Ashima Goyal

Don't tar all banks with one brush

ASHIMA GOYAL | Updated on August 08, 2012

Banking practices that triggered the 2008 financial crisis are more a feature of advanced economies than Moody's or the IMF would have us believe.

Banks in emerging markets (EM) are normally placed in the high-risk category, while developed country banks are generally thought to be robust and well-regulated.

The experience from the 2008 global financial crisis, however, suggests the opposite. Following the crisis, a recalibration of the scales for measuring risk should have happened, but has not. Late last year, the International Monetary Fund warned of dangers to EM banks, while Moody's revised its outlook on India's banking sector from stable to negative.

What is needed is a careful reassessment of risks, not a mechanical inclusion of EM banks in the vulnerabilities of banks around the globe.

Stronger economies

The period after the East Asian 1997 crises has seen a strengthening of EM economies, with better macro stabilisation and other reforms. Exposure to cross-border risks and doubtful sovereign debt has been limited, along with absence of high leverage, short-term funding and risky endogenous expansion of balance sheets that led to the global financial crisis.

In India, too, the path of steady market development and regulatory evolution reduced risks. Structural ratios such as the rate of return on assets registered improvement, while the percentage of banks' gross non-performing assets reached a low of 2.4 in 2009-10, compared with 12.8 in 2000.

A new philosophy of regulation — a shift from interfering with individual transactions to macro-management based on broad sectoral exposures (such as higher provisioning on lending to real-estate) — generated incentives that reduced pro-cyclical behaviour in financial markets.

Indian regulators did aim to comply with Basel capital adequacy regulation norms based on banks' own risk assessments.

But in the absence of relevant skills among Indian banks, the required depth of data and market-determined parameters were missing.

So, by default, they followed capital adequacy regulations based on broad sectoral exposures, instead of mathematical models that could aggravate risk-taking in booms.


But EM banks are also emerging from a period of financial repression and government ownership, which creates risks, just as the narrow financial markets and higher inflation regimes in which they typically operate.

These structural risks have fallen for Indian banks, but cyclical risks have risen in the recent period with the sharp rise in interest rates.

Although regulatory ratios have remained healthy, growth in banks' net interest income has fallen and NPAs have also risen somewhat for the first time after several years.

The current slowdown has affected credit quality, but it is not systemic, as the impact has varied across banks. Even 7 per cent growth is high enough to expand banking assets at more than double the growth rate, creating many profit opportunities.

Cyclical risks may have peaked with the pause in rate hikes and reduction in exchange rate volatility.

Cyclical risks can be contained, as long as macroeconomic policy helps moderate large fluctuations in asset prices. This is especially so because of thin markets, higher levels and spreads of interest rates, and higher pass-through because of a less competitive banking sector.

Large fluctuations in exchange rates, due to capital flows driven by external shocks, also create risk. So policy needs to smooth such fluctuations.

Advice from international institutions to sharply raise interest rates and allow exchange rates to freely float creates the above risks they precisely warn against.

Such advice is, therefore, not fully thought through and lacks understanding of context, as was demonstrated in the East Asian crisis.

Policy goal posts

The steady market and institutional development, which has allowed interest and exchange rates to be market-determined, reduced their volatility, improved monetary transmission and imposed some discipline on governments, should continue.

But policy goal posts cannot remain the same after the global financial crisis. And awareness about these issues is essential, since the markets tend to mechanically punish any deviation from advanced-country norms.

EM banks have to continue to modernise, but an ideal regulatory system would include regulation based on broad ratios.

Similar features could also fill gaps in global regulatory reforms — including too much regulatory discretion and therefore, delays in response to systemic risk, exemptions for shadow banks and potentially risky activities, and excessive reliance on capital buffers that are difficult to build and would reduce lending.

With such regulation, a trade-off that reduces loss-absorbing buffers in return may be feasible.

The highly bank-based Basel III regulatory stance is a problem for EMs, given that their financial systems are bank-dominated, already have strong regulation and taxes, but are yet to reach scale. Bank assets are typically less than output in EM economies, while they are many multiples of output in developed countries.

Moreover, international shadow banks that generate volatile flows to EMs escape regulation. Rather than contributing to risk, EMs are at the receiving end of such flows. It is the latter risks that international institutions should focus on moderating.

(The author is Professor, Indira Gandhi Institute of Development Research, Mumbai. >

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Published on March 11, 2012
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