The progress in the implementation of various reforms in different countries is likely to be guided as much by legacy
issues as by a mix of factors such as the stage of financial sector development on the one hand and relative significance
and priorities of various reforms for the respective economic systems on the other. In the interim, there is a risk that
emerging inconsistencies in regulatory approach in some of the major jurisdictions may create hurdles to the smooth
functioning of international financial markets and institutions. In any case, regulatory dialectics are expected to
continue as new regulatory gaps emerge.
India has made steady progress in implementation of the G20/ Financial Stability Board (FSB) led global reforms,
in various areas viz. Basel – III, OTC derivatives, regulation of systemically important financial institutions,
shadow banking sector etc. While staying committed to the reforms agenda, India is conscious of the pitfalls of the
‘one size fits all’ approach to regulation. Furthermore, it is important to take cognizance of the historical evolution
and unique characterisitics of the financial system, while reviewing the legal-regulatory framework for the Indian
financial sector.
The recent episodes of some unhealthy practices in the shadow banking sector have underlined the importance of
extending the regulatory perimeter and strengthening the supervisory functions. That brings forth the need for
enhancing the effectiveness of coordination mechanism with law enforcement agencies to ensure a higher degree of
consumer protection in financial sector.
At a time when efforts are on to augment the household financial savings, it is important to enhance the credibility
of the financial system by addressing the risks posed by mis-selling of financial products, perverse incentive practices,
risks from the technology issues such as erroneous trades, high frequency trading, card / electronic payment
transactions etc.
Implementation of Global Regulatory Reforms
Regulatory Dialectics
3.1 Implementation of agreed global reforms is
underway in various jurisdictions even as there is a
parallel process of rethinking on the architecture of
financial regulation. Excessive deregulation and soft
touch regulations were among the main factors that
contributed to the financial crisis which the reforms
intended to address. However, as memories of the
crisis are fading, questions are being raised over the
proposed measures for reregulation. The rethinking
on the reforms veers around the relative benefits of
increased capital levels (especially of ‘too big to fail’
entities) versus the development of the financial
markets and the costs of banking business. While the
regulatory dialectics will continue, regulators may
find it difficult to steer their reforms through such
trade-offs (Box 3.1).
Signs of Home-bias in Regulation
3.2 While considerable progress has been achieved
in building global consensus on reforms, regulatory
chauvinism has been raising its head in certain
jurisdictions. The divergent approaches to additional
regulatory measures in many advanced jurisdictions
might lead to slowdown in financial globalisation. For
example, the main proposals under the Volker rules
in the US, Vickers report in the UK and Liikanen report
in the EU, are essentially based on ring-fencing
models. However, there are some important
differences in terms of the range of activities that can
be undertaken by and between the ring-fenced
entities. While the relative merits and de-merits of a
home-bias to regulation might be difficult to gauge at
this juncture, there are some immediate possible
effects of such regulations, such as the Volcker Rule
prescriptions affecting the operations of the US banks in India as they are major players in domestic foreign
exchange, government securities and interest rate
swap markets.
Box 3.1: Regulation, Innovation and Regulatory Dialectics
More than three decades ago Edward J. Kane put forth
the idea of a dynamic model depicting the interaction
between the regulated and the regulators and called
it “regulatory dialectics”. Under this model, financial
market regulation is an endless process with both
the regulator and the regulated making alternative
moves. Interestingly, way back in the eighties Kane has
suggested the following order in which the financial
market players in the dialectics model exhibit their
average adaptive efficiencies, and concluded that the lag
between regulation and avoidance is shorter than the lag
between avoidance and regulation.
- Less regulated players move faster and more freely
than the more regulated ones
- Private players move faster and more freely than
governmental ones
- Regulated players move faster than the regulators
- International regulatory bodies move more slowly
and less freely than all other players
In a recent paper1 Kane opined that “In the US, strategies
for dealing with regulation-induced innovation and for
disciplining the institutions that recklessly spawned
these plagues have been assigned to teams of incentive
conflicted and understaffed regulators to work out”
and that “Bankers understand the financial safety net
as a politically enforceable implicit contract that they
have negotiated with their national governments” and
“not as something external to their balance sheets”. He
further feels that “lobbyists create a taxpayer put by
creating an excessive fear in the minds of regulators of
letting banks’ accounting decisions or health be called
into question”2
Indian Approach to Implementation of Reforms
3.3 Domestic factors and policy priorities have
continued to guide the Indian approach to financial
sector regulation, while adhering to the commitment
to implement the agreed global reforms and
international standards. The Financial Stability and
Development Council (FSDC), through its Sub
Committee is coordinating and monitoring the
implementation of various reforms, starting with an
assessment of extant regulatory framework in the
country vis-à-vis the proposed reforms. The reforms
directly related to and contained within the regulatory
purview of the individual sectoral regulators are being
handled independently by them; reform areas which
need active inter-regulatory/inter agency coordination are being spearheaded by the inter-agency
implementation groups focussing on specific areas,
viz. resolution regime, shadow banking, financial
market infrastructure, legal entity identifier, and
credit rating agencies. A roadmap indicating the
timelines for implementation of these reforms is
proposed to be set out by the respective groups.
Basel – III
Effect of Risk Weight Based Approach
3.4 Basel III aims to address the shortcomings in
the Basel-II framework, which surfaced during the
global financial crisis. One of the main factors for the
crisis was the build-up of excessive leverage while
maintaining the risk based capital ratio above the
regulatory requirement, as some of the banks’ internal
models facilitated mathematical maneuvering of risk
weights. The inherent complexity and opacity
involved in the modelling exercise, notwithstanding the scrutiny and supervisory validation process,
allowed the banks to indulge in aggressive application
of risk weights, driven mainly by their business
considerations.
3.5 A recent paper3 has found that the risk-weight
density defined as ratio of risk-weighted assets (RWAs)
to total assets, of banks is observed to be lower once
regulatory approval is granted for the internal ratingsbased
(IRB) approaches of Basel II. It is further noted
that the effect persists for different loan categories,
which cannot be explained by flawed modelling or
improved risk-measurement alone. These observations
have resulted in the additional regulatory prescriptions
under Basel III, wherein common equity requirements
have not only been more than doubled but also are
required to be topped up with capital conservation
buffer4.
Marginal Increase in RWAs for Indian Banks
3.6 The scatter diagrams of ratio of RWA to total
assets5 of Indian banks show that the average value
of the ratio has increased from 60 per cent as at
end March 2012 to 62 per cent as at end March 2013
(Chart 3.1). The dispersion in ratio values has also
decreased marginally between these two dates. The
trends and outliers need to be monitored as more and
more banks adopt the internal model based approaches
under Basel II and Basel III6.
