, let us take the Basel III package. A BIS study estimates that a two
percentage point increase in the target ratio of tangible common equity (TCE) to risk-
weighted assets (RWA) phased in over a four year period reduces output by a maximum of
0.3 per cent. It is argued though that as the financial system makes the required adjustment,
these costs will dissipate and then reverse in the medium term, and the growth path will
revert to its original trajectory. A BCBS study estimates that there will be net positive benefits
out of Basel III because of the reduced probability of a crisis and reduced volatility in output
in response to a shock. An IIF study, however, estimates a higher sacrifice ratio – that the G3
(US, Euro Area and Japan) will lose 0.3 percentage points from their annual growth rates
over the full ten-year period 2011–20.
What are the implications of these numbers relating to growth sacrifice for EMEs? Let me
take the example of India. Admittedly, the capital to risk weighted asset ratio (CRAR) of our
banks, at the aggregate level, is above the Basel III requirement although a few individual
banks may fall short and have to raise capital. But capital adequacy today does not
necessarily mean capital adequacy going forward. As the economy grows, so too will the
credit demand requiring banks to expand their balance sheets, and in order to be able to do
so, they will have to augment their capital.
BIS Papers No 62
In a structurally transforming economy with rapid upward mobility, credit demand will expand
faster than GDP for several reasons. First, India will shift increasingly from services to
manufactures whose credit intensity is higher per unit of GDP. Second, we need to at least
double our investment in infrastructure which will place enormous demands on credit. Finally,
financial inclusion, which both the Government and the Reserve Bank are driving, will bring
millions of low income households into the formal financial system with almost all of them
needing credit. What all this means is that we are going to have to impose higher capital
requirements on banks as per Basel III at a time when credit demand is going to expand
rapidly. The concern is that this will raise the cost of credit and hence militate against growth.
A familiar issue in monetary policy is an inflexion point beyond which there is no trade-off
between growth and price stability. Is there a similar inflexion point in the growth-financial
stability equation? If there is, how do we determine that point?
Question 3: Does regulation have a role in achieving equity?
That takes me to my third question: does regulation have a role in achieving equity?
The dichotomy between growth and equity is standard stuff of development economics. For a
long time, the orthodoxy was that if we took care of growth, equity followed automatically a la
a high tide raising all boats. Experience has taught us that reality is more complex. Received
wisdom today is that growth is a necessary, although not a sufficient, condition for equity. To
achieve equity, we need growth that is poverty sensitive – that is growth to which the poor
contribute and growth from which the poor benefit.
How does this standard question translate in the context of financial sector regulation? This
is a question that we in India struggle with. Should stability be the sole objective of our
regulation, with other instruments being deployed to achieve equity? Or should equity be a
variable in the objective function of regulation?
To seek answers, we must ask a variant of the above questions. Is the financial sector
inherently equity promoting, or at least equity neutral? Our experience in India has been that
left to itself, the financial sector does not have a pro-equity bias. Indeed, it is even possible to
argue that the financial sector does not necessarily reach out to the bottom of the pyramid.
Our response to counter this bias has been to use regulation to encourage socially optimal
business behaviour by financial institutions. Let me just list a few of our affirmative action
regulations. We have a directed credit scheme, called priority sector lending, whereby all
banks are required to ensure that at least 40 per cent of their credit goes to identified priority
sectors like agriculture and allied activities, micro, small and medium industries, low cost
housing and education2. We have a ‘Lead Bank’ scheme under which there is a designated
commercial bank identified for each of the over 600 districts in the country with responsibility
for ensuring implementation of a district credit plan that contains indicative targets for flow of
credit to sectors of the economy that banks may neglect. We have largely deregulated
licencing of bank branches; banks are now free to open branches freely in population centres
of less than 100,000 – with two stipulations: first at least a quarter of the branches should be
located in unbanked villages with a maximum population of 10,000; and second, their
performance in financial penetration will be a criterion for giving banks branch licences in
metro and large urban centres.
2 The ratio and the composition of the priority sector are different for foreign banks in consideration of the fact
that they do not get ‘full national treatment’ on some regulatory aspects.
BIS Papers No 62
By far our most high profile campaign in recent years has been our aggressive pursuit of
financial inclusion. Why is financial inclusion important? It is important because it is a
necessary condition for sustaining equitable growth. There are few, if any, instances of an
economy transiting from an agrarian system to a post-industrial modern society without
broad-based financial inclusion. As people having comfortable access to financial services,
we all know from personal experience that economic opportunity is strongly intertwined with
financial access. Such access is especially powerful for the poor as it provides them
opportunities to build savings, make investments and avail credit. Importantly, access to
financial services also helps the poor insure themselves against income shocks and equips
them to meet emergencies such as illness, death in the family or loss of employment.
Needless to add, financial inclusion protects the poor from the clutches of the usurious
The extent of financial exclusion is staggering. Out of the 600,000 habitations in India, less
than 30,000 have a commercial bank branch. Just about 40 per cent of the population across
the country have bank accounts, and this ratio is much lower in the north-east of the country.
The proportion of people having any kind of life insurance cover is as low as 10 per cent and
proportion having non-life insurance is an abysmally low 0.6 per cent.
These statistics, distressing as they are, do not convey the true extent of financial exclusion.
Even where bank accounts are claimed to have been opened, verification has often shown
that the accounts are dormant. Few conduct any banking transactions and even fewer
receive any credit. Millions of households across the country are thereby denied the
opportunity to harness their earning capacity and entrepreneurial talent, and are condemned
to marginalization and poverty.
Over the last few years, the Reserve Bank has launched several initiatives to deepen
financial inclusion. Our goal is not just that poor households must have a bank account, but
that the account must be effectively used by them for savings, remittances and credit. Our
most ambitious initiative has been the ‘Business Correspondent’ model or branchless
banking which, leveraging on technology, helps reach banking services to remote villages at
a low overhead cost.
In the context of this conference theme, the issue is the following. Financial inclusion is
equity promoting. Banks, however, may see this more as an obligation rather than as an
opportunity. Given that scenario, should we pursue financial inclusion through moral suasion
or issue a regulatory fiat? What combination of regulatory incentives and disincentives would
As I leave this topic, I must also add that using regulation, or political direction in a larger
sense, for achieving equity has not been a practice unique to emerging and developing
economies. It is quite common in rich societies as well. In his bestselling book, Fault Lines,
Raghuram Rajan persuasively argues that America’s growing inequality and thin social
safety-nets created tremendous political pressure to encourage easy credit and keep job
creation robust, no matter the consequences to the long-term health of the financial system.
That is a thought we must ponder over.
Question 4: Should we make banking boring?
Post-crisis, there is a deluge of ideas and suggestions on reforming banks, banking and
bankers. Analysts with a historical perspective believe that the seeds of the 2008 crisis were
sown when the separation of banking from securities dealing was undone. What really
contributed to the disproportionate growth of the financial sector relative to the real sector
that I spoke about earlier was investment banking and securities dealing. It is the huge
leveraging by this segment that fuelled the crisis. Hence, as the noted economist and Nobel
BIS Papers No 62
laureate Paul Krugman has argued, the way to reform banking is to once again make it
boring. It is worth exploring this question as it has implications for growth, stability and equity.
Taking a long term historical view, Krugman argues that there is a negative correlation
between the ‘business model’ of banking and economic stability. Whenever banking got
exciting and interesting, attracted intellectual talent and bankers were paid well, it got way
out of hand and jeopardized the stability of the real sector. Conversely, periods when
banking was dull and boring were also periods of economic progress.
To support his thesis, Krugman divides American banking over the past century into three
phases. The first phase is the period before 1930, before the Great Depression, when
banking was an exciting and expanding industry. Bankers were paid better than in other
sectors and therefore banking attracted talent, nurtured ingenuity and promoted innovation.
The second phase was the period following the Great Depression when banking was tightly
regulated, far less adventurous and decidedly less lucrative – in other words banking
became boring. Curiously, this period of boring banking coincided with a period of
spectacular progress. The third phase, beginning in the 1980s, saw the loosening of
regulation yielding space for innovation and expansion. Banking became, once again,
exciting and high paying. Much of the seeming success during this period, according to
Krugman, was an illusion; and the business model of banking of this period had actually
threatened the stability of the real sector. Krugman’s surmise accordingly is that the bank
street should be kept dull in order to keep the main street safe.
Krugman’s thesis of ‘boring banking’ is interesting, but debatable. It raises two important
questions. Is making banking boring a necessary and sufficient solution to preventing the
excesses of the pre-crisis period? And what will be the cost of making banking boring? Both
questions cause much confusion, the first because it has too many answers and the second
because it has too few. The Dodd-Frank Act of the US is a response to the excesses of
investment banks. In Europe, the responses are somewhat different. Abstracting from the
specifics, I will argue that it is neither possible nor desirable to make banking boring.
The narrow banking of the 1950s and 1960s was presumably safe and boring. But that was
in a far simpler world when economies were largely national, competition was sparse,
pressure for innovation was low, and reward for it even lower. Bankers of the time, it is said,
worked on a 3 – 6 – 3 formula: pay depositors 3 per cent interest, lend money at 6 per cent
and head off to the golf course at 3 pm. From the 24/7/365 perspective of today, that may
appear romantic but is hardly practical.
The boring banking concept does not appear persuasive even going by more recent
evidence and on several counts. First, recall that during the crisis, we saw the failure of not
only complex and risky financial institutions like Lehman Brothers but also of traditional
banks like Northern Rock. What this demonstrates is that a business model distinction
cannot be drawn between a utility and a casino; and if it can, it does not coincide with the
distinction between what has to be safe and what need not be. Second, in an interconnected
financial sector, how can a ‘boring’ bank realistically ring-fence itself from what is happening
all around given all the inter-connections? Third, will not the co-existence of utilities and
casinos open up arbitrage opportunities? During ‘tranquil’ periods, financial institutions with
higher risk and reward business models will wean away deposits from narrow banks. But
when problems surface and stresses develop in the financial sector, the position will reverse
with the deposits flowing back into the so called ‘boring banks’, triggering procyclicality.
