Raghuram Rajan (Reserve Bank of India) (Aug 2014)

Raghuram Rajan (Reserve Bank of India Governor) – Importance of Basel III regulations (Aug 2014)

Chapters

00:00:03 Basel III Regulations: Capital, Liquidity, and Resolution

00:03:20 Roles of Capital in the Banking System

Introduction:
Raghuram Rajan presents a comprehensive analysis of the reasons for regulating banks and the role of capital in banking systems, particularly in emerging markets like India.

Reasons for Regulating Banks:
Rajan identifies four main reasons for regulating banks: Financial stability: To prevent systemic risks and ensure the smooth functioning of the financial system. Individual risk: To mitigate the risk of individual banks failing and causing losses to depositors and creditors. Too big to fail: To address the issue of systemically important banks that cannot be allowed to fail without severe consequences. Political reasons: To prevent public backlash and maintain public confidence in the banking system, especially after crises like the 2008 financial crisis.

Capital Requirements:
Rajan emphasizes the importance of capital requirements in banking systems, despite concerns about the cost of capital. Capital acts as a loss absorber, protecting depositors and creditors from losses. Capital serves as a budget constraint, limiting the types of investments banks can make and promoting prudent risk-taking. Capital acts as a signal, indicating the financial health of a bank and prompting regulators to take action if necessary.

Capital Requirements in Emerging Markets:
Rajan acknowledges the unique challenges faced by emerging markets like India, which have significant financing needs and less aggressive risk-taking compared to developed economies. He raises the question of whether emerging markets need the same level of capital requirements as prescribed for industrial economies.

Role of Capital in Indian Banking System:
Rajan outlines the specific roles of capital in the Indian banking system: Loss absorber: Capital protects depositors and creditors from losses in the event of bank failure. Budget constraint: Capital requirements limit the investments banks can make, promoting prudent risk-taking and encouraging banks to generate profits to increase their capital base. Signal: Capital serves as a signal to the market and regulators about the financial health of a bank.

Comparison with Global Banks:
Rajan presents data showing that Indian banks have lower capital levels compared to global banks since the global financial crisis. He highlights the need for Indian banks to increase their capital levels to meet global standards.

Conclusion:
Rajan emphasizes the importance of carefully considering the cost of capital and the unique circumstances of emerging markets when setting capital requirements. He underscores the need for Indian banks to strengthen their capital positions to enhance financial stability and resilience.

00:13:08 Capital Requirements for Indian Banks in a Global Context

International Pressures:
Raghuram Rajan discusses the international pressures on India to conform to global banking standards, especially as the country becomes more internationalized. He emphasizes the importance of maintaining a strong capital base for banks that is comparable to global banks.

Private and Public Sector Banks:
Rajan acknowledges that many private sector banks in India are well-capitalized, while public sector banks still have some way to go. He cautions against relying solely on implicit capital (government capital) and highlights the need for adequate capital buffers.

New Capital Requirements:
Rajan mentions upcoming moves to increase capital requirements beyond current levels. He raises concerns about finding investors for new sources of capital, such as perpetual bonds and Gone Concern loss-absorbing capacity.

Skepticism towards New Capital Requirements:
Rajan expresses skepticism about the applicability and necessity of some newfangled capital requirements in India’s context. He questions whether India needs to adopt all the regulations pushed by developed countries, given that the country did not experience the same excesses as those markets.

Public Sector Bank Capital:
Rajan emphasizes the importance of addressing the issue of public sector bank capital. He identifies two key steps: stopping the erosion of capital by dealing with non-performing assets (NPAs) and taking the necessary accounting hits to make non-performing assets performing again.

Addressing NPA Issues:
Rajan highlights the need to avoid window dressing and take a proactive approach in dealing with NPAs. He urges banks to stabilize NPAs and ensure that any stabilization is real and not merely a result of data manipulation.

Asset Sales:
Rajan stresses the importance of asset sales in dealing with balance sheet issues and releasing capital. He emphasizes the need for these sales to be genuine and not merely a way to park unwanted assets elsewhere. He also acknowledges that asset sales can be beneficial in putting assets in better hands that are better able to manage them.

00:19:36 Improving Capital Raising and Governance in Indian Banks

Abstract

Balancing Act: Navigating Capital, Liquidity, and Resolution in the Banking Sector

In the aftermath of the global financial crisis, the banking sector has undergone significant changes, particularly in regulatory practices. This comprehensive article will delve into the intricacies of banking regulations, focusing on capital and liquidity requirements, systemic risk, and the unique challenges facing Indian banks compared to their global counterparts. Key regulatory imperatives and initiatives, such as Basel III, and the role of capital in banking will be discussed, alongside the evolving landscape of public sector banks in India. The article will conclude with insights into capital raising strategies and the collaboration between banks and regulatory bodies for sustainable growth.

Capital, Liquidity, and Resolution Regulations

The Basel III regulations, a cornerstone of modern banking regulation, focus on three critical pillars: capital/leverage, liquidity, and resolution. These regulations, as pointed out by Raghuram Rajan, are complex and necessitate extensive documentation and detailed computations. They were developed in response to the financial crises during 2008-2009 and 2010-2011 in Europe. Their primary aim is to ensure banks maintain adequate capital to absorb losses, thus preventing systemic instability. They also mandate that banks hold sufficient liquid assets to meet short-term obligations and include provisions for living wills and other mechanisms to facilitate the orderly resolution of failing banks, which is crucial for preventing financial contagions.

