It is clearly evident that the migration to a market-based model, from the conventional bank-based model where banks used to play a very critical role in intermediation, has not diminished the importance of banks in the financial system. In fact, with higher growth in the financial markets, the responsibilities cast on the banks are on the increase.

Therefore, it would be a fallacy to assume that with the migration to a market-based model, banks' role in the financial system and therefore, the need for regulatory focus is less than critical.

Rather, I would say, the regulatory challenges have grown manifold due to this new evolving relation between banks and financial markets.

It is imperative for any regulatory framework to recognise this close inter-linkage and frame regulations accordingly. The critical focus area, as part of the emerging macro-prudential and systemic risk frameworks, would have to be identification of where the risks lie.

The following are some of the broad issues that would need to be addressed in the Indian context going forward:

How to strengthen capital requirements for market risk when most banks are on Standardised Approach?

The Basel III regulatory initiatives under Market Risk are largely focussed on the Internal Model based approach. Banks in India are currently on the standardised approach and in any case, most of the banks would continue to remain under the standardised approach.

There is, therefore, a need to address the upgradation of the standardised approaches also. We are considering calibrating the capital requirement under standardised approaches with the available data for market risk.

Conflict of interest

How to strike a balance in regard to fee-based revenue streams of banks? While non-interest income does offer diversification benefits, it may not necessarily be less risky than conventional loans.

Apart from the financial risks, there are significant reputational risks, particularly when banks engage in distribution of third party products.

There cannot be rule-based prescriptions in this regard. But it would be imperative for the bank Boards to closely understand the underlying risks, assess whether returns are commensurate with the risks and monitor such businesses of banks.

For the market discipline to work, increased, granular disclosures of fee-based income may have to be looked into.

How to address conflicts of interest in banks' lending relationships and capital market activities? Can the Chinese walls be really effective in ensuring real separation of these activities within a bank?

This issue is also relevant in respect of banks' being allowed to trade on exchanges for clients.

Rating regime

How to strengthen the rating regime? The rating requirements in India are essentially driven by regulatory policies applicable to exposures of the regulated entities to various asset classes. It would therefore be imperative that the rating methodology employed for such activities is looked into by the regulator concerned.

The rating agencies are supposed to adopt a through the cycle approach while assigning ratings. The regulators will need to modulate the risk weights applicable to the external ratings dynamically as per their assessment of systemic risk.

Towards strengthening the framework for CRAs, the system needs to shift away from issue-rating to issuer rating - the rating assigned to a particular instrument cannot be taken as reflective of the credit risk of the issuing entity.

Market development

How to address excessive collateralisation of balance sheets? In view of the SLR requirement, such collateralisation may not, as yet, be posing serious risks to bank balance sheets in India. However, significant reliance of market entities on collateralised overnight funding market (CBLO/market repo) and increasing use of collateralisation for OTC derivatives may still put a strain on banks, particularly in times of systemic crisis.

This aspect may have to be considered in framing leverage requirements for banks.

How to increase the appetite for credit risk among non-bank institutional investors? This would be a big challenge for the development of credit markets.

At the structural level, two things would be critical here: an efficient legal framework to enforce security and a sound bankruptcy regime. Lastly, how to encourage true market development without the support of banks?

This can be a challenging task in a financial system still dependent on banks for financial intermediation. It is really a chicken and egg situation – without banks support, markets may not develop but once having allowed banks to provide support, it becomes impossible to withdraw it. Perhaps a middle ground may have to be explored.

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