Leverage Ratio – ‘Back to Basics’
3.7 In order to arrest the tendency to build up
excessive leverage, a simple non-risk based leverage
ratio has been prescribed under Basel II, which will
act as a complementary ‘backstop’ measure to the
risk-based capital requirements. The leverage ratio
can be easily understood by all the stakeholders of a bank, viz., shareholders, creditors, depositors and
regulators and facilitates easier assessment of the
capital adequacy of the institution. The Basel
Committee is testing the Tier I leverage ratio during
the parallel run period from January 1, 2013 to January
1, 2017.
Revised Basel III Guidelines on Short Term Liquidity
3.8 In January 2013, the Basel Committee on
Banking Supervision (BCBS) issued the revised
guidelines7 on Liquidity Coverage Ratio (LCR)8 after
incorporating a number of changes in the original
version published in December 2010 (Box 3.2). The
changes were necessitated to minimise the potential
impact of the LCR standard on the financial markets,
extension of credit and economic growth. Also, the
BCBS has considered a broader timeframe for the
introduction of the LCR standard, in view of the
significant financial strains persisting in some banking
systems.
Reserve Bank’s Guidelines on Liquidity Norms
3.9 The Reserve Bank indicated in the guidelines
on liquidity risk management issued in November
2012, that the final guidelines on Basel III liquidity
standards will be issued once the Basel Committee
finalises the relevant framework. The Basel Committee
has since issued the guidelines (Basel III: The Liquidity
Coverage Ratio and Liquidity Risk Monitoring Tools)
in January 2013 and is in the process of finalising the
LCR disclosure requirements and the Net Stable
Funding Ratio (NSFR)9. The Reserve Bank will issue
the final guidelines on Basel III liquidity standards
and liquidity risk monitoring tools, taking into
account the revisions by the Basel Committee. While
the enhanced liquidity risk management measures
are expected to be implemented by banks immediately,
the Basel III liquidity standards, viz., LCR and NSFR,
will be binding on banks from January 1, 2015 and
January 1, 2018, respectively.
Box 3.2: Major Changes Announced in the LCR Guidelines
Expansion of the range of eligible assets as part of
high-quality liquid assets (HQLA) - through the addition
of a new category of Level 2B assets which national
supervisors may choose to recognise as HQLA in their
local LCR regulations.
Recalibration of the stress assumptions for some
cash-flow items (including in respect of retail and nonfinancial corporate deposits and undrawn committed
facilities), taking into account industry feedback and
actual experience in times of stress.
Affirmation of the usability of the stock of HQLA by
banks in times of stress, allowing the LCR to fall below the minimum requirement. Supervisors will need to
establish guidance to specify the circumstances for usage
of the HQLA, and to ensure appropriate supervisory
action in response to such circumstances; and
Adoption of a phase-in arrangement that introduces
the LCR as planned on January 1, 2015, but with the
minimum requirement set at 60 per cent. This will then
rise by 10 percentage points per annum to reach 100 per
cent on January 1, 2019. This graduated approach is to
ensure that the standard can be implemented without
material disruption to the ongoing strengthening of
banking systems and financing of economic activity.
More Stringent Capital Requirements and Timelines
3.10 The Reserve Bank of India has already
introduced Basel III capital regulations, effective April
1, 2013, to be implemented in a phased manner over
a period of time ending March 31, 2018. Thus India’s
schedule for full implementation is nine months
ahead of Basel committee’s deadline. As a matter of
prudence and also to preempt the possibility of the
judgemental errors in computing capital adequacy,
the Reserve Bank has prescribed a higher minimum
Tier I capital, which is one full percentage point above
the Basel III requirements (Table 3.1). Pending
finalisation of leverage ratio by the BCBS, the Reserve
Bank has introduced a minimum Tier I leverage ratio
of 4.5 per cent (Tier I capital to total assets ratio),
which will be reviewed later based on the final
recommendations by the BCBS.
Table 3.1: Capital requirements for Indian banks under Basel III |
(as percent of RWAs) |
|
Basel III
standards |
RBI
prescriptions |
Minimum common equity (MCE) |
4.5 |
5.5 |
Capital conservation buffer (CCB) |
2.5 |
2.5 |
Total (MCE+CCB) |
7.0 |
8.0 |
Minimum Tier I Capital |
6.0 |
7.0 |
Minimum Tier I Capital + CCB |
8.5 |
9.5 |
Minimum Total Capital |
8.0 |
9.0 |
Minimum Total Capital + CCB |
10.5 |
11.5 |
Additional Capital Requirements
3.11 Analytical studies10 have indicated the likely
adverse impact on lending (and growth) due to the
higher capital requirements for banks, at the global
level. However, the burden from the increase in cost
of lending is expected to be offset by the benefits
accruing from a more robust banking system. The
improved capital ratios of banks are expected to instill
more trust among the stakeholders, thereby reducing
their cost of capital over a period of time.
3.12 It is expected that the long timeframe to phase
in Basel III capital requirements will allow Indian
banks to make a smooth and non-disruptive transition.
Initial estimates indicate that the additional capital
requirements of Indian banks would be to the order
of `5 trillion, of which non-equity capital will be to
the tune of `3.25 trillion with the rest to come from
equity.11
Foreign Banks’ Presence in India - Subsidiary
Structure
3.13 Traditionally Indian approach to financial
regulation has been on combining global experience
and local circumstances. As regards the global mega
banking institutions, ‘too complex to regulate’ had
been a concern for Indian regulators in respect of
their Indian operations. The road map laid down by
the Reserve Bank in 2005 allowed foreign banks the
choice of entering India either as a branch or a
subsidiary. Reflecting the post crisis shift in global
policy thinking, the current stance of the Reserve
Bank is in favour of subsidiarisation model. While
some tax related issues such as exemption from
stamp duty and capital gains tax-subsequent to the
conversion of branches into subsidiaries, have been
addressed; certain legal issues are still being
resolved.
Operational Risk under Advanced Measurement
Approach
3.14 The previous FSR had raised concerns about
the difficulties in measuring operational risks and
limitations of the standardised approaches. The
Advanced Measurement Approach (AMA) for
computing capital charge for operational risks is the
most risk-sensitive and sophisticated among the three
approaches prescribed under the Basel II.
3.15 The Reserve Bank had issued guidelines on
AMA in April 2011 and Indian banks could apply for
migration to AMA with effect from April 1, 2012. Four
banks have, since, approached the Reserve Bank for
permission for migration to AMA. Some major
challenges being faced by banks in implementation
of AMA approaches relate to issues of internal
governance, difficulties in determining the relevant
business environment and internal control factors
(BEICFs), constraints on availability of historical loss
data, including both internal and external data,
scenario data, and modeling and quantification of
operational loss data. Regulatory permissions for use of AMA for operational risk capital computation would
be considered based on the assessment of the
preparedness of banks in this regard.