Finally and most importantly, what will be the cost of boring banking in economic terms?
Does restraining banking to its core function just to keep it safe not mean forgoing
opportunities for growth and development?
What is the lesson from this discussion of ‘boring banking’ for the EMEs where universal
banking is in early stages and trading of the kind witnessed in the North Atlantic systems is
nowhere comparable? It is important for the EMEs to draw the right lessons – markets may
not be self-correcting but they cannot be substituted by central planning and micro
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management. Making markets competitive, open and transparent while putting in safeguards
to curb excessive trading can help EMEs to enable financial markets to play their rightful role
in efficient allocation of resources.
Question 5: Why is burden sharing across countries still off the reform
The last question I want to raise concerns cross-border equity, in particular the burden
sharing on account of the external spillovers of domestic regulatory policies. Why is cross-
border equity still off the agenda in any international meeting? I know I am asking that
question somewhat provocatively, but that is deliberate. Let me explain.
The crisis challenged many of our beliefs, and among the casualties is the decoupling
hypothesis. The decoupling hypothesis, which was intellectually fashionable before the crisis,
held that even if advanced economies went into a downturn, EMEs would not be affected
because of their improved macroeconomic management, robust external reserves and
healthy banking sectors. Yet the crisis affected all EMEs, admittedly to different extents,
discrediting the decoupling hypothesis.
The decoupling hypothesis was never persuasive given the forces of globalization. But the
forces of globalization are asymmetric. What happens in systemically important countries
affects EMEs more than the other way round. The regulatory policies that the advanced
economies pursue have knock-on impact on the growth and stability of EMEs. I need hardly
elaborate – capital flows engineered by the multi-speed recovery and the consequent
volatility in exchange rates, the spike in commodity prices triggered by their financialization,
the shortage of the reserve currency because of the flawed international monetary system
and the constant threat of protectionism.
As all these problems confronting EMEs are a consequence of the spillover of advanced
economy policies, should their solution remain the exclusive concern of EMEs? Isn’t there a
case for sharing the burden of adjustment? How do we evolve a code of conduct for building
in cross-border equity concerns into financial regulation? I do hope these questions will figure
in our discussions over the next two days.
Let me now conclude. I have raised five questions straddling growth, equity and stability in
the context of the post-crisis approach to regulation:
(i) If financial sector development is good, is more of it better?
(ii) Financial sector regulation, yes, but at what cost?
(iii) Does financial regulation have a role in achieving equity?
(iv) Should we make banking boring?
(v) Why is burden sharing across countries still off the reform agenda?
I realize I have raised more questions than answers. For considered answers, I look to the
insights and intelligence of the delegates at this conference.
One last thought. Even as I have annotated my five questions from the perspective of
emerging economies, I realize that these concerns are not unique to them. We only have to
look around the world. What began with demonstrations in Madrid this spring has coalesced
into something on a much grander scale. The discontent has traversed from southern Europe
across the Atlantic and has inspired the ‘Occupy Wall Street’ movement in New York’s
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Zuccotti Park and beyond. Despite its amorphous nature and its refusal to formulate a set of
demands, the protest campaign across the world is fired by a simple, but powerful idea – that
the elite cannot go on doing obscenely well even as the rest keep moving backwards. The
message from this collective rage is that growth itself can be destabilizing if it has no equity
dimension. That is a sobering thought.
Before I leave this platform, let me place on record my deep appreciation for the intellectual
and logistic effort that has gone into organizing this conference by the team at CAFRAL led
by Usha Thorat and the counterpart team at BIS led by Philip Turner. We owe them a great
I wish the deliberations over the next two days all success.
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Financial and real sector interactions:
enter the sovereign ex machina
I am delighted to join Governor Subbarao and his colleagues at the Reserve Bank of India at
this conference on “Financial sector regulation for growth, equity and stability in the post-
crisis world”. And I would like to thank Usha Thorat, the first head of the Centre for Advanced
Financial Research and Learning, for the invitation.
All credit is due to Governor Subbarao and Usha Thorat for this important initiative. One of
the lessons of this crisis is our need to better understand the complex interactions between
the financial system and the real economy. CAFRAL, as a centre of excellence for research
and learning in banking and finance, will greatly contribute to building and sharing this
knowledge. And this in turn will promote better regulation and supervision.
The Reserve Bank of India has a strong tradition of expertise and action in this area. Let me
also compliment Y V Reddy, who, as Governor, conceived of a global hub for policy research
that would be of practical use to policymakers, central bankers and bankers. As India’s
financial sector becomes increasingly important in the global economy, it is reassuring that
there is both a vision and an institution to guide its aspirations. The BIS is honoured to
contribute to these efforts and co-host this international inaugural conference.
I especially appreciate the optimism in the title’s reference to the post-crisis world. Such
optimism is more apparent here in Asia than in Europe.
In my remarks today, I would like to step back and consider somewhat schematically the
interactions between the financial and the real sectors. As the latest events have reminded
us, financial stability depends not only on the link between banks and the corporate and
household sectors2 but also on their links with the sovereign. The sovereign must be
prepared to act as ultimate backstop for the financial system. But this requires that fiscal
buffers be built up in good times. Otherwise, the sovereign can itself become a source of
financial instability as its credit risk damagingly interacts with that of banks and other private
sector entities.3 Sovereigns must now earn back their reputation as practically risk-free
borrowers. And as history has taught us, sovereign solvency is a precondition for the central
bank’s success in dealing with threats to monetary and financial stability.
In what follows, I will first outline the link between the financial sector and the private sector
over the financial cycle – the link that has so often been at the root of financial crises. I will
then bring the sovereign into the picture. Finally, I will discuss the relationship between bank
capital and growth.
1 General Manager, Bank for International Settlements.
2 The portion of the speech that discusses this link is partly based on Basel Committee on Banking Supervision,
“The transmission channels between the financial and real sectors: a critical survey of the literature”, BCBS
Working Papers, no 18, February 2011 (www.bis.org/publ/bcbs_wp18.htm).
3 This is further elaborated in Committee on the Global Financial System, “The impact of sovereign credit risk
on bank funding conditions”, CGFS Publications, no 43, July 2011 (www.bis.org/publ/cgfs43.htm).
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Financial-real sector interactions: business and/or household debt crises
Let us consider first the interactions between the financial system and the business and
household sectors in the boom phase of a financial cycle. In Graph 1, the black arrows point
in both directions. This indicates that, even as the flow of bank credit is leveraging up those
sectors, the banking system is leveraging itself up in the process of extending credit. Several
mechanisms are at work in this phase.
Boom in corporate and/or household lending
From the borrower side, stronger demand and income as well as higher asset prices tend to
cut the cost of funding. Stronger aggregate demand makes for stronger cash flows and, for
businesses, it increases the abundance of internal funds, which are cheaper than externally
raised funds. Higher asset prices lift the net worth of firms and households, hence easing
their access to bank credit, in terms of both volume and price. More abundant cheap internal
funds and greater access to external credit lower the effective cost of debt. This leads firms
to invest more in structures, capital goods and inventory. Households, meanwhile, are
encouraged to spend more on housing and consumer durables.
On the lender side, strong demand and higher asset prices reduce loan losses, raise profits
and strengthen capital. More profitable and better capitalised banks attract wholesale funding
more cheaply. And if banks hold onto assets that are rising in price, their capital gets a direct
But excessive leverage leaves banks more vulnerable to any subsequent downturn in
economic activity and asset prices. At the same time, they are hit with a rising tide of
delinquencies and defaults. As shown in Graph 2, loan losses during the bust become a
major source of weakness for banks, as indicated by the red arrows pointing from the
corporate and possibly household sectors to the banks.
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Bust in corporate and/or household lending
When borrower distress undermines their balance sheets, banks are prevented from
extending credit even to healthy borrowers. It is this combination of weak balance sheets and
capital deprivation that prevents credit from flowing. In Graph 3, this is indicated by red
arrows pointing from the banking sector to the business and household sectors.
Bust in corporate and/or household lending leading to credit crunch
India is fortunate that the Reserve Bank took macroprudential measures in the middle of the
last decade to slow the growth of household indebtedness. For several countries, indeed, the
recent international crisis originated mainly in the household sector.
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If the banking sector becomes a source of weakness for healthy firms and households, then
the distress of these borrowers can ramify widely through the economy. Banks will find that
raising external equity becomes especially difficult as problem loans escalate, not least if
investors have trouble assessing the size and distribution of losses.
Under severe circumstances and in the absence of effective resolution regimes,
governments may be forced to inject equity into banks. This is shown in Graph 4, where the
sovereign props up the banking system. In effect, the sovereign becomes a deus ex
machina, the supernatural intervention that resolves some ancient Greek tragedies.
Bust in corporate household and/or lending leading
to government recapitalisation of banks
Enter the sovereign
Alas, as we have learned, the story does not end here. The sovereign and banks can prove,
and have proved to be, sources of weakness for one another.
Channels for transmission of bank risk to sovereigns
A remarkable feature of Europe’s sovereign debt strains is the role played by sovereigns that
had spent years apparently on the right side of the Maastricht criteria, keeping a prudent lid
on both deficits and debt. Anyone predicting sovereign debt downgrades in 2005 would
hardly have listed Ireland or Spain.
In the event, hidden weaknesses in financial sector balance sheets fed through to the
sovereign. Graph 5 shows this in the case of Ireland, with a generalised version of the
mechanism presented in Graph 6. There are two important transmission channels from
banks to sovereigns.
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Irish CDS spreads1
In basis points
1 Five-year on-the-run CDS premia. 2 Simple average over a sample of domestic financial institutions.
Banks as source of weakness to sovereign
First, private credit booms can flatter the public sector’s accounts. In the boom phase, all
sorts of unsustainable revenues temporarily improve the fiscal accounts and tempt
policymakers to reduce tax rates and to increase long-term spending commitments. As
Governor Honohan of the Central Bank of Ireland put it:
“The tax revenue generated by the boom came in many forms: capital
gains on property, stamp duty on property transactions, value added tax on
construction materials and income tax from the extra workers – immigrants
from the rest of Europe, from Africa, from China, flooded in as the
construction sector alone swelled up to account for about 13 per cent of the
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numbers at work (about twice the current level, which is closer to what
would be normal).”4
Research on Spain points in the same direction. When the boom comes to an end, these
boom-related revenues fall away, revealing underlying fiscal deficits. And then when the
banks run into trouble, the cost of rescuing and recapitalising them does grievous damage to
the public accounts. This has important policy implications regarding the size of the fiscal
space needed to prevent this situation.
