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Saturday, February 25, 2012

How the RBI prevents banks from being 'too connected to fail'

Post the 2008-date financial crisis, there is increasing recognition that besides size, risk and profitability, interconnectedness of banks is another key consideration for the banking system to consider. In his speech titled 'Indian Banking- Journey into the Future', at the Bancon-2011 at Chennai on November 6, 2011(http://rbi.org.in/scripts/BS_SpeechesView.aspx?Id=660)  the Deputy RBI Governor Anand Sinha made a host of interesting points amidst which I focus on this aspect. The points in bold italics are made by him, with my following commentary.
  1. prudential limits on aggregate interbank liabilities as a proportion of banks’ Net Worth:- This measure ensures that banks do not lend to each other and create a chain. That is why even equity investments in other banks is deducted for the purpose of calculating regulatory capital.
  2. restricting access to uncollateralized funding market to banks and Primary Dealers with caps on both borrowing and lending:- Repo lending is asset backed, but unsecured lending could pose problems later. Hence, these restrictions force banks/PDs to solve their problems using the capital markets instead of subjecting other banks to their systematic risk
  3.  increasingly subjecting NBFCs to more stringent prudential regulations:- NBFCs and banks increasingly compete for the same customers, investors and depositors. Yet, NBFCs are not regulated to the same extent, most importantly when it comes to priority sector obligations and branch audits.
  4. restricting banks’ exposure to NBFCs to contain regulatory arbitrage:- Banks used to view NBFCs as a easy way to fulfill their priority sector lending. That is why microfinance companies and gold loans companies profited from the access to assured cheap funding till the AP crisis/RBI diktat respectively
  5. Financial Stability and Development Council (FSDC) monitoring inter-alia, financial conglomerates:-Since issues with one arm of the conglomerate may cause run on the banking arm, RBI prefers to go for integrated monitoring and ring fencing via Bank Holding Company structure etc. Also, it aims at improving financial sector regulatory coordination to reduce arbitrage, and thereby lower the risk of interconnectedness. 
All these are noble goals and good tools, so I hope they stand the test of time.

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