Systemic Risk and Shadow Financial System

The financial crisis highlighted the critical issue of systemic risk, arising not just from banks but also from non-bank entities, including the shadow financial system. Rajan emphasizes that systemic risk can emerge from these non-bank entities and stresses the importance of a comprehensive approach that encompasses both banks and the shadow financial system. This is essential for effective regulation and mitigating potential risks that could destabilize the entire financial system.

Need for Regulation

Bank regulation is essential due to the unique systemic risks and externalities posed by banks, which are distinct from those of corporations. Rajan underscores the importance of regulating banks due to these externalities. He acknowledges that systemic risks were a significant factor during the great financial crisis, driven by both banks and non-banks. He suggests that existing regulations need to be augmented with additional measures to address the evolving nature of financial markets.

Caution in Regulation

Regulation, while crucial, must be implemented cautiously to avoid unintended consequences, such as risk migration outside the regulated sector. Rajan concludes with a caveat about the current regulations, acknowledging that they may not be comprehensive enough to address systemic risk fully. This balance is vital for ensuring financial stability without stifling economic growth.

Regulatory Imperatives for Banking Institutions

Banks are regulated to ensure stability and prevent systemic crises, with measures aimed at minimizing individual and systemic risks. Certain banks, due to their systemic importance, are subject to stringent capital and liquidity requirements. Political considerations also play a role, as the public outcry over bank bailouts and compensation practices has fueled political pressure for stricter regulations. A delicate balance is required between ensuring capital adequacy and fostering economic growth.

Capital’s Multifaceted Role in Banking

Capital serves multiple functions in banking: it acts as a loss absorber, a budget constraint, and a health indicator. Rajan identifies four main reasons for regulating banks, including financial stability, individual risk, too big to fail, and political reasons. Capital constraints limit the types of investments banks can make, promoting prudent risk-taking, and it acts as a signal of a bank’s financial health, prompting regulatory action if necessary.

Comparative Analysis of Indian and Global Banks’ Capital Levels

Post-2008 financial crisis, Indian banks have shown a lag in capital adequacy compared to global banks. By 2013, while global banks had improved their capital ratios, Indian banks witnessed a decline, indicating the need for regulatory intervention, especially in public sector banks. Rajan discusses the international pressures on India to conform to global banking standards, especially as the country becomes more internationalized. He acknowledges that while many private sector banks in India are well-capitalized, public sector banks still have some way to go. He raises concerns about finding investors for new sources of capital, such as perpetual bonds and Gone Concern loss-absorbing capacity.

Regulatory Capital Requirements for Banks

Indian banks face international pressures to match global capital standards. Rajan expresses skepticism about the applicability and necessity of some new capital requirements in India’s context. He emphasizes the importance of addressing the issue of public sector bank capital by stopping the erosion of capital and dealing with non-performing assets (NPAs).

New Sources of Capital

Emerging proposals for additional capital requirements in India pose challenges in attracting investors. Rajan highlights the need to avoid window dressing in dealing with NPAs and stresses the importance of genuine asset sales for balancing the balance sheets.

Public Sector Bank Capital Improvement

Improving public sector bank capital involves addressing NPAs, avoiding financial data manipulation, and undertaking necessary accounting measures to restore asset health.

Stabilization of NPAs

Signs of NPA stabilization in Indian banks are promising but require more data for confirmation. Economic growth and project recovery are essential for reducing NPAs.

Asset Sales and Balance Sheet Management

Selling non-core assets can enhance balance sheet health and release capital. These transactions should be genuine and not merely for asset parking.

Capital Raising and Governance Reforms for Banks

Under Rajan’s guidance, public sector banks are focusing on cost reduction and governance improvements to attract capital. Government measures aim to enhance governance credibility and attract investment.

Basel III Implementation and Capital Requirements

There are concerns about additional capital requirements beyond Basel III. The Reserve Bank of India (RBI) is willing to consider suggestions and address constraints faced by banks.

Moving Towards Net MTM Accounting

Transitioning to net MTM accounting is desirable for deepening bond markets, but clarity regarding public sector bank defaults is needed.

Raghuram Rajan’s Advice for Indian Banks to Raise Capital and Improve Governance

Advice for Public Sector Banks:

Rajan advises focusing on cost reduction and considering raising capital from public markets. Improving governance through longer tenures and protection from interference is essential. He encourages preparing for substantial credit opportunities in the future and suggests long-term financial institutions buy long-term bonds.

Advice for Private Sector Banks:

Most private sector banks recognize the need for raising capital. Regulations under Basel III are designed to ensure sufficient credit and risk-taking capacity for growth. The Central Bank is open to working with banks to address constraints and support growth.

Balancing Basel III Requirements:

A balance between following capital requirements and the calculations that lead to them is necessary. Efforts are being made to align regulations with international standards.

Netting of Market-to-Market Positions:

Moving to netting of market-to-market positions requires a clear understanding of what happens when public sector banks default. Once appropriate structures are in place, transitioning to netting can be facilitated.

Notes by: ChannelCapacity999

Raghuram Rajan (Reserve Bank of India Governor) – Importance of Basel III regulations (Aug 2014)

Chapters

Abstract

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