Second, as described before, other less direct effects come into play as the balance sheets
of banks and other financial institutions deteriorate. If institutions have failed to build up
sufficient capital and liquidity buffers during the boom, credit constraints become more
significant, over and above any perceived deterioration in borrower quality. This can quite
unnecessarily choke off the credit supply and, unless balance sheets are repaired quickly,
may lead to serious distortions in its allocation. This further dampens economic activity, thus
widening the public sector deficit.
All this raises deep questions about the implications of private sector boom-bust cycles for
trend output and growth.
The policy conclusion is that the sovereign must build up sufficient reserves in good times to
draw on in bad times. Fiscal policy also has a macroprudential responsibility.
Channels for transmission of sovereign risk to the financial sector
Of course, the sovereign can run up its own deficits and debt to the point where it becomes a
source of weakness to those that hold that debt, including domestic banks. This can happen
either as a result of the financial cycle I have just described, or quite independently from it.
The link is shown on Graph 7.
This is a recurring story,5 recently best exemplified by Greece. One can see in credit default
swaps on the Greek sovereign and Greek banks how the impairment of the sovereign’s
creditworthiness has affected the banks’ creditworthiness (see Graph 8).
Deterioration in the perceived creditworthiness of sovereigns can hurt the financial sector
through a number of channels. I shall concentrate in a moment on the direct balance sheet
exposures to the sovereign. But let me first mention the other three channels highlighted in
the CGFS (“Panetta”) Report.
First, deterioration in the sovereign’s creditworthiness weakens bank balance sheets,
increases counterparty risks and raises the cost of bank funding via new bond issues. It also
reduces banks’ access to credit from repo and derivative markets, owing to the reduced
value of government collateral.
Second, implicit or explicit government guarantees of banks and their borrowers lose value.
Despite the changing policy toward systemically important institutions, the rating agencies
give big banks in major countries more credit for sovereign support than they did before the
4 “Banks and the budget: lessons from Europe”, speech to SUERF Conference, Dublin, 20 September 2010
5 C Reinhart and K Rogoff, This time it’s different: Eight centuries of financial folly, Princeton University Press,
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Third, the loss of the sovereign’s creditworthiness can induce fiscal consolidation. Even if
necessary and overdue, this may undermine credit demand and weigh on the quality of
private sector debt in the short term.
Sovereign as source of weakness to banks
Greek CDS spreads1
In basis points
1 Five-year on-the-run CDS premia. 2 Simple average over a sample of domestic financial institutions.
In most economies, banks have sizeable exposures to the home sovereign, showing a strong
home bias. Not surprisingly, holdings of domestic government bonds as a percentage of
bank capital tend to be larger in countries with high public debt. Thus, among the countries
severely affected by the sovereign crisis, banks’ holdings are relatively largest in Greece and
smallest in Ireland. To some extent, accounting shields banks from the immediate impact of
declines in the market prices of sovereign bonds. Indeed, across EU countries, most of the
domestic sovereign exposure (85% on average) is held in the banking book. Then, in
addition to the domestic exposure, there are exposures to other sovereigns. These can
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weaken the home sovereign when its banks need support to deal with exposures to the
Given these two-way influences, there is a clear and present danger of malign feedback from
banks to sovereigns and from sovereigns to banks. In Europe today, just such a pernicious
feedback loop joins the sovereign’s credit risk with that of the banks. This is shown in the
abstract in Graph 9 and in the data for Italy, Spain, Belgium and France in Graph 10. In
Graph 11, this feedback becomes a source of weakness in the business and household
sectors and jeopardises the normal flows of credit.
Sovereign and banks as two-way sources of weakness
In basis points
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1 Five-year on-the-run CDS premia. 2 Simple average over a sample of domestic financial institutions.
Sovereign and banks as two-way sources of weakness leading to credit crunch
When sovereign debt morphs from a risk-free into a “credit risk” instrument, the
consequences are likely to be severe. They are likely to include disruption to the financial
system and abrupt deleveraging by banks, harming the real economy and employment.
Sovereigns need to earn back their risk-free status by credible and tangible fiscal
consolidation. Structural reforms are desirable to allow faster trend growth. In the meantime,
credible multilateral financing backstops can concentrate the minds of market participants on
fundamental improvements rather than market dynamics. This is shown in Graph 12. Speed
is critical if contagion is not to spread.
When a sovereign crisis leads to rapid deleveraging, the financial spillovers to other
economies can be significant. This is particularly true for countries where cross-border credit
grew strongly ahead of the crisis. An important feature of cross-border credit flows is that
they tend to exacerbate domestic credit cycles.
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Multi-sovereign backstop for sovereign and banks
Given the dynamics of sovereign and bank interactions, there has been some discussion of
the role of bank regulation. In that context, let me remind you of the treatment of sovereigns
in Basel II and III.6 Let me reiterate that, in an ideal world, sovereigns would have managed
their debt in a macroprudential fashion. Then they would have presented so little credit risk
that it would not much matter what bank risk managers thought of their default probability. It
is this practically risk-free status, together with the confidence it engenders, that sovereigns
must now win back.
However, this ideal world is not the one we now live in. Large, sophisticated banks that base
their credit risk on their internal ratings are required by Basel II and Basel III to discriminate
among risks. The Basel II internal ratings-based approach for calculating capital to be held
against credit risk does not imply a zero risk weight, even for highly rated sovereigns. It calls
instead for a granular approach that allows for a meaningful differentiation of sovereign risk.
Banks need to assess the credit risk of individual sovereigns using a granular rating scale,
one which accounts for relevant measured differences in risk with a specific risk weight per
sovereign. Such an approach will bolster banks’ capital and help them repair their balance
sheets, thereby increasing their financial strength and bolstering confidence in their funding
positions. In passing, let me note that the 3% leverage ratio in Basel III in effect sets a floor
on sovereign holdings.
Capital and growth
More and better capital will go a long way towards achieving a more resilient financial
system. Some have expressed concerns that strengthening bank capital could slow growth
6 H Hannoun, “Sovereign risk in bank regulation and supervision: where do we stand?”, speech to the Financial
Stability Institute High-Level Meeting, Abu Dhabi, United Arab Emirates, 26 October 2011
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and delay recovery. From the outset, policymakers have devoted a great deal of careful
analysis to this question. In the process, we have made some real advances in our
understanding of how additional capital might affect growth. This was very much a
cooperative enterprise in which many central banks participated with a variety of models.
Two studies conducted last year under BIS auspices found that the costs of better capitalised
banks are likely to be modest, and far outweighed by the benefits. And this applies both in
the transition phase and in the steady state.
On the one hand, the Macroeconomic Assessment Group formed by the FSB and the Basel
Committee looked at whether banks might attempt to reduce lending during the transition to
higher capital. They found that this would have a rather small impact on the economy, with
reduction in annual growth rates limited to 3 to 5 basis points during the time that the extra
capital is being built up. In addition, the impact on activity would be only temporary, as GDP
would return to its trend path afterwards. So the impact would be quite minor. And indeed,
this conclusion is supported by what we have so far observed: many banks have already
increased their capital ratios, ahead of schedule, and this without any noticeable impact on
lending spreads or tightening of lending terms.
On the other hand, the long-term economic impact (LEI) group was tasked to study the long-
run costs and benefits of the requirements, ie after the transition period that the MAG
analysed. The LEI group found that additional permanent GDP costs should be small. By
contrast, the benefits from reducing crisis risks will be substantial. The costs will be low
because investors will come to recognise that soundly capitalised banks are less risky, and
will demand a lower return on equity. This limits any long-term widening in credit spreads. At
the same time, there are huge potential gains from the reduced risk of financial crises and
the attendant GDP losses. The LEI group found that, with capital ratios at or even above the
proposed Basel III minimum of 7%, the benefits would greatly exceed the costs.
Moreover, the transition period will be long enough for banks to achieve the higher capital
ratios without skimping on their lending and so derailing the recovery. In fact, the persistence
of vulnerabilities argues in favour of building strength now – and even for going faster than
the Basel III schedule where possible. The reason is simple: a sound recovery hinges on
having a secure financial system. Businesses and households will not regain the confidence
to plan, to invest and to innovate until they have regained their trust in the financial system
and its durability.
With this reference to research that has informed policymaking in real time, let me close with
an admission and a plea. I admit that we policymakers and central bankers face conceptual
challenges in striking the right balance between growth, equity and stability. And I make a
plea for research, knowledge-sharing and training that can prepare supervisors to meet
these difficult challenges. This is a mission that I am very confident that CAFRAL will fulfil
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The more insular environment of the early 1980s for global finance was followed by an era of
liberalisation and deregulation facilitated by the revolution in information and communication
technology. This radically transformed the global financial system. The funding requirements
of global trade, investment and output were met, in no small measure, by the financial
system contributing to the steady growth and prosperity in the world. Regulation in its part
evolved and responded to the innovations and the developments in the financial sector. The
philosophy underlying it increasingly moved towards deregulation, rather towards
encouraging innovation. The overarching view was that that the markets knew best and were
self-correcting. But as innovation overtook itself and financial sector growth became an end
in itself, the excesses morphed into a global crisis leading to a host of challenges for
regulation. In responding to these challenges thrown up by the crisis, regulation has had to
evaluate and take a new path, in particular, by looking at systemic risk and systemic stability.
This is what has been attempted over the last three years and the end is still not in sight. In
the process, stability, rightfully so, has taken the centre stage. But that alone is not sufficient.
The other objectives of the society – growth and equity – are equally important to get out of
the debt crisis, attain sustainability and ensure equity through employment-generating
growth, which is so important for social stability.