Over The Counter Derivatives
3.16 The thrust of the post crisis reforms on Over
The Counter (OTC) derivatives is towards
standardisation of products, central counter party
(CCP) based electronic trading platform and reporting
of trades through trade repositories (TRs). Opacity of
products, excessive bilateral exposures coupled with
insufficient collateral and the interconnectedness
amongst market participants are the main risks in the
OTC derivatives markets, globally. FSB is currently
monitoring the progress of implementation of these
reforms within the G20 nations.
Status of Implementation in India
3.17 In India, the small size of the OTC derivatives
market, low level of complexity in products, orderly
development and regulation of market have ensured
that there are no major concerns with regard to
systemic risks from OTC markets. The OTC
derivative products were introduced in a phased
manner keeping in view the hedging needs of the
real sector. The current regulations mandate that
validity of any OTC derivative contract is contingent
on one of the parties to the transaction being a
regulated entity. The Clearing Corporation of India
Limited (CCIL) provides the clearing and settlement
of transactions in government securities, money
market instruments and foreign exchange products.
Reserve Bank, as the regulator of the OTC derivative
markets, has focussed on improving transparency
and reducing counterparty risk in the OTC derivatives
markets and has fostered development of robust
market infrastructure for trading, settlement and
reporting of transactions. As India is committed to
implementation of the G20 / FSB reforms, reasonable
progress has been made in implementing the OTC
derivative reform measures.
Standardisation of Products
3.18 The process of standardisation of OTC
derivative products is planned to be undertaken
gradually. Credit Default Swaps (CDS) transactions
are standardised in terms of documentation, coupon,
coupon payment date etc. The standardisation of
Interest Rate Swap (IRS) contracts is aimed to be
achieved in terms of minimum notional principal
amount, tenors, trading hours, settlement calculations
etc., in consultation with the market participants. As
the first step, standardisation has been made
mandatory for INR Mumbai Inter Bank Offer Rate
(MIBOR)-Overnight Index Swap (OIS) contracts, from
April 1, 2013. Other benchmarks in IRS are proposed
to be standardised in subsequent phases. Foreign
exchange derivatives are ‘plain vanilla’ and structures
go by market convention.
Centralised Clearing of Foreign Exchange and
Interest Rate Forward Trades
3.19 There is a guaranteed centralised clearing
arrangement for settlement of USD-INR forward
transactions. Mandatory central clearing of foreign
exchange forwards is proposed to be introduced
shortly. The IRS and Forward Rate Agreements (FRA)
in the Indian rupee, which form the bulk of interest
rate derivative transactions in the market, are
currently being centrally cleared in a non-guaranteed
mode. Although it is not mandatory for market
participants to clear their trades through CCP, more
than 97 per cent of fund flows in IRS/FRA are being
settled through CCIL. The CDS market in India is still
developing and it may take more time to achieve the
necessary market activity to support central clearing
of CDS transactions. The risk management framework
and procedural aspects proposed by the CCP and the
issues relating to exposure norms for derivative
transactions are being examined.
3.20 Electronic platforms are available for
transactions involving repos in government securities,
IRS, FRA and foreign exchange forwards. The report12 of a Working Group set up by the Reserve Bank has
recommended, among other things, introduction of
an electronic swap execution facility for the IRS
market under a CCP, which may provide guaranteed
settlement of trades executed through the electronic
platform. The modalities involved in introducing
these features are presently under examination.
3.21 As per existing regulatory guidelines, banks and
primary dealers report IRS/FRA and foreign exchange
derivative transactions on CCIL reporting platform.
All CDS trades (including client trades), by market
makers are required to be reported on CCIL’s reporting
platform. Reporting of all major OTC foreign exchange
derivatives to the TR has commenced since July 2012.
Also, the reporting of client trades in foreign exchange
derivatives, under suitable confidentiality protocols,
has commenced from April 2013. Presently, client
trades in IRS are being reported by banks to the
Reserve Bank and steps are being taken to institute
the reporting framework for the client trades in
respect of interest rate derivatives.
Risks from Extra Territorial Regulatory Jurisdiction
of Regulation
3.22 The US and European laws dealing with OTC
derivatives reform have raised concerns over
possibilities of extra territorial regulatory jurisdiction
leading to regulatory clashes and disruptions for
market activity. For instance, European Market
Infrastructure Regulation (EMIR) and the Commodity
Exchange Act (CEA)-as modified by the Dodd-Frank
Act, contain prescriptive rules that may prevent
European/US banks from participating in third-country
clearing houses that have not applied for recognition
by the European Securities and Markets Authority
(ESMA) or that are not registered as a derivatives
clearing organisation (DCO) as per Commodity Futures
Trading Commission (CFTC) regulations. While the
discussions are still on, the uncertainty over the
inconsistencies between EU and US rules, the process
and timeline for equivalence assessments may affect
the functioning of international financial markets and may have an impact on progress of implementation
of G20 reform agenda.
Margins for Non-Centrally Cleared OTC Derivatives
3.23 The international standards on margining for
non-centrally cleared OTC derivatives are in the
process of being finalised. A Working Group set up by
the BCBS and International Organisation of Securities
Commission (IOSCO) to develop consistent global
standards for margin requirements has submitted its
draft report for consultation. One of the key principles
being proposed for all covered entities (i.e. financial
firms and systemically-important non-financial
entities) that engage in non-centrally-cleared
derivatives is that they must exchange initial and
variation margin as appropriate to the counterparty
risks posed by such transactions. However, the actual
quantum of the margin threshold may have to be left
to national discretion to suit the domestic financial
markets.
Demand for Collateral
3.24 The improved standards for margin
requirements and the shift towards central clearing
of standardised OTC derivatives contracts may
contribute to a structural increase in the demand for
collateral assets. At present there is no evidence or
expectation of widespread scarcity of safe assets in
global financial markets. However, the temporary
supply-demand imbalances and associated price
changes are expected to generate powerful incentives
for endogenous private sector responses such as
broader eligibility criteria for collateral assets in
private transactions, increased collateral re-use,
collateral transformation etc. While such responses
may help mitigate any shortage of collateral assets,
they could also result in increase in interconnectedness,
pro-cyclicality and financial system opacity as well as
higher operational, funding and rollover risks. These
risks can be addressed by measures such as increased
transparency through market disclosure and better regulatory reporting, stress-testing, risk-adjusted
deposit insurance, prudential limits on asset
encumbrance etc.
