Ashima Goyal

Neglected aspects of financial sector reforms

Ashima Goyal | Updated on November 01, 2020

A corporate bond market is the key to infrastructure finance

The pandemic has provided India a good opportunity to strike a balance between financial discipline and support

The financial sector is doing better than expected in the Covid-19 period. This suggests it was in a relatively healthy state after ongoing reforms. It was liquidity that was the binding constraint. Even so the stagnation of Plan driven resource allocation warns us that reform to facilitate non-discretionary allocation through markets and financial institutions must continue. But such reforms are not just about a greater role for markets. We take up some relatively less understood aspects.

India has a very heterogeneous population with diverse needs. Diversity also makes for safety in the financial sector, since market participants tend to hold similar views and follow similar strategies, which results in too much of one-way positions and fragility.

Well governed private as well as public financial institutions as well as corporates are critical for financial markets to work successfully. Poor corporate governance and disclosure were partly responsible for the problems at IL&FS and YES Bank. Better disclosure would reduce credit risk and spreads in bond markets.

Much has been done to strengthen boards and governance, so the legacy concentration on corruption should reduce. Investigative agencies should keep the distinction between a commercial decision and a criminal act in mind, just as the Companies Amendment Act 2020 changes certain criminal compoundable offences into civil wrongs carrying civil liabilities. Independent directors, with no executive role, are not held personally liable in any country. Such liabilities should go here also. As in the amended Prevention of Corruption Act, investigation should begin only if there is evidence of wrongdoing such as disproportionate assets.

Asset-liability mismatch

Asset-liability mismatch has created many problems for the Indian financial system. Since infrastructure assets pay off in the long term, they cannot be financed by the short-term liabilities of commercial banks.

Large concentrated exposures in banks have underlined the importance of alternatives such as well-functioning corporate bonds markets, as well as a modern autonomous development finance institution for long-term finance.

Infrastructure projects must be made bankable by making the regulator-set user charges mandatory. Maybe electricity should have a central regulator with a department for each State. Pricing power could be taken away from States. Then no one will expect this form of political patronage. Just as now there are no protests when petrol prices are raised. States are free to provide subsidies to select groups but everyone must pay for services used.

Principle-based regulation is light giving operational freedom. Rule-based regulation has detailed multiple compliance requirements. India moved towards the first after the reforms, but when frauds and corporate failures emerged it reverted towards the second. Delegating more monitoring to Boards is consistent with the first, since Boards are well-suited to interpret principles and policies. But regulatory over-reaction is forcing Boards to operate as compliance checkers neglecting strategy.

Regulators should upgrade to specialised high-skill big-data based supervision departments, together with random inspections to keep entities on their toes, without too much disruption. Self-regulation and certification should be encouraged. Recent moves towards centralised compliance information across regulators should logically lead to one compliance window, with use of technology to automatically populate standardised information fields. Financial regulation has modernised considerably, introducing regulatory sandboxes to encourage innovation.

A via media is principle-based rules, where a few rules with good incentive properties, remove the necessity for detailed rules. Examples are different types of macro-prudential regulation such as loan to value ratios (LTVs). These LTVs can cap leverage at a level below the leverage ceiling derived from the level of capital held and the leverage ratio, making it possible to economize on capital buffers. Their simplicity makes them universal — they can also be applied to shadow banks so are less subject to arbitrage than principle based regulation, even while avoiding the cumbersome detail of rule-based regulation.

Emerging markets use more of macro-prudential regulation although advanced economies are also increasing its use after the global financial crisis (GFC). But Indian regulators implement more than the required Basel III capital buffers, since it is a ‘comply or explain’ not a ‘comply or else’ framework, markets may regard any deviation unfavourably. This is unfortunate since Indian credit deposit ratios are much below global averages and need to increase.

Although there may be non-performing assets, prudential regulation makes bank leverage much lower than it is internationally. A trade-off should be worked out between different types of regulations.

There is no delay in capitalising public sector banks now the bankruptcy reform is in place but tying-up excessive capital is best avoided. Since financial systems in emerging markets tend to be bank dominated, their lending has to expand with development, even as other legal, governance and market reforms occur. Therefore, bank-focused buffer rules hurt them disproportionately, while the neglect of shadow banking and liquidity creation hurts them again through capital flow volatility. Liberalisation of foreign capital has to be gradual and move in step with domestic market deepening.

Systemic risks

Individuals tend to follow the market rather than fundamentals, leading to bust and boom cycles and panics. Countercyclical prudential regulations should therefore increase the long-term cost of giving credit during booms and reduce these costs during busts. Such regulation can complement macro-economic policy.

De facto capital buffers tend to be pro-cyclical since they are often built up in bad times, hurting recovery and neglected in good times. The focus should be on preventing risky behaviour rather than on the loss-absorbing or shock-insulating role of buffers. Again macro-prudential regulation such as counter-cyclical provisioning on credit to some sectors, position limits and limits on exposure to different types of risk reduces risk-taking even without large pro-cyclical capital buffers. It prevents arbitrage through strategic use of risk weights. India was a pioneer in using counter-cyclical macro-prudential regulation before the GFC but then shifted to pro-cyclical tightening in the 2010s that ended up hurting financial stability.

Individuals do not take into account spillovers from their decisions. Regulators need to prevent systemic effects of such spillovers. But continuing tightness in financial regulations and macroeconomic policy, as well as a liquidity window restricted only to banks, led to a sharp fall in credit and in growth after the IL&FS collapse. Corporate failures that followed created extreme risk aversion and spreads rose in the market. Inflation targeting was introduced in order to help the corporate bond market develop but its over-strict implementation with macroeconomic as well sectoral liquidity tightening severely hurt corporates and therefore the bond market.

As the Indian financial system diversifies the lender of last resort function has to be more widely available so that illiquidity does not become insolvency. A repo in corporate bonds can help.

Investigations following the excesses and scams of the post GFC period created a trust deficit. But a large external shock like Covid-19 is an opportunity to recover the delicate balance required between discipline and support. Easing of financial conditions that had delivered a turnaround in February 2020, could do so again after the Covid-19 shock. In India a loosening of financial conditions can help markets recover unlike in the West where new liquidity infusion is following quantitative easing that has already driven up asset prices making valuations dangerously stretched.

The writer is member of RBI’s MPC. Views are personal

Published on November 01, 2020

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