While this has been largely a trans-atlantic scenario, the issues for EMEs have been
different. EMEs did not contribute to the crisis but had to bear its consequences. For EMEs
the imperatives of equitable growth continue to be real and strong. Consequently, regulation
seeks to blend in their context the concerns of growth and equity with those of stability.
To what extent does the framework of financial sector regulation adopted globally in the
post-crisis period impinge on the growth objective, especially for the EMEs? Should and can
equity be a specific objective for financial sector regulation? What are the targets,
instruments and institutional arrangements for macroprudential policies to address systemic
risk in EMEs? What are the implications of the linkages between the real sector financial
sector and sovereign for growth, equity and stability? How does the global financial
architecture impinge on national policies? In order to think through these and related
questions, the Centre for Advanced Financial Research and Learning (CAFRAL) and the
Bank for International Settlements (BIS) jointly organised a conference for regulators and
central banks during 15-16 November 2011 in Mumbai.
The symbol chosen to represent the theme for the conference was the tree of life –
representing the global ecosystem with its interconnectedness and symbiotic relationship
between the different parts, particularly between the real sector and the financial sector.
Regulation and growth
The issues relating to regulation and growth can be seen from a global perspective and from
an EME perspective. From a global perspective, three issues emerge as relevant in the
context of the discussion on the implications of regulation for growth. The first is whether
there is a tradeoff between growth and stability; the second, whether there is any “optimal”
size or composition of the financial sector; the third, whether regulation can directly target
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growth and equity or whether through targeting stability, it provides a necessary but not a
sufficient condition for ensuring growth and equity.
The relationship between growth and finance is usually seen as positive but there have been
different views. Recent events have shown that excessive growth in the financial sector can
become a source of instability and can become a drag on the growth of the real sector . All
recent studies on the implication of the new capital and liquidity requirements on growth point
out that there could be some adverse impact on growth. However, the sacrifice in growth is
negligible – even after taking into account the varying results of different studies – seen in
the context of the sharp drop/slowing down in world trade, output and investment in the
aftermath of the crisis with its concomitant impact on equity. Hence the trade-offs, if any,
between growth, equity and stability are only in the short run. The overwhelming objective of
financial sector regulation is stability, so that both growth and equity objectives are met in a
On the question of the optimal size of the financial sector, Governor Subbarao points out that
over the last 50 years, the share of the financial sector in aggregate profits more than
doubled from 17 per cent to 35 per cent. “The large share of the financial sector in profits,
when its share of activity was so much lower, tells a compelling story about the misalignment
of the real and financial sectors.” But how does one judge the optimal share (or, for that
matter, the optimal scope or composition) of the financial sector? In answering this question,
it may be necessary to consider enlarging the scope of the indicators used for determining
financialisation. According to former Governor Reddy, financialisation is not confined to
measures of credit, leverage and derivatives, it should encompass financialisation of the
commodity markets, household budgets, corporate, and the government besides the
financial sector itself. He suggests that it would be useful to attempt an empirical
cross-country assessment of the appropriate size of the financial sector conducive to
sustained and stable growth. Similarly, jurisdictions need to take a view on the optimal
structure of the banking system. This involves issues such as the share of the public sector
financial institutions and foreign banks; and in both cases an important factor is to what
extent the regulator can have sufficient oversight. In the former, this relates to independence
of the regulator from the political interests and in the latter, whether the presence of foreign
banks is through subsidiaries or branches and the effectiveness of the home-host
relationships. In the post-crisis period, the subsidiary route has emerged as a preferred mode
of presence from the host country perspective, even though subsidiaries also cannot be
ring-fenced completely. The need for subsidiaries may not be there if it were possible to work
out a more effective resolution regime.
On the third issue of whether banks should confine themselves to the traditional role of
boring banking, the cross-country experience shows that while global finance contributed to
growth in world trade, investment and output, some countries have achieved high and
consistent growth rates without too much innovative banking or even too much growth in
investment banking. The counterfactual would be the continuation of real sector growth in
these countries in the same manner without development of sophisticated financial markets.
Analysing this would require cross-country comparisons of the composition, coverage and
penetration of the financial sector and links with growth, stability and equity. This would help
our understanding the optimal composition of financial sector development appropriate to
each country. The need for “good” innovation like “good” cholesterol to facilitate both growth
and equity and the need for good regulation to encourage such type of innovation needs
Turning to the EME perspective of regulation and growth, there are two separate sets of
issues. The first covers issues of implementation. Regulation should be easy to understand
and easy to implement. This is particularly important for EMEs and, it would not be too
radical to think of a ‘reduced form’ Basel framework for EMEs. Implementation of Basel II/III
is particularly challenging for EMEs because of the lack of sophisticated risk management
systems, appropriate IT and staff skilled in quantitative techniques. There is also a lack of
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historical data necessary for the estimation of expected credit losses and operational losses.
Even if considered more appropriate, EMEs would find it challenging to pursue the sectoral
approach for countercyclical provisioning (which is more appropriate for many EMEs than the
agreed Basel metric of aggregate credit to GDP). The challenge is that sectoral approaches
might be perceived as non-compliant by the markets.
The second set of issues relating to EMEs is the implications of regulation for growth
especially for the specific financing needs of trade, SMEs and infrastructure investment.
EMEs would gain in general from the new regulations through spillover effects. These
measures are expected to lead to a more resilient banking sector in the developed markets
which need sound institutions and markets to stimulate growth, which in turn is vital for the
growth momentum to be sustained in the EMEs.
It was noted that trade finance was critical for most EMEs and it was the first channel of
transmission of the global crisis affecting the real sector instantaneously. The Basel III
measures relating to trade credit have been modified recently to take into account the
concerns expressed by EMEs, although the ring-fencing of trade credit in the wake of any
disruption in global markets could well be considered as part of the international agenda for
SME financing, even in normal times, is considered as non-viable business on risk-adjusted
basis especially when banks have the option of investing in risk-free sovereigns. This sector
not only faces a liquidity crunch in the wake of a crisis on account of shrinking cross-border
flows but also because domestic large businesses tend to hold up payments due to such
SMEs at such times. This consideration apart, banks are usually not as willing to reschedule
loans for SMEs as for large businesses. Many countries took special measures to support
SME financing in the post-crisis period. Such intervention is generally through: policy
mandate (directed credit); subsidised credit guarantee schemes assignment of lower risk
weights and provisioning (Basel already allows 50 per cent weights); and ensuring the better
availability of credit records and credit information. Ultimately, it comes to a more robust
manner of assessing credit risk to this sector to improve efficiency even in the presence of
State support and guarantees.
The impact of regulation on the financing for infrastructure investment would also be an issue
in EMEs. Stipulation of ‘net stable funding ratio’ (NSFR) may increase cost of infrastructure
credit. There is also a view that current exposure norms for single/group exposures
prescribed under Basel norms need to be scaled down. This could create a problem in
jurisdictions where even the current norms are considered to be constraining infrastructure
development. In the absence of alternate longer-term sources of finance for infrastructure,
the maturity transformation role has to necessarily borne by the banks. Here again State
intervention through provision of credit enhancements may be needed to facilitate bank
funding of infrastructure while recognising the problems of moral hazard. However, such
enhancements may not in all cases eliminate the problem of exposure norms. Banks also
have to cope with a lack of information on financing – so they cannot be sure that the assets
being financed by them are not being financed in parallel by others.
Regulation and equity
The impact of regulation on equity can be examined at the macro level as also at the micro
level. Macroeconomic and macroprudential policies tend to ignore the impact of such policies
on the poor. This is echoed in Andrew Sheng’s comment that, over the past 30 years, the
growth in the wage rate and the deposit rate have been lower than the real growth rate. This
has led to wage and financial repressions that have contributed to the poor subsidising the
rich, at the national as also at the global level. In an important sense, the anti-inflationary
stance of the monetary authority is the most appropriate “pro-poor” policy. Policymakers
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must ensure that monetary and regulatory policies curb excess financialisation which can
cause undue volatility in exchange rates and commodity prices that become difficult for the
small businesses and the poor to sustain. At the micro level, finance by itself does not have a
pro-equity bias – indeed the seeking out of collateral to mitigate risk can be said to have an
anti-equity bias. Similarly economies of scale dictate serving large and valuable customers
rather than the many small customers. Hence, mainstream finance does have a “pro-big and
pro-rich” bias. This raises three important questions. Should equity be a specific objective of
regulation? If so, will this run counter to the objective of securing stability? How do regulators
balance the objectives of equity and stability?
The Chair of the session, Stephany Griffith-Jones, argued that 'Too small to be counted', is
too real an issue to be ignored by financial regulation and it is imperative for equity to be an
explicit objective for regulation. The important caveat she added is that, if instruments for
pro-poor growth are to be effective on a sustainable basis, they need to be supported by
broader policy and institutional framework with simplified regulation – reliance on credit alone
could be dangerous. This resonates with Governor Subbarao’s reference to the risk to the
financial system of using easy credits to keep job creation robust – something that was
brought home in the subprime crisis.
The requirement of the financial sector to adopt specific pro-poor policies, according to
Reddy, can be justified because of the implicit subsidies to those who have a banking
franchise (deposit insurance, bailouts due to the public utility and systemic importance of the
banking system etc). There is increasing support for the view that some prescriptions about
the allocation of credit and pricing of transactions in order to achieve the equity objective are
likely to win greater acceptance than they did in the pre-crisis period. This is not to advocate
regulatory forbearance or relaxation of prudential norms, but to support the use of regulatory
prescriptions to encourage financing of directly productive activities which support
self-employment and small businesses in the real sector. Similarly, there is merit in
incorporating incentives for financial inclusion in the regulatory regimes of developing
The provision of safety nets could indeed be one form of protection for the poor. As financial
crises of different dimensions recur periodically, regulation therefore needs to ensure that the
engagement of poor with the formal financial system is within a framework which supports
their survival during downturns. There should be sufficient space for them to limit their
losses. This could be achieved through some form of insurance/credit guarantees. Similarly
ring-fencing of trade credit in future crises could be an important area for regulatory reform
while drawing up living wills of financial institutions entities.