3.25 Asset encumbrance is very low in Indian
banking system due to the fact that the funding of
commercial banks in India is largely from unsecured
and stable public deposits. Banks are required to
maintain a portion of their assets in liquid
unencumbered assets including sovereign securities
to comply with the Statutory Liquidity Ratio13 (SLR).
A relatively lower use of securitisation also limits the
extent of encumbrance.
Legal Entity Identifier System
3.26 The global financial crisis, among other things,
underscored the need for establishing a uniform
global system for legal entity identification to support
aggregation of risk positions and financial data. FSB
took up the project on a global Legal Entity Identifier
(LEI) system to provide support to the objectives of
efficient assessment of micro-prudential and macroprudential
risks. LEI is a form of legal entity
aggregation that allows authorities to view and
analyse the potential systemic risk arising from OTC
derivatives transactions or positions, in one or more
products, attributable to a group of legal entities
sharing common affiliation. The data attributed to
such an LEI group can assist authorities in assessing
concentration and contagion risk associated with a
group and its counterparties. The LEI system is
expected to help facilitation of orderly resolution,
containing market abuse and curbing financial fraud,
and enabling higher quality and accuracy of financial
data overall.
3.27 In January 2013, the global LEI system was
formally launched with the establishment of the
Regulatory Oversight Committee (ROC). The Reserve
Bank has joined the ROC of the global LEI system and
has set up a Steering Committee, to carry out a
detailed study of the requirements of the project for India. Apart from the OTC derivatives markets, the
LEI system may also help in achieving a more robust
credit information system in India.
Systemically Important Financial Institutions
3.28 Regulation and supervision of large and
diversified financial institutions referred to as
Systemically Important Financial Institutions (SIFIs)
have assumed significance considering the system
wide damage that their failure could potentially cause.
India does not, at present, have any Globally
Systemically Important Banks (G-SIBs) figuring in the
list of 28 G-SIBs14. However, there are banks and other
types of financial intermediaries which may not be
significant from an international perspective, but
could still have an important impact on India’s
domestic financial system and economy, as compared
to non-systemic institutions.
3.29 Recognising the importance of such entities,
the FSB and the standard setting bodies are extending
the SIfiframework to other systemically important
financial institutions, in respective areas. For the
banking system, the FSB and BCBS have finalised a
principles-based, minimum framework for addressing
domestic systemically important banks (D-SIBs)
(Box 3.3). According to FSB’s proposed timelines, the
national authorities should begin to apply
requirements to banks identified as D-SIBs in line
with the phase-in arrangements for the G-SIB
framework, i.e. from January 2016.
Consolidated Supervision of Financial Conglomerates
in India
3.30 In India such big financial groups are identified
as Financial Conglomerates (FCs), on the basis of their
significant presence in two or more market segments
(Banking, Insurance, Securities, Non-Banking Finance
and Pension). In an important step towards a more
effective consolidated supervision of the FCs, the four
financial sector regulators in India, viz. Reserve Bank
of India (RBI), Securities and Exchange Board of India
(SEBI), Insurance Regulatory and Development
Authority (IRDA) and Pension Fund Regulatory and Development Authority (PFRDA), have signed a
Memorandum of Understanding (MoU) for cooperation
in the field of consolidated supervision and
monitoring of FCs.
3.31 An Inter-Regulatory Forum (IRF) has been
constituted by the Sub Committee of the FSDC to
strengthen the monitoring of FCs. The IRF is
structured as a college of domestic supervisors by
adopting the lead/principal regulator model, with a
mandate to carry out two major functions viz.
developing supervisory cooperation for effective
consolidated supervision of FCs and assessing the
risk to systemic stability due to activities of the FCs.
The IRF, on a special case basis, may identify one or
more ‘systemically important financial groups’ having
‘significant/dominant’ presence in one financial
market segment and a ‘major/substantial’ presence
in one more market segment for the purpose of
inclusion in the FC Monitoring framework. The
respective regulators are in the process of devising
the criteria for entities under their jurisdictions,
considering various indicators.
Cross Border Co-operation in Supervision
3.32 The arrangements for sharing of information
for improved cross border banking supervision and
cooperation, in respect of internationally active banks,
are being formalised through the signing of bilateral
Memoranda of Understanding (MoU) by the Reserve
bank with overseas supervisory counterparts (as
“Home” and “Host” supervisors). This channel
assumes greater importance as the cross border
operations of Indian banks are expanding. The MoU
provides a formal, yet legally non-binding gateway of
information between the supervisors on the health
of the supervised entities, coordination during on-site
examinations and times of crises, while preserving
the confidentiality of information shared. The MoU
does not override the laws of the land of either
supervisor but only tries to build an environment of
supervisory cooperation and coordination in complete
adherence to such laws. Reserve Bank has executed
such MoU with 16 overseas supervisors and proposals in respect of 28 other overseas supervisors are under
discussion.
Box 3.3: Extension of SIFI framework to D-SIBs
The principles proposed for D-SIBs15 focus on the higher
loss absorbency (HLA) requirement for D-SIBs.
The 12 principles for D-SIB framework are set out below:
Assessment methodology
Principle 1: National authorities should establish a
methodology for assessing the degree to which banks are
systemically important in a domestic context.
Principle 2: The assessment methodology for a D-SIB
should reflect the potential impact of, or externality
imposed by, a bank’s failure.
Principle 3: The reference system for assessing the impact
of failure of a D-SIB should be the domestic economy.
Principle 4: Home authorities should assess banks for
their degree of systemic importance at the consolidated
group level, while host authorities should assess
subsidiaries in their jurisdictions, consolidated to include
any of their own downstream subsidiaries, for their degree
of systemic importance.
Principle 5: The impact of a D-SIB’s failure on the domestic
economy should, in principle, be assessed having regard
to bank-specific factors: (a) Size; (b) Interconnectedness;
(c) Substitutability/financial institution infrastructure
(including considerations related to the concentrated
nature of the banking sector); and (d) Complexity
(including the additional complexities from cross-border
activity). In addition, national authorities can consider
other measures/data that would inform these bankspecific indicators within each of the above factors, such
as size of the domestic economy.
Principle 6: National authorities should undertake regular
assessments of the systemic importance of the banks
in their jurisdictions to ensure that their assessment
reflects the current state of the relevant financial systems
and that the interval between D-SIB assessments not be
significantly longer than the G-SIB assessment frequency.
Principle 7: National authorities should publicly disclose
information that provides an outline of the methodology
employed to assess the systemic importance of banks in
their domestic economy.
