Column: Managing the too-big-to-fail

Dec 16 2013, 05:02 IST
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SummaryRBI’s draft rules for large Indian banks adds uncertainty to their capital raising processes and operations

Reserve Bank of India (RBI) recently released on its website the draft framework for dealing with Domestic Systemically Important Banks (D-SIBs). The draft framework discusses the methodology to be adopted by RBI for identifying the D-SIBs and proposes regulatory and supervisory policies that large banks would be subjected to. Reserve Bank had indicated in the second-quarter review of monetary policy that it would place a draft of the proposed framework for

D-SIBs on its website by end-November 2013 and, for a change, it actually pretty much stuck to its schedule by releasing it in the first week of December.

Post the financial crisis of 2008, an important policy focus for regulators—some would say the major focus—was, and continues to be, risks to the financial system posed by SIBs as they have come to be known. These institutions, at the domestic level (D-SIBs), are institutions of such size, interconnectedness, and financial system importance that their failure, or even their severe distress, causes significant destabilisation and substantial adverse economic consequences. For instance, a bank like SBI or ICICI is so systemically significant that if it were to exit, it could potentially cause a major disruption to the Indian financial system. A D-SIB’s contribution to systemic risk is therefore reflected in the size of its liabilities and the impact its failure may have on markets and the real economy. If a bank like HDFC is domestically viewed as too-big-to-fail, it exacerbates moral hazard concerns. The implicit public guarantee for such banks is seen as translating into a funding advantage that distorts market competition. RBI therefore needs to regulate the D-SIBs more sternly so that they pay for the ‘negative externalities’ they create and are incentivised to become less-systemically important.

My assessment of the new capital requirements by RBI is that it has maintained the Basel Committee’s ‘buffer-on-a-buffer’ approach in determining the safety net to make D-SIBs more resilient to financial and economic shocks and, as such, to reduce the likelihood of failure. More capital absorbs more losses in bad times; however, the ‘magic number’ approach propagates a tick-box compliance mentality (see chart) typical of Indian banks rather than support proactive risk management. The add-on prescription for D-SIBs by RBI undermines the need for bank management to think critically about risk management, while the ‘one-size-fits-all’ approach, even with tier-ing banks into buckets of systemic importance, is an agnostic approach to the source and concentrations of risks.

My

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