The paper presented by Sriram alludes to the need to expand time horizons for engagement
of the financial sector with the poor as the current accounting standards, regulatory
guidelines and institutional behaviour focus on the short term. The small stakeholders suffer
the worst since their engagement is seen as a charge on current profits, irrespective of long-
term gains. It is here that the role of alternate non-bank channels becomes important.
Perhaps a different regulatory approach to entities which are not governed purely by market
forces and which can afford to take a longer term view – such as social enterprises – can be
given appropriate policy and fiscal support to innovate within certain thresholds.
Specific innovations taking advantage of information and communications technology (ICT)
solutions to achieve scaling up of outreach, reducing transaction cost while ensuring
sufficient safeguards, relate to the use of the business correspondent model and mobile
banking. Experiences in Brazil, India and various countries in Africa highlight the win-win
aspects of these innovations. The mobile telephone companies have a larger footprint than
banks in China and India: getting them to help provide financial services through mobile
banking for the poor is both a challenge and an opportunity in these and other EMEs. Both
banking regulation and payment system regulation need to respond to the challenge and
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opportunities of rapid and dynamic changes taking place in the ICT sector that can make
financial inclusion a reality.
An important issue raised in regard to 'credit worthiness' of small clients was that banks need
to think innovatively beyond credit bureaux and develop a mechanism based on
transparency of transactions – much as eBay does for its sellers. Transaction history, based
on cash flows, could be a strong indicator of credit worthiness. This could overcome the
problem of collateral for small borrowers.
Regulation and stability
The sources of systemic risk in EMEs are several and some of them go beyond the scope of
national financial sector regulator/s. Even if EMEs have perfectly flexible exchange rates
(and in most cases they do not), the monetary and fiscal policies of significant reserve
currency countries have impact of systemic nature on EMEs especially through volatile and
undependable capital flows. Hence capital account management becomes very much part of
the tool kit to ensure macroeconomic and financial stability in EMEs. Other macroeconomic
factors are the nature and extent of cross-border lending, inadequacy of resolution
mechanisms for cross-border financial institutions and the perimeter of regulation. The extent
of sovereign paper holdings in the financial sector and erosion of confidence in what is
otherwise considered a risk-free paper could also threaten financial stability as is currently
the case in the euro area. This is an important lesson for the EMEs. The microeconomic
aspects of systemic risk relate to externalities – interconnectedness, procyclicality and
contagion. Equally important is the quality and effectiveness of supervision.
The practical issues in implementing macroprudential measures pointed out by Philip Turner
relate to data gaps, operational targets, choice of instruments and institutional arrangements.
In the case of EMEs, data on system-wide currency and maturity mismatches as also on the
highly geared counterparties in the more innovative segments of domestic capital markets
need to be collected and monitored at regular intervals. In view of the interconnectedness
between the financial sector, macro economy, businesses, households and sovereigns, there
could be a problem of choosing the right indicators to measure systemic risk. Each
jurisdiction will need to build up an integrated indicator which reflects the global buildup of
risk; comparable parameters locally, as also local risk build up including exposures and
leverage of local financial institutions. Even if such a metric is built up, a judgment call would
need to be exercised on when to invoke the instruments or tools as there is a risk of too early
or too late an intervention.
This calls for coordination between monetary and macroprudential policy, and adequate
preparation of the market through appropriate communication of the authorities’ intention to
bring in macroprudential measures unless the risks subside. Usually, the desired change in
monetary policy and macroprudential policy would be in the same direction. But
circumstances may arise when macroeconomic and macroprudential policies will need to
move in opposite directions. It may be difficult to have clear demarcations and in practice the
two may have to be framed jointly although there could be a hierarchy in the decision making
process. The choice of policy tools is largely a country-specific issue and use of greater
number of instruments in a modest way would generally be less distortionary (and therefore
more effective) than heavy reliance on just a few instruments.
As regards institutional arrangements for macroprudential policies, there is a dominant
opinion in favour of the levers being in the central bank in view of the close link between
monetary policy and macroprudential policy, the expertise within central banks due to active
participation in financial markets, and the central bank role as lender of last resort. The focus
on macroprudential regulation has brought a new equilibrium between central banks and
supervisory authorities which may have interesting connotations even where both the
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activities reside within the same body. There are concerns that the monetary authority may
lose some independence in the process. Whatever the model, there would be a need to
shield the body responsible for these policies from both political and commercial interests of
the financial industry. Central banks, being independent of the political cycle as well as of the
industry, are well-placed to “take away the punch bowl” before excess leads to disaster.
While return to the risk-free status of the sovereign is imperative for financial stability, in the
interregnum, there is need for supervisors to ensure that financial institutions undertake a
realistic risk assessment of sovereign assets. Such assessments will have to be based on
more fundamental parameters rather than market assessments which could be extremely
volatile. In the euro area, deleveraging by financial institutions which is affecting the
short-term interests of the economy is less on account of the demand for recapitalisation but
more on account of the overall macroeconomic environment. In the longer term, only well
capitalised banks will be able to attract both capital and debt from the markets. The need to
bring in systemically important shadow banking in whatever form into the macroprudential
framework is strongly underscored.
Macroeconomic policy and financial regulation
In his inaugural address, Jaime Caruana set the tone in broadening the topic of the
conference to go beyond regulation to macroeconomic policies impacting the objectives of
stability and growth. While discussing the linkages between the real sector and the financial
sector he drew attention to the fact that “financial stability depends not only on the link
between banks and the corporate and household sectors but also on their links with the
sovereign. Given these two-way influences, between banks and sovereigns, there is a clear
and present danger of malign feedback from banks to sovereigns and from sovereigns to
banks.” He drew the analogy with macroprudential policies that emphasise the building up of
buffers in good times to be drawn down in bad times. He said that one lesson from the crisis
is the need to build headroom in the government budget in good times to be able to have
enough policy space to support the economy in a downturn. Otherwise the government itself
could become a source of instability “as its credit risk damagingly interacts with that of banks
and other private sector entities. Sovereigns must now earn back their reputation as
practically risk-free borrowers. And as history has taught us, sovereign solvency is a
precondition for the central bank’s success in dealing with threats to monetary and financial
stability”. A sound recovery hinges on having a secure financial system. Businesses and
households will not regain the confidence to plan, to invest and to innovate until they have
regained their trust in the financial system and its durability. Structural reforms are desirable
to allow faster trend growth.
In a wide-ranging speech, Reddy covered the synergies and tradeoffs between the
objectives of growth equity and stability and the use of macroeconomic policy and financial
regulation to balance these objectives in an optimal manner. He did this against the
background of globalisation and the weak international financial architecture. Alluding to
Caruana’s query about the optimism implied in conference title as to whether we are really in
a post-crisis period, Reddy said that the risks have been passed on to the sovereign, and
there are now significant threats to economic political and social stability. Re-regulation or
rebalancing of regulation by itself may not be enough to achieve the optimal share or size of
the financial sector that would be conducive to growth and stability. It may be useful to do a
cross-country study taking into account the diverse experiences of different countries in
regard to composition of financial sector, growth and stability using five related factors, viz,
the macroeconomic environment in which the financial sector operates; the share of financial
sector in the total economic activity; the composition of the financial sector in terms of
banking, non-banking, derivatives etc; the framework of regulation of financial sector and the
quality of supervision of the sector. The possible dualism in growth of the financial sector
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reflected in underserving of certain sectors and excessive financialisation in others should be
analysed by EMEs. Alternative paths of development of financial sector need to be
considered, keeping in view the lessons from the global financial crisis.
A lively discussion on the role of global imbalances and persistence of the paradox of the
“uphill” flow of capital from the EMEs to developed countries was provoked by John Lipsky.
Neither Reddy nor Sheng saw the capital flows to developed countries reversing in the near
future: public debt is growing faster than GDP in advanced countries; demographic factors
are putting pressure on government budgets; there is limited scope for increased savings in
advanced countries; and there is no credible alternate to the dollar as the reserve currency,
Nor did they see the euro area problem, essentially being internal, as contributing to global
imbalances. But slower growth in Europe could have sizeable adverse spillover effects.
Global financial stability depends on three key infrastructure elements: the reserve currency;
the lender of last resort; and the prevalence of oligopolistic conditions in the rating industry,
the accounting profession and news/wire agencies. Describing the present system as a non-
system, where there is no market discipline on the dominant reserve currency, multiple
reserve currencies or fully floating exchange rates cannot be seen to be solving the problem
due to presence of network externalities and the absence of a credible global lender of the
last resort. There is scope for regulators to ensure that CRAs follow the rules of the game
and are subject to market discipline. Equally, informed institutional investors must build their
own capabilities for proper risk assessment.
Global finance and the presence of large international banks also bring into sharp focus the
issue of autonomy and effectiveness of the national financial regulator. To quote Reddy
“globalisation of finance in the context of serious market imperfections and absence of
globally enforceable rules could, by virtue of close linkage of finance with other macro
policies at national level, restrict the space available for national authorities to conduct
The conference brought to light the intricacies of interrelationships of regulation and
macroeconomic policies not only with respect to growth and stability, but also with respect to
equity. The conference provided an opportunity for regulators and policymakers to focus on
the issues from the angle of the EMEs. Divergent views were aired frankly. We were able to
debate the global implications of national policies while making suggestions on regulation
and macroeconomic policies in the backdrop of the current global financial architecture. The
conference also provided suggestions for initiating several areas of empirical research. It has
opened up to CAFRAL new vistas to explore in planning its future activities. And it
contributed to the international financial cooperation that is the vocation of the BIS. By
sharing knowledge on policy issues confronting central banks and financial supervisory
authorities, the aim is to promote not only better regulation and supervision worldwide but
also deeper mutual understanding.
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Financial sector regulation and macroeconomic policy
The Bank for International Settlement (BIS), the Centre for Advanced Financial Research
and Learning (CAFRAL), and the Reserve Bank of India (RBI) need to be complimented not
only for the excellent logistics, but also the outstanding background papers that have been
prepared for the conference. I had in fact prepared a draft for delivery today, but discarded it
after listening to the stimulating presentations made by Governor Subbarao and Jaime
Caruana, and to the discussions that followed. I, therefore, decided to revise my presentation
in order to supplement the proceedings of yesterday by posing a series of questions and
exploring some possible answers.