Higher loss absorbency
Principle 8: National authorities should document the
methodologies and considerations used to calibrate the
level of HLA that the framework would require for D-SIBs
in their jurisdiction. The level of HLA calibrated for D-SIBs
should be informed by quantitative methodologies (where
available) and country-specific factors without prejudice
to the use of supervisory judgment.
Principle 9: The HLA requirement imposed on a bank
should be commensurate with the degree of systemic
importance, as identified under Principle 5. In the case
where there are multiple D-SIB buckets in a jurisdiction,
this could imply differentiated levels of HLA between
D-SIB buckets.
Principle 10: National authorities should ensure that
the application of the G-SIB and D-SIB frameworks is
compatible within their jurisdictions. Home authorities
should impose HLA framework for dealing with D-SIBs
requirements that they c alibrate at the parent and/
or consolidated level, and host authorities should
impose HLA requirements that they calibrate at the
sub-consolidated/subsidiary level. The home authority
should test that the parent bank is adequately capitalised
on a standalone basis, including cases in which a D-SIB
HLA requirement is applied at the subsidiary level.
Home authorities should impose the higher of either
the D-SIB or G-SIB HLA requirements in the case where
the banking group has been identified as a D-SIB in the
home jurisdiction as well as a G-SIB.
Principle 11: In cases where the subsidiary of a bank is
considered to be a D-SIB by a host authority, home and
host authorities should make arrangements to coordinate
and cooperate on the appropriate HLA requirement,
within the constraints imposed by relevant laws in the
host jurisdiction.
Principle 12: The HLA requirement should be met
fully by Common Equity Tier 1 (CET1). In addition,
national authorities should put in place any additional
requirements and other policy measures they consider
to be appropriate to address the risks posed by a D-SIB.
3.33 There is a need for supervisory emphasis on
domestically significant institutions, including banks,
especially those having substantial cross-border
operations. Supervisory Colleges have been established
for two big Indian banks, as part of the efforts to
increase the supervisory intensity for such institutions.
Resolution Regime
3.34 The previous FSRs have mentioned about the
absence of comprehensive/separate legal-institutional
arrangement for resolution of different types of
financial sector entities in India. Currently, the
resolution of banks is facilitated under the Banking
Regulation (BR) Act, 1949 which has provisions for
compulsory or voluntary mergers. The work on
implementation of reforms on resolution regime has
started with an examination of existing legislative
arrangements for resolution of various types of
financial sector entities (including commercial banks,
cooperative banks, insurance companies etc.). A
Working Group was set up under the direction of the
FSDC Sub Committee on a comprehensive resolution
regime for all types of financial institutions in India.
Shadow Banking
3.35 Shadow banking entities played a significant
role during the global financial crisis, due to their
interconnectedness with the rest of the financial
system. It is, therefore, imperative to identify and
manage any risks that the shadow banking may pose
to the rest of the financial system. The FSB led reforms
are mainly focused on risks from banks’ interactions
with other financial institutions, risk from money
market mutual funds (MMMFs), securitisation, and
securities lending and repos.
Role of shadow banking in India
3.36 The reach of the banking sector to efficiently
cater to all segments of population in far flung areas
is limited and to some extent entities in non-bank
sector have been filling this gap. Some parts of this non-bank sector [such as the Non-Banking Finance
Companies (NBFCs) under the regulation of the
Reserve Bank] are regulated in India, although less
tightly than the banking system. However, a large part
of the non-bank sector exists in the form of
unincorporated entities which may be considered as
part of shadow banking system, going by the spirit of
FSB definition. In the light of their useful economic
function, especially in countries like India where
financial inclusion is a national priority, there is need
for a different approach to regulation of such nonbank
entities, while pursuing the objective of
consumer protection alongside that of financial
stability.
Deposit Taking and Other Systemically Important
NBFCs
3.37 The regulatory focus of RBI has primarily been
on protection of depositors’ interest, and hence on
deposit taking NBFCs (referred as NBFC-D). The
regulatory measures over time, especially since 1997-
98 have resulted in consolidation of the NBFC sector
reflecting in a reduction in the number of deposit
taking NBFCs. The quantum of the public deposits of
NBFCs absolute terms as well as in terms of proportion
of the bank deposits has also decreased substantially
(Chart 3.2). As many NBFCs stopped their deposit
taking activities, the scale of operations of non-deposit taking companies increased during this period. In
view of these trends and the changing profile of the
NBFC sector, the Reserve Bank has subsequently
extended the regulatory requirements applicable to
NBFC-D category (in respect of capital adequacy and
credit concentration norms) to the non-deposit taking
but systemically important NBFCs (NBFC-ND-SI) also.
Charts 3.3 and 3.4 give the trends in number of
companies and total assets of NBFCs in the categories
of NBFC-D and NBFC-ND-SI.
 Proposed Regulatory Changes for NBFC Sector
3.38 The NBFC sector is presently in the process of
a regulatory overhaul. The Working Group on NBFCs
in its report submitted in August 2011 has made far
reaching recommendations; both to ensure the
resilience of the NBFC sector and to contain risks
emanating from the sector in the context of overall
financial stability. The draft guidelines based on
recommendations of the Working Group have been
placed in public domain for comments in December
2012 and the final guidelines are expected shortly.
The major recommendations can broadly be divided
into four categories, namely (i) Entry Point norms,
Principal Business Criteria, Multiple and Captive
NBFCs; (ii) Corporate Governance including
Disclosures, (iii) Liquidity management and
(iv) Prudential regulation including capital adequacy,
asset provisioning, risk weights for certain sensitive
exposures, and restrictions on deposit acceptance.
Money Market Mutual Funds
Low Retail Participation
3.39 In India, MMMFs and liquid fund schemes are
regulated within the ambit of SEBI (Mutual Funds)
Regulations 1996. The MMMFs are those mutual
funds which are set up with the objective of investing
exclusively in money market instruments. The Liquid
mutual fund schemes can make investment in /
purchase debt and money market securities with
residual maturity of up to 91 days. Presently, the
MMMFs and liquid funds are mainly used by the institutional investors as an investment vehicle which
is accessible, convenient and cost-effective with
protection of the principal and liquidity. At the end
of March, 2013, the net assets under management
(AUM) of MMMFs/Liquid funds in India was around `934 billion, with 98 per cent of the contributions
coming from non-retail investors. The MMMFs
account for 19 per cent of the total AUM of the debt
mutual funds which, in turn, form 71 per cent of the
whole mutual fund sector.