The theme for the Conference is very valuable and path breaking since it raises fundamental
issues contextually and is also forward looking. Contextually the subject covered in the
Conference provides necessary correctives to the pre-occupation in the current debates on
financial regulation relating it with the issue of maintaining financial stability as a response to
the global financial crisis. It is also forward looking in the sense that it recognises the
possible contributions that the developing and emerging market economies, particularly Asia,
could make to the evolving debate on the subject, in view of their potentially enhanced role in
the global economy in future. Fundamentally, it is of great significance, because the title of
the Conference recognises the main purpose of public policy relating to the financial sector,
viz, ensuring growth with stability while addressing the issues of (social) equity. The trade-off
between growth and stability, and their inter-linkages have been recognised as being
inherent in financial regulation, but equity considerations have come to the fore in global
debates in the very recent past, mainly as a consequence of the adverse impact of the crisis
on welfare of large segments of population. This Conference, in a way, recognises the
instrumentalist view of the role of the financial sector in public policy and asserts its primary
goals as growth, stability and equity. By sponsoring this conference, the BIS is also rightly
projecting itself as a truly global institution, for which Jaime Caruana and Philip Turner
deserve full credit. Governor Subbarao and Usha Thorat are simultaneously placing India as
an active participant in the journey towards a better global financial system in the interest of
global economy as a whole.
A world in crisis or post-crisis world?
Jamie Caruana made a profound statement in a casual manner when he said in his speech:
“I especially appreciate the optimism in the title’s reference to the post-crisis world. Such
optimism is more apparent here in Asia than in Europe”. It is generally agreed that a possible
collapse in the financial sector was avoided in 2008. There has also been some recovery in
the global economy. Hence, many analysts tend to describe the current situation as a post-
crisis world. There are others who argue that we are still living through the crisis, and hence
it is premature to proceed on the basis that the phase of crisis management is behind us.
It is undeniable that the crisis in the financial sector has been significantly moderated, but the
process of correction of the excesses of the past, especially high leverage in some advanced
economies, is far from complete. In a sense, therefore, there are risks to the financial sector,
though it may not be a continuing crisis situation. However, in the process of managing the
financial crisis, a fiscal crisis has ensued, since excess leverage has been shifted from the
balance sheets of private financial sector to the public/government sector. In particular, the
current situation, in the euro area and potentially in the United States and the United
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Kingdom, evidently represents a continuation or a spillover of the crisis from the financial
sector. It is also clear that unemployment continues to be high in many of the advanced
economies. There is a stalling of growth and employment generation in developing and
emerging economies too. In a way, therefore, the fallout of the financial crisis and the
consequent strain on government finances has been the economic crisis afflicting many parts
of the world. Economic activity appears to be far from normal. Furthermore, in managing this
combination of financial, fiscal and economic crises, another crisis situation has surfaced at
the political level. As part of a political deal to manage the crisis, for instance, two Prime
Ministers (of Greece and Italy) had to make way for the appointment of technocrats.
Managing the political economy at a national level as a fallout of global financial crisis means
facing unprecedented challenges, be it in the United States or China or India. In addition,
there is widespread pressure on social cohesion in several countries. This is illustrated by
spontaneous mass movements, both in advanced economies such as the United Kingdom
and the euro area, and in developing economies such as parts of Asia and the Arab world.
Perhaps there is more to come ahead of us due to further spill over into several social
segments. These developments are in some ways a reflection of a broader rebalancing on
several fronts that has been triggered by the crisis in the financial sector.
In brief, therefore, the financial crisis may be over if viewed from a narrow perspective, but
from broader and longer-term perspectives, we are still living through the crisis. One
important lesson from these developments is that in the conduct of macro policy, it is difficult
to define the boundaries of the financial, fiscal, and monetary environments, and they cannot
be treated in silos, particularly under extraordinary circumstances involving rebalancing on
Re-regulating or rebalancing the financial sector
It may be useful to distinguish between re-regulation and the rebalancing of regulatory
structures and policy regimes as a result of the broader lessons from the crisis so far.
Excessive deregulation was one of the causes of the global financial crisis, but it was not a
global phenomenon. Excessive deregulation of the financial sector was generally confined to
the United States, the United Kingdom and other European countries. The standards of
regulation even in advanced economies have not been uniform as the contrasting examples
of Canada or Australia with the United States or the euro area would illustrate. It is true that
excessive deregulation was a key feature of systemically important economies which had
severe negative consequences for the global economy. But that does not mean that
contagion itself is due to globally pervasive excessive deregulation of the financial sector. It
would therefore, be unrealistic to generalise that public policy should attempt re-regulation in
all jurisdictions. Moreover, several incidents that have come to light indicate considerable
regulatory forbearance in the systemically important countries, that was disproportionate to
the inherent weaknesses in their financial systems. It can be argued that in some cases, the
issue was more of ineffective supervision than of excessive deregulation. Better supervision
does not mean more regulation but striking the right balance between regulation and
Empirical studies comparing developments in Canada and the United States may shed some
light in this regard. Both have close trade integration; both have open capital accounts; and
both have floating exchange rates. Yet the financial sector in Canada has not been as
vulnerable as in the United States. Part of the reason may lie in the macroeconomic policy
environment which is instructive, but a large part may have something to do with the nature
and quality of regulation and supervision.
In many developing economies, neither shadow banking nor toxic financial derivatives have
been prevalent: so re-regulation may not be warranted. Many emerging market economies
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may not need large-scale capital infusions in banks or changes in incentives that are now
being advocated for advanced economies. But they may have certain symptoms of what may
be broadly described as repression in the financial sector. The current debate often
addresses the correctives needed for what may be described as excessive financialisation;
but it does not specifically address the issues of managing development of the financial
sector in economies that may be far from such excesses. More important, the linkages
between the macroeconomic environment and the financial sector may be somewhat
different in countries with under-developed financial sectors than in those with overleveraged
financial sectors. Perhaps it would be appropriate for the developing countries to consider
the paths of development of their financial sectors to reach the optimal level, keeping in view
the lessons from the global financial crisis.
In brief, therefore, the major thrust of regulation of the financial sector may be in terms of
defining the perimeter and the substance of regulation. The lessons we have learnt about the
framework for financial sector regulation that is appropriate to each country point to the
rebalancing of existing regulatory systems. Hence, with the task ahead being ideally
described as rebalancing, some re-regulation of the financial sector may be appropriate in
many advanced economies. In the effort of rebalancing in each country, the global
perspectives gained from the crisis become particularly relevant in view of the contagion that
Optimal level of financialisation
Governor Subbarao in his address indicated that a developed financial sector would serve
the interests of the real sector, but that does not mean that more of the financial sector would
always lead to better outcomes. He made two profound statements, and they are closely
related: “Is there such a thing as a ‘socially optimal’ size for the financial sector?”, and “It is
the real sector that must drive the financial sector, not the other way round”. While it may be
difficult to define what is optimal, we have experienced excessive financialisation that could
damage the real sector. We must strive to understand this phenomenon. Excessive
financialisation is generally taken to mean excessive leverage or excessive expansion of
credit through leverage, or excessive recourse to exotic derivatives. But excessive
financialisation has several additional aspects that are relevant for economic analysis and
First, there has been significant financialisation of commodity markets. It happened both by
virtue of deregulation of the commodity markets and by virtue of the excessive liquidity that
happened to be readily available. This phenomenon has arguably resulted in excessive
volatility in commodity markets. In standard economic analysis, the price of a commodity is
determined by the law of supply and demand. In the case of excessive financialisation,
commodities become an asset class, and hence the price is determined not only by demand
and supply of the commodity in the real sector but also by the demand and supply for the
commodity as a financial asset. A persistent disconnect between the spot prices of
commodities and the underlying demand and supply conditions – that is mainly caused by
the conditions in financial markets – is evidence of financialisation of commodity markets.
Persistent volatility in commodity prices, due more to commodities as an asset class than to
trading could imply avoidable costs in the process of price discovery and possible distortions
in the market. The correctives in public policy in regard to excessive financialisation of
commodity markets extend beyond the scope of regulation of financial sector.
Secondly, there has been significant financialisation of household budgets, particularly in
advanced economies. The changes in demand for houses or scooters or cars are often
dependent on credit conditions, rather than on the standard assumptions about income and
price elasticities of demand. Even the expected cash flows, including in particular social
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security, are determined by the market value of the pension funds and other sources of
social security over people’s lifetimes. Not only current consumption, but also the future
streams of income derived from savings are determined by the conditions of the financial
Thirdly, there has been financialisation of corporates. Corporates are exposed to financial
markets not only through their underlying operations of producing and selling, but also
through their treasury operations. Many corporations derive incomes from their treasury
operations, often totally unrelated to their main business activity, and they may take
significant risks on this account. Their treasury operations are not necessarily restricted to
the jurisdiction of a single country, especially when they have cross-border operations. Many
large corporations have built up large cash surpluses in recent years as they held back
investments in the real economy. The cross-border treasury operations of corporates often
fall outside the scope of regulation of the financial sector, and the impact of this phenomenon
on the effectiveness of macroeconomic policy is unclear.
Fourthly, there has been excessive financialisation of the financial sector itself in many
advanced economies. In other words, incentives in the form of commissions related to
transactions led to multiple layers of transactions. Some innovations were like mirrors of
reality; as the mirrors multiplied, the distortion of the original object became all the greater.