Absence of Constant Net Asset Value Feature
3.40 As constant Net Asset Value (NAV) MMMFs do
not exist in India, the risks observed in some
advanced jurisdictions, especially the US, are not
relevant. The valuation norms have been reviewed
by SEBI and accordingly the overarching and
overriding principles of fair valuation were outlined
in a notification issued in February 2012. This
included valuation of securities of all maturities
reflective of the realisable value/ fair value. All debt
and money market securities across maturities are to
be valued at the weighted average price at which they
are traded on the particular valuation day and in case
such securities are not traded on a particular valuation
day then the securities with residual maturity up to
60 days are to be valued on amortisation basis and
securities with residual maturity over 60 days have
to be valued at benchmark yield/ matrix of spread
over risk free benchmark yield obtained from agencies
entrusted for the said purpose, provided such
valuation is be reflective of the realisable value/ fair
value of the securities/assets.
Liquidity Risks of Short Term Debt Funds -
Regulatory Measures
3.41 The liquid funds and other short term debt
funds in India had faced severe liquidity strain from
redemption pressures, as an impact of the global
financial crisis during 2008-09. The Reserve Bank had
facilitated a short term liquidity window to mutual funds to help ease liquidity pressures. Subsequently,
a number of prudential measures were put in place
to help the mutual funds withstand the impact of
such events of liquidity stress in future.
3.42 These regulatory measures included the
restriction on investments of Liquid funds to
instruments of up to 91 day residual maturity (as
against 182 days permitted earlier), with a view to
addressing the asset liability mismatches in open
ended schemes. The listing of close ended mutual
fund schemes has been made mandatory to provide
investors with an exit option. Also, the close ended
schemes are allowed to invest in securities of residual
maturities not exceeding the maturity of the scheme
itself, for a better asset liability management. The
provisions regarding uniform cut-off timings for
applicability of NAV of mutual fund schemes/plans
were modified. The application for investment has to
be recognised only after the funds are available for
utilisation before the cut-off time without availing
any credit facility. Further, to address the credit and
concentration risks, no mutual fund scheme is
allowed to invest more than thirty percent of its net
assets in money market instruments of an issuer,
except for investments in Government securities,
treasury bills and collateralised borrowing and lending
obligation (CBLO).
Circular Flow of Funds between Banks and Liquid
Mutual Funds
3.43 In recent years, banks’ investments in liquid
schemes of mutual funds have grown manifold17. The
liquid schemes continue to rely heavily on institutional
investors such as commercial banks whose redemption
requirements are likely to be large and simultaneous.
On the other hand, these mutual funds are large
lenders in the over-night money market instruments
such as CBLO and market repo, where banks are large
borrowers. The various schemes of mutual funds also
invest heavily in certificates of deposit (CDs) of banks. Such circular flow of funds between banks and mutual
funds could lead to systemic risk in times of liquidity
stress. With a view to address these risks, the Reserve
Bank has stipulated that the total investment by banks
in liquid/short term debt schemes of mutual funds
with weighted average maturity of portfolio of not
more than 1 year will be subject to a prudential cap
of 10 per cent of their net worth as on March 31 of
the previous year.
Regulatory Gaps in Collective Investment Schemes
3.44 Some instances have come to light of certain
individuals / companies raising money from public
by taking advantage of the lack of clarity about in the
legal provisions and roles of different agencies like
Ministry of Corporate Affairs (MCA), SEBI, RBI, State
Governments, and Registrar of Co-operative Societies
etc. This highlights the need for extending the
regulatory perimeter and also plugging the regulatory
gaps in the existing framework.
Role of State Governments and Law Enforcement
Agencies
3.45 As an immediate interim measure to address
the regulatory gap, there is greater focus on information
sharing and increased co-ordination among the
existing regulators, with an active role for the State
Governments. There is also a need for a greater
involvement of and coordination with the law
enforcement agencies, through the platforms like
State level Coordination Committees (SLCC). However,
despite all efforts to fill regulatory gaps, the risk
appetite and vulnerability of the individual investors
to succumb to promises of high returns are difficult
to curb. The regulators have taken measures, from
time to time, to caution the public and investors to
avoid getting lured by various schemes promising fast
and high rates of return.
Market conduct and Consumer protection
3.46 Intense competition and perverse incentive
structures have frequently led to widespread misselling
of products and misdirection of clients to inappropriate and risky investments by financial
service providers. The instances of mis-selling of
products have been observed across customer groups,
such as faulty derivatives to corporates (for hedging
their exposures) or inappropriate insurance products
to individuals. The reputation risk for individual
institutions indulging in such activities for short term
gains is high. Against this backdrop, regulation is
increasingly tilting towards strengthening the aspects
of consumer protection and market conduct in the
financial sector.
Bancassurance
Mis-selling
3.47 Under, ‘bancassurance’ model, banks in India
have been permitted to undertake insurance business
as agents of insurance companies subject to certain
conditions and without any risk participation since
August 2000. As announced in the Union Budget
2013-14, it is proposed to permit banks to act as
insurance brokers so that the entire network of bank
branches will be utilised to increase the penetration
of insurance services in the country. As insurance
brokers the banks will be able to sell insurance
products of any company, as against the restriction
of only one company applicable under the agentprincipal
model.
Use of unfair and restrictive practices
3.48 While banks are well suited to distribute
insurance products because of their wide network,
several issues have arisen regarding their conduct in
the process, generally pertaining to mis-selling and
certain restrictive / unfair practices (such as linking
provision of locker facilities to purchase of insurance
products, selling of unsuitable and/or multiple
policies etc.).
3.49 It was observed that in some cases, banks did
not have clear segregation of duties of marketing
personnel from other branch functions and bank
employees were directly receiving incentives from third parties such as insurance companies, mutual
funds and other entities for selling their products. In
some cases direct incentives to the bank staff have
created distortions in the sales structure.
3.50 According to IRDA’s Annual Report 2011-12 the
maximum complaints in life insurance related to
mis-selling. They also mainly pertained to the private
sector, though LIC leads the business with over 70
per cent share. The type of complaints were mainly
in the nature of unfair trade practices and mis-selling
of products (e.g. malpractices, actual product sold
being different from what was proposed, single
premium policy being issued as annual premium
policy, surrender value being different from projected,
free look refund not paid, misappropriation of
premiums etc). As a significant portion of private life
insurance companies use banks as their corporate
agents, there seems to be an urgent need to revisit
the marketing and sales strategies used by the banks
in pushing insurance products, especially since
insurance is among the more complex of financial
products for the common man to fully comprehend.
Recently, banks in the UK have also been penalised
for mis-selling of payment protection insurance to
their lending/ credit card customers.
3.51 The limits on commission structure and the
operating expenses of insurance companies are laid
down in the Insurance Act, 1938 and the Rules framed
there under. The compliance with these limits is being
monitored by IRDA on an annual basis, and instances
of breach are dealt with through penal action. In
recent past, there have been instances of both
insurance companies as also the corporate agents
(banks) being penalised.
3.52 Banks have been advised to disclose to the
customers, details of all the commissions / other fees
(in any form) received, if any, from the various
companies for marketing / referring their products,
even in cases where the bank is marketing/ distributing/
referring products of only one company. As a further step in enhancing transparency, banks have also been
advised to disclose details of fees / remuneration
received in respect of the bancassurance business
undertaken by them in the ‘Notes to Accounts’, from
the year ending March 31, 2010. Similar disclosures
and codes of conduct for insurance companies have
been prescribed by IRDA also. The IRDA is working
with the RBI to ensure that the disclosure made by
the banks acting as corporate agents, in the Notes to
Accounts are enhanced to bring about transparency
in the nature of payments received by them.
Mis-selling in Wealth Management and Other
Related Activities
3.53 Wealth Management Services (WMS) generally
include referral services, Investment Advisory
Services (IAS) and Portfolio Management Services
(PMS). In India, banks are permitted to offer very
limited services, mainly advisory and referral services.
3.54 Grievances relating to mis-selling, whereby
products that are unsuitable for a particular customer,
either for commission-linked reasons or lack of
knowledge, clarity regarding accountability between
the product issuer and the advisor/portfolio manager,
need to be addressed by improving consumer
protection measures. The issues have been widely
debated in the inter-regulatory technical group of the
FSDC Sub Committee and a review of the extant
guidelines on wealth management services offered by
banks is being carried out. The aspects on marketing
and distribution of third party financial products by
banks also need to be factored in while issuing
comprehensive guidelines on Wealth Management
Services by banks.
3.55 The recently notified SEBI (Investment
Advisers) Regulations, 2013, contain detailed norms
for risk profiling and suitability, creation of a
Separately Identifiable Department or Division (SIDD)
for IAS, detailed disclosure to the clients including
any conflicts of interest, redressal of investor
grievances, etc. Such norms are expected to address
mis-selling risks to a certain extent.
Need for Stronger Operational Procedures
3.56 All financial sector entities need to comply with
the extant KYC, which are meant for safeguarding the
financial system against the possibility of its use for
money laundering. There is a move for simplifying the
KYC guidelines and also towards achieving a uniform
basic KYC structure for various segments of the
financial system.
3.57 In the wake of recent episodes reported in the
media, the Reserve Bank undertook investigations to
examine the practices at certain banks involving
structuring of transactions to aid tax evasion and
fraudulent transfer of funds. Some of these practices
related to sale of third party products such as insurance
and wealth management services which have been
discussed in previous sections. The main findings
point towards laxity in adherence to the Know Your
Customer / Anti Money Laundering (KYC/AML)
guidelines by banks.
3.58 The areas where banks are required to adopt
more focussed strategies to ensure adherence to KYC/
AML measures include, among other things,
monitoring large value transactions in newly opened
accounts, operational control over multiple customer
identities for the same customer, enhanced skill sets
in dealing with money laundering alerts, quicker
follow-up and escalation of suspicious transactions.
Such measures also relate to accelerated review of
risk categorisation at prescribed intervals, need for
review of alert thresholds in AML monitoring systems
in tune with changing dimensions of transactions in
various accounts. Further, the banks need to address
the concerns on tackling technological issues
involved in updating changes in customers’ details
over phone lines or through internet banking leading
to frauds, diligent adoption of single and enhanced
due diligence (SDD/EDD) measures for ascertaining and updating KYC details of customers, dealing with
issues relating to splitting of transactions with a view
to avoid anti-money laundering checks etc.
3.59 The supervisory efforts of the Reserve Bank
have been combined with ‘guidance’ in the form of
specific circulars and the broad regulatory guidelines
issued to the banks on the subject. Such guidance has
covered aspects relating to (i) IT initiatives to be taken
by banks for enabling appropriate risk based
transaction monitoring mechanism, (ii) dedicated KYC
Audits, (ii) recommending operational aspects relating
to risk profiling, (iv) fictitious offers of funds/fake
lottery rackets/phishing etc.
Technology Risks18 in the Changing Business
Environment
3.60 Alongside the rapidly increasing use of
technology in banking and finance in recent years,
the risks emanating from abuse and failure of
technology have also risen. The recent cases of cyber
frauds at some banks have highlighted the increasing
complexity, sophistication and diversity in the risks
to the security and integrity of technology based
banking and finance. Globally, the use of online and
mobile technologies is driving the proliferation of
virtual banks, virtual currencies (Box 3.4) and
provision of banking and payment services by unlicensed
entities. While leveraging on technology has
resulted in many benefits, especially, in extending
the reach of the financial services, these developments
pose challenges in the form of regulatory, legal and
operational risks.
3.61 One of the main risks related to the information
technology (IT) systems in banks relates to the
obsolescence of the technology and processes built
according to the needs of the then prevailing
regulatory-cum-business environment. Therefore, a review of suitability of the existing IT infrastructure
is required to be carried out to assess the capability
of the IT systems to handle the changing demands of
business and compliance functions in the evolving
environment.
Box 3.4: Virtual Currency Schemes
A virtual currency can be defined as a type of unregulated,
digital money, which is issued and usually controlled by
its developers, and used and accepted among the members
of a specific virtual community19. The virtual currency
schemes provide a financial incentive for virtual
community users to continue to participate and are able
to generate ‘float’ revenue for their owners. They also
provide a high level of flexibility regarding the business
model and business strategy for the virtual community.
There are different kinds of virtual currency schemes in
vogue at present. While for some kinds of virtual
currencies there is no interaction or exchangeability with
the ‘real’ currency, for others the relationship with the
real money, goods and services is more active and direct.
The ‘closed’ virtual currency schemes, which are mostly
used in online games, have no connection with the real
money. Some virtual currency schemes offer the facility
of a (mostly unidirectional) conversion rate for purchasing
the virtual currency, which can subsequently be used to
buy virtual goods and services. Under another category
of virtual currency schemes which provide for bidirectional
flows, the virtual currency acts like any other convertible currency, with two exchange rates (buy and sell). In such
schemes, the virtual currency can be used to buy not only
the virtual goods and services, but also to purchase real
goods and services. Virtual currency schemes are different
from electronic money schemes as the virtual currency
being used as the unit of account has no physical
counterpart with legal tender status.
A virtual currency scheme may also be designed to
compete with traditional currencies used for international
trade. The absence of a distinct legal framework implies
that the traditional rules under financial sector regulation
and supervision, including the institution of central
banks, are not involved in the case of virtual currency.
Also, the unregulated link between virtual currency (if
permitted), and traditional currency with a legal tender
status poses challenges as the complete control over the
differently denominated virtual currency is given to its
issuer, who governs the scheme and manages the supply
of money at will.