Further, complexity was injected in regard to some of these innovations to circumvent the
regulatory prescriptions on transparency or on capital adequacy, or to mislead the
counterparty. The comparisons of the growth of the financial sector as a percentage of GDP,
the growth of profits of financial institutions as a percentage of profits of all the corporates
engaged in economic activity, the remuneration of managers in the financial sector relative to
others, and the share of shadow banking systems as well as derivatives in the total activity of
the financial sector, would be useful indicators of the extent of financialisation of the financial
sector. Analysis of the indicators of excessive financialisation with reference to the record of
economic growth and stability in the countries may be useful. The analysis could encompass
advanced economies such as Canada, the United States, Sweden, Norway, Japan,
Australia, and emerging market economies in Asia, in particular China and India, and Latin
America. In brief, empirical evidence may be a good pointer to the excessive financialisation,
and thus throw some light, at least in broader terms, on the optimal level of financialisation
for each country.
Composition of financial sector, growth and stability
Governor Subbarao, who has earlier expressed himself against making banking too boring,
elaborated on the issue when he said: “Is making banking boring a necessary and sufficient
solution to preventing the excesses of the pre-crisis period? And what will be the cost of
making banking boring?” This issue can be restated in broader terms as one of optimal
composition of financial sector. It is not only the level of financialisation of an economy, but
also the nature and composition of the sector that may be relevant for growth and stability.
East Asia had displayed significant growth, and faced a major episode of instability in recent
decades. As a result of the crisis, it changed its policies relating to financial sector. Malaysia
followed one distinct model of crisis management and the others another model. Both helped
Asia to come out of the crisis stronger. In the recent decades, Latin America had displayed
lower growth rates than East Asia, but witnessed far higher instability than east Asia. Latin
American economies are characterised by impressively liberalised financial sectors. East
Asia, on the other hand, displays a strong presence of traditional banking and, in particular, a
lower market share of foreign banks. China has displayed remarkable growth and impressive
stability in the recent decades, and is characterised by a financial sector dominated by state
ownership, significantly regulated and highly directed (by public policy). India also represents
a high growth economy with stability and a financial sector which, as in the case of China, is
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dominated by traditional banking and by state-owned financial institutions. Similarly, it is
possible to identify several advanced economies with varying levels of growth and record of
stability, emanating among other things from differing patterns of financialisation.
The diverse growth and stability experiences of different countries with quite different
financial sector structures would therefore require enquiry into five related factors, viz:
(i) the macroeconomic environment in which the financial sector operates;
(ii) the share of the financial sector in total economic activity;
(iii) the composition of the financial sector in terms of banking, non banking, derivatives
(iv) the framework of financial sector regulation; and
(v) the quality of supervision of the sector.
There may well be instances of over-regulation, but under-governance. Regulation and
supervision can play a role in influencing the composition and the quality of the financial
sector. Hence, analysis of the trade-offs between growth, stability and regulation may include
considerations of the composition and quality of the financial sector – which encompasses
both the conduct of the markets and the conduct of regulation, including supervision.
It is also possible that there is excessive financialisation in one segment of the economy, say
the financial sector, and there may be several segments of real sector (such as agriculture
and SMEs) or regions or sections of the population that are under-served by financial sector.
The initiatives in regard to financial inclusion by the G20 resolutions represent the recognition
of the possible dualism in the growth of the financial sector. Cross-country comparisons of
the composition, coverage and penetration of the financial sector and its links with growth,
stability and equity, may be valuable for understanding the desirable composition of the
financial sector appropriate to each country.
Coupling or decoupling of developing and emerging market economies
There was a reference in the discussions to the validity of the decoupling hypothesis in view
of the experience with the global financial crisis. It is useful to consider the evolution of this
debate. Before the global financial crisis erupted, the benefits of global integration and
possible downsides were highlighted. In the initial stages of the global uncertainties in 2007-
08, there was a hypothesis that the developing and emerging market economies are
significantly decoupled from one another despite the global integration that had taken place.
The hope was that their economies would grow in a way that could compensate for loss of
momentum in economic activity in the crisis-hit advanced economies. Subsequently, as a
result of the contagion observed in the global economy in 2008-09, the hypothesis of
contagion and coupling overtook the hypothesis of decoupling. In 2010 and 2011, with
impressive recovery in the emerging economies, the decoupling hypothesis again took
centre stage. More recently, the picture has been far more confusing, and in any case, a
significant divergence between the emerging and developed economies in economic
performance in terms of parameters such as unemployment, growth and inflation, is being
observed. It is very clear that the economies are in many ways coupled; but much depends
on the structure of a national economy, and the nature of its integration with the rest of the
global economy. At a conceptual level, the debate reflects both the incomplete global
integration of economies and the continued importance of public policy at the national level.
The issue of the financial sector is more complex because externalities are more pervasive
than in the goods sector. Thus, it may be useful to explore the importance of differentiating
between the financial and goods sectors in assessing coupling and decoupling. The main link
between international trade in goods and international finance is trade finance. The margins
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for the financial sector are low in trade finance, and so are the risks. The immediate impact of
any disruption in the financial sector from the advanced to developing economies occurred
through trade finance. A second level of contagion is through financial flows, and this
happens on account of the gross capital flows in the short run and not over an extended
period. Sentiment and herd behaviour influence gross capital flows, and this is, perhaps, an
important source of coupling. A third level of contagion is through the demand and supply of
goods and services that determine current account balance. This is influenced by the trade
linkages. For example, the impact of the global financial crisis on China was more through
trade and sentiment, than through financial flows. It may be useful to analyse the coupling
and decoupling in terms of the nature of contagion through different, but related channels.
An important policy issue would be the need to identify global regulatory regimes that
immunise global trade finance from the vagaries of volatile financial markets. It may be useful
to explore the possibility of treating trade-finance as one similar to payment system and retail
banking in a country; this would argue for ring-fencing this activity from investment banking
and other riskier cross-border financial activities.
Globalised financial markets and competitive efficiency
The current policy initiatives at the global level on the financial sector basically assume that
global financial markets are good for achieving efficiency and stability in all countries,
provided they are well regulated at the national level with a global perspective in view. The
thrust of global initiatives is to provide for the harmonisation of national regulations, by
prescribing minimum standards of regulation for all countries, and coordination between
national regulators especially on matters relating to cross-border presence and systemically
important financial institutions. Further, the financial sector and its regulation should be put in
the context of the macroeconomic conditions in the country, and its functioning is subjected
to what may be described as basic infrastructure for global financial markets to function
efficiently in the country. It is useful to explore the state of infrastructure for global financial
markets in assessing the scope for efficiency in global finance through market mechanisms.
First, the international monetary system has generally been described as a non-system. The
US dollar is the dominant reserve currency. The supply of this currency is determined by the
Federal Reserve, which is statutorily mandated to make such supplies available to serve the
interests of the United States. If the interests of the United States coincide with that of the
global system, there may be no serious problems, but that may not necessarily be the case.
There have been no globally agreed rules to govern the supply of this dominant international
reserve currency since the fall of the Bretton Woods system. There is no serious alternative
to this currency, and thus there is no market discipline in ensuring efficiency and appropriate
supply to meet the demand. There is recognition that it is a non-system, and there is a
search for finding a solution to this problem. The option of a currency of another country that
could replace the US dollar as the dominant international reserve currency will not solve the
basic problem of the present system, namely, “my (domestic) currency, but your (global)
problem”. It is possible to argue that several reserve currencies could be encouraged, but
there is no system that could possibly achieve this. The SDR (Special Drawing Rights),
which is a unit of accounting based on a basket of currencies, is currently being advocated.
However, this may provide the benefit of diversification, but will not solve the problem of the
possible inconsistency between the national goals of certain countries and the interests of
global economies. In brief, global financial markets suffer from a monetary non-system.
Secondly, globalised finance would require a lender of last resort to address problems of
sudden illiquidity. Such a lender of last resort should ideally have capacity to create or
destroy money. More importantly, such an institution should be able to take some solvency
risk since a lender of last resort has to make judgements about solvency. There is no
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institution in global finance to undertake this responsibility. The IMF is some sort of a lender
of last resort, but its infirmities in terms of governance, ideology, trust and reputation are
recognised and under discussion. There are still no mechanisms for the orderly restructuring
of sovereign debt in cases of default or potential default. The implicit assumption of the
absence of credit risk in regard to sovereign debt creates a huge incentive for the financial
sector to be less than a responsible lender. It is difficult to conceive efficient global markets in
a system that does not have a credible monetary system and is without an effective lender of
Thirdly, the existing infrastructure for global financial markets comprises, inter alia, credit
rating activity dominated by two entities; the accounting functions are dominated by four
entities; and the dissemination of information by two news agencies. Their infirmities are also
well known. The issue is whether such an infrastructure contributes to the comfort of
efficiency in global financial markets.
Fourthly, it may be useful to draw a distinction between multinational banks which have
subsidiaries or branches in different countries (but predominantly operate in domestic
markets) and international banks which specialise in cross-border financial activities,
especially influencing capital account flows, both short-term and long-term. International
banks are able to operate across financial markets in different countries with significant
divergence in fiscal regimes as well as regulatory regimes. They may be involved in financial
flows of suspect legality in one country, though not in both countries. Because of these
operations, international banks enjoy a significant influence over the political economy in
Under these circumstances, two fundamental issues arise. The first is the validity of the
assumption that global financial markets have an inherent tendency to be efficient and to
self-correct. The second is the compatibility of autonomy in macroeconomic policies and the
autonomy of financial sector regulation at the national level with the globalisation of finance.
In brief, the globalisation of finance in the context of serious market imperfections and the
absence of globally enforceable rules could, by virtue of the close linkages of finance with
other macro policies at the national level, limit the space available for national authorities to
conduct effective macro-policies.
Financial and real sectors
Jamie Caruana has described the interactions between the financial and real sectors in a
very clear-cut fashion. The analysis is essentially in the context of the cyclical nature of
financial activity being reinforced by its relationship with the real sector, and the cyclical
nature is equally applicable to both the borrower and the lender. From a developing country
perspective, some interesting issues arise. First, the major problem for developing countries
relates to the financing of the structural transformation of the economy. The critical issue is
whether the deregulated financial sector is reasonably efficient in the allocation of resources
for structural transformation. In many advanced economies, such structural transformation
was not necessarily financed through developed financial markets. It is possible to hold that
the financial markets have a tendency to focus too much on the short-term outlook, and this
may drive the political economy, and also macro-policy, towards a similar time horizon. This
may lower household savings.
Secondly, to the extent that the real and the financial sectors interact with each other on
several fronts, the issue of synchronisation between the development of factor markets and
goods markets in relation to the development of financial markets would become critical. It is
possible to argue that the financial sector may exacerbate the market distortions in the real
economy due to the existence of structural rigidities. A deregulated financial sector may take
advantage of structural rigidities rather than inducing their corrections. This would raise the
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issue of sequencing and harmonising of reforms and deregulation in the real and financial
Thirdly, Jaime Caruana has brought to attention an important aspect of external flows in the
relationship between real and financial sector, “An important feature of cross-border credit
flows is that they tend to exacerbate domestic credit cycles”. Since the financial markets of
emerging and developing economies are not large, even modest levels of cross-border credit
flows by global standards could have enormous influence on the domestic credit cycles. In
this situation, the requisite policy tools both in macroeconomic terms and in terms of
regulation of the financial sector may have to be multi-dimensional and have to be
reasonably effective. In this light, a combination of macro-policies, prudential regulation and
capital controls may be warranted. Such a management of the capital account would involve
differentiation by residential status of an entity, or by denomination of currency.
Fourthly, I agree with Jaime Caruana when he says, “Sovereigns must now earn back their
reputation as practically risk-free borrowers. And as history has taught us, sovereign
solvency is a precondition for the central bank’s success in dealing with threats to monetary
and financial stability”. The critical issues for many emerging and developing economies are
that credit rating agencies heavily influence the view on sovereign solvency. The current
global financial architecture as already explained shows that the odds are loaded heavily
against developing and emerging market economies, though some advanced economies
have been facing issues in this regard, in the recent past. In these circumstances, there is an
additional burden on the part of policy makers in developing countries to assure sovereign
Fiscal and financial sector linkages
Jaime Caruana has referred to the two-way influences and said: “There is a clear and
present danger of malign feedback from banks to sovereigns and from sovereigns to banks”.
It may be interesting to recall that the two-way influence has often been benign: the
government provided reinforcement of trust to the banks, and the banks ensured success of
the government’s borrowing programmes. This cozy arrangement between the government
and the banking sector worked smoothly, as long as both of them operated within the
confines of a sovereign entity. This is no longer the case. In any case, the global financial
crisis has brought about what may be termed the significant fiscalisation of the financial
sector and the noticeable financialisation of fiscal policy.
First, traditional deposit insurance itself provided some sort of subsidy in as much as it has
never been a commercially viable proposition. The recent extraordinary market interventions
by monetary authorities have taken the characteristic of providing fiscal support to financial
sector. The bail-out by the fiscal sector signifies a more direct subsidy to financial
institutions. In some cases, capital has been injected by the government into banks, and in a
few cases, banks have been nationalised. In managing the crisis and the subsequent exit
policies, the boundaries between monetary and fiscal policies became unclear, and quasi-
fiscal costs are not easy to compute. At the same time, there are on-going discussions in
regard to the financing of direct and indirect fiscal support that had to be extended to the
financial sector. This includes considering a financial sector transactions tax, including a
Tobin Tax. However, there is significant opposition to these measures by national
governments on the ground that the financial sector would move to other jurisdictions.
Jaime Caruana’s observations on the sovereign as ultimate risk bearer are specifically
relevant for economies which do not happen to be fiscally strong but desire to deregulate the
financial sector in the belief that such measures would be benign. Jaime Caruana said, “In
effect, the sovereign becomes a deus ex machina, the supernatural intervention that resolves
some ancient Greek tragedies”. The problem arises when the sovereign’s capacity for
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supernatural intervention is constrained by globalisation which may be beneficial in many
respects, but could undermine the capacity of the sovereign to tackle a crisis in the financial
sector. Thus, the financialisation of fiscal policy occurs because the conduct of fiscal policy is
itself dominated by the consideration of the view of the global financial markets on the
sovereign’s solvency and its capacity to support a financial sector in distress. The
phenomenon of fiscal policies being significantly constrained by views of the financial
markets is being witnessed by advanced economies. In brief, the supernatural intervention
by the sovereign through fiscal measures is subject to the blessings of the credit rating
agencies on the state of their solvency. This state of affairs is bound to have a bearing on the
conduct of both regulation of financial sector and macroeconomic policies.
Financial sector and macroeconomic policies
It is recognised that the regulation of the financial sector should serve the broader goals of
human endeavour, namely, growth, stability and equity. Public policy in general and
macroeconomic policy in particular share similar objectives. Markets are considered to be
efficient when subjected to appropriate regulation, and thus are ideal means of achieving
these goals. Both macroeconomic policy and regulation of the financial sector have to ensure
that there is an appropriate balance between the State and the market, between fiscal and
financial, and between the financial and real sectors. Accountable governance arrangements
are available only at a national level, and both the regulation of the financial sector and
macroeconomic policy are conducted at national levels. Under these circumstances, an
appropriate space for public policy at a national level in regard to both financial sector and
macroeconomic policy broadly defined is essential. Public policy has to guard itself against
the erosion of such policy space. Simply stated, the extent and nature of sovereignty of a
sovereign in a globalised economy with globalised finance is critical in designing and
implementing coordination between regulation of the financial sector and macroeconomic
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Summary of the discussion
In the discussion that followed Dr Reddy’s speech, several issues concerning nature and
direction of capital flows, persistence of global imbalances, exchange rate regimes and
reserve currency choices and the political economy of macroeconomic policy framework and
implementation surfaced. After some discussion, views converged on all important issues.
Exchange rate regimes and Reserve Currency
If the tendency of more and more countries adopting flexible exchange rates continues,
exchange rates would get determined by economic fundamentals and countries will not have
to accumulate reserves. Will this be a way of avoiding dependence on one reserve currency?
This is premised upon the assumption that if there are multiple exchange rates, then there
can be multiple reserve currencies and there would be no need for any single currency as a
means of international payment and store of value. But, there will still be a need for a
numeraire, and there are network externalities. Furthermore, there is increasing evidence
that exchange rate by itself is not neutral to other macroeconomic policies, apart from the
fact that some of the advanced economies themselves intervene in foreign exchange
What we have ended up with is a non-system where it is perfectly legal to follow fixed
exchange rates with closed capital markets or open capital markets or more flexible systems
with open capital markets. But, more and more we see some hybrids of flexible rates, but
influenced by periodic interventions with capital markets not being completely open. Above
all, self correcting mechanism of market forces also does not work, as evident from the
recent crisis. In this environment, the feature of a non-system is likely to continue for quite
some more time. A universal flexible exchange rate regime by itself is not a solution.
Capital flows and Global Imbalances
One of the goals of the international monetary system is to deal with global imbalances. It is
paradoxical that capital continues to flow uphill from developing economies to developed
economies. Yet, there is no scope for this paradox changing in the near future. The public
debt to GDP ratio of advanced economies has increased three fold to four fold while the
share of GDP of the advanced economies as a share of the total global economy has
declined. Public debt of the advanced countries is going to demand a large share of global
capital on the demand side. Second, the age or demographic profile implies that fiscal stress
will continue. On the supply side, the likelihood of savings to GDP increasing is not
significant. Because of globalization, the labour force in advanced economies is worried
about keeping their jobs and maintaining the same standards of living for themselves and for
the next generation. So, there is no possibility of large public debt requirements of advanced
countries being met without matching capital flows from the emerging markets.
Dr Sheng however viewed that the logic of the Triffin dilemma is that if the growth of the
reserve currency country is slower than the rest of the world, the reserve currency country
has to provide liquidity to the rest of the world and by definition the reserve currency country
must run a current account deficit and the rest of the world has to finance the reserve
currency country. And capital is not flowing downhill or uphill, it is nothing but the reverse
side of current account deficit.
In so far as the Eurozone is concerned, it does not have economic imbalances vis-à-vis the
rest of the world and the problem is internal to Eurozone. However, to the extent there is
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moderation in economic growth in the Eurozone, it definitely will affect the rest of the world
due to spillover effects.
Ring fencing Trade Finance
Trade finance has followed the restructuring of the global economy. With rapid globalization
of the manufacturing process, the growth of trade in inputs has grown more rapidly than
growth in trade in final products and this has driven trade credit and the underlying forces
have been much more non-financial than financial. When the crisis erupted in 2008, the first
to be affected was trade finance and it was an area which hurt the real sector the most. If we
can regulate trade credit so that it is ring fenced in a period of crisis, it would be of benefit to
all. This could be through capital account management on which there is more consensus
today. Most of the living wills seem to sacrifice trade credit in the first instance and it is
desirable if through regulation, ring fencing of trade credit is ensured in the same way as we
accept payments systems are important for current transactions and can justify their ring
Credit Risk Assessments
The primacy given to CRAs during the crisis was a mistake. Nevertheless, the process of
securitization of finance places the largest burden of credit analysis on the end investor.
Therefore, what is more mysterious is the comprehensive failure of the institutional investors
who had the fiduciary responsibility to their clients while investing in instruments -which they
probably did not understand- only on the basis of third party recommendations. While the
large investors are supposed to have their own analysis, in the case of the institutions it was
a business decision to outsource this activity. But, what is more important is for regulators to
review their guidance on using external rating agencies for regulatory purposes and ensure
that the CRAs follow the rules of the game.
Political economy of Policy framework and implementation
How does one deal with political and financial interests while bringing about an optimal
regulation of the financial sector from the real economy perspective? Both political interests
and financial markets have short term views, whereas the regulators have a long term view.
The financial regulators may have become somewhat independent of the political leadership,
but the acceptability of the regulations to the financial markets is still vital. When interests
converge there is no problem; but, when they diverge there is a problem. In the final analysis,
the regulatory instruments act as a constraint on the regulated institutions and markets.
Occupy Wall Street is a sign of the people’s spontaneous reaction to the way the financial
markets function and their nexus with politics.
The political interference on specific regulatory decisions is varied. By and large, the desire is
that there should be no political interference on regulatory decisions, in the short term. But,
from a longer term perspective, regulation reflects the political thrust at any point of time.