The regulators are studying the impact of online payment
options and virtual currencies to determine potential
risks associated with them.
Need for Review of IT Risk Management Framework
3.62 Globally, the management of IT systems is being
increasingly outsourced. There is a wide spread trend
of further sub-contracting of some of the subprocesses
by the primary outsourcer to third parties,
which exposes the clients to transfer risks. The legal
issues, pricing and service level agreement (SLA)
terms with the outsourced vendor play an important
role in case of a dispute with the outsourced vendor
who has the responsibility of completing the assigned
responsibility. With this, risks relating to security and reputation come to the fore, which need to be
dealt with carefully.
3.63 In view of the risks arising out increased use
of technology, there is a need for banks to implement
systems and processes to establish a robust technology
risk management framework. There is a need for
these institutions to put in place adequate risk
mitigation techniques and security controls to ensure
business continuity. Further, banks and regulators
have to play a proactive role in increasing the
financial awareness of their customers, especially
under the IT environment. The regulators have taken
various measures to address the emerging technology
risks in their respective areas, e.g. the Reserve Bank
has issued additional guidelines20 to the banks on
securing card transactions and electronic payment
transactions.
Financial Market Infrastructure
Compliance with International Standards in
Financial Market Infrastructure
3.64 India is committed to the adoption and
implementation of the international standards and
best practices in payment systems including, the new
Committee on Payment and Settlement Systems
(CPSS)-IOSCO standards Principles of Financial
Market Infrastructures (PFMIs). The oversight
framework for CCIL is proposed to be drawn up based
the PFMIs and CCIL was assessed using the assessment
methodology of the PFMIs. As found from this
exercise, CCIL has implemented several measures to
strengthen its risk management framework which
include complete revamp of the margining system in
Securities Segment, implementation of changes to
forex forwards regulations pertaining to exit option
for members, limited liability for members and
computation of default fund etc.
3.65 The Securities and Exchange Board of India
(SEBI) has also examined the policies related to
technology risk management being followed by the
Financial Market Infrastructures (FMIs) under its
regulatory jurisdiction, viz. exchanges, clearing
corporations and depositories. It has been found that
while there were no major technology risks to the
functioning of FMIs at present, the technology
infrastructure needed to be geared to meet the newer
challenges.
Payment and Settlement Systems
3.66 The payment and settlement systems (PSS)
forming the major part of the FMI play a vital role in
ensuring financial stability. The PSS infrastructure in
India continued to perform without any major
disruptions. The broad policy direction of the Reserve
Bank, which has the legislative authority to regulate
and supervise PSS in the country, is inclined to migrating an increasing proportion of all payment
transactions, especially the large value / wholesale
transactions, to the electronic payment products.
Risks from High Frequency Trading
3.67 The previous FSRs had covered the potential
risks from high-frequency trading (HFT) in equity
markets. Even as the risks from HFT specific to the
segments of the market are being addressed, the
nature of the HFT and the associated risks are
undergoing a transformation due to innovations like
‘big data21’. The ‘new HFT’22 using analytics and
algorithms based on ‘big data’ attempt to develop
trading strategies by extracting information on
market sentiments from the enormous amount of
information available on internet including the
social media. As the use of big data is transforming
the financial markets, the regulations also need to
keep pace.
Regulation of Algorithmic Trading in Indian Equity
Markets
3.68 At present, Algorithmic trading (Algo) and HFT
account for only about 14 per cent of the cash market
turnover in the Indian exchanges as against 80 per
cent in developed markets like US and Europe. A
proper regulatory structure and continuous monitoring
of regulatory systems would avert, inter alia,
operational risks and other risks posed by Algo and
HFT. As algorithmic trading is an evolving field, SEBI
and stock exchanges are continuously studying the
practice and taking steps as deemed necessary to
minimise the associated risks and to better regulate
the same.
3.69 India is one of the few securities markets in the
world to implement a framework regulating the
practice of algorithmic trading. SEBI has issued
instructions in March 2012 which inter alia included
a list of minimum order-level checks to be performed on algorithmic orders, framework for penalising cases
of high order-to-trade ratios and framework of
conformance testing of new algorithms. Other risk
management measures that have also been mandated
include increase in the Base Minimum Capital (BMC)
of the trading members that undertake algorithmic
trading and changes to the practice of enablement of
the trading terminals of the trading members that
were disabled upon exhaustion of the collateral. In
continuum to the earlier instructions, SEBI has laid
down further guidelines by specifying that the stock
brokers / trading members that provide the facility of
algorithmic trading shall subject their algorithmic
trading system to a system audit every six months in
order to ensure that the requirements prescribed by
SEBI / stock exchanges with regard to algorithmic
trading are effectively implemented.
Need for ensuring fairness in order management
under co-location facility
3.70 SEBI is presently examining various issues, as
part of proposed measures to better regulate the
facility of co-location. SEBI’s proposals seek to provide
greater equality and fairness in order handling to the
participants that do not use co-location services visà-
vis participants that place orders using automated
trading system and are co-located at the stock
exchange.
Erroneous Trades on the Stock Exchanges – Measures
Taken
3.71 “Error Trades” are transactions that result from
system or human error in entering the order
parameters such as name of the security, volume to
be traded, price for trade, etc. Such unintended trades
usually have an adverse effect on the price formation
and impact orderly trading. While incidents of
erroneous orders are few as compared to the total
number of orders handled by the exchanges in a year,
measures implemented by the stock exchanges such
as ‘upfront real-time risk management system’, ‘scriplevel price bands’ and ‘market-wide index circuit
breakers’, are expected to limit the damage that may
result from erroneous orders. SEBI has also taken
measures to strengthen the pre-trade risk management
framework by introducing Value per order Limit,
Cumulative limit on value of unexecuted orders of a
stock broker, Dummy price bands and Risk Reduction
Mode etc.
Exposure of Settlement Guarantee Funds of Clearing
Houses to banks
3.72 In the screen-based trading environment where
counterparties to trade are anonymous, Clearing
Corporation/ Clearing House of a Stock Exchange acts
as a CCP and guarantees settlement of net obligations
arising out of trades executed on the stock exchange.
Under this arrangement, the CCP assumes the risks
of unsettled transactions on behalf of the brokers and
their ultimate clients. In order to mitigate these risks,
the CCP maintains a Settlement Guarantee Fund (SGF)
and collects margins which comprise of contributions
from brokers/clients in the form of Bank Guarantees
and securities (which may in turn be issued by banks)
amongst others. The CCP is thus exposed to the banks
both directly and indirectly and therefore CCPs are
interconnected to Banks they are exposed to. This
interconnectedness of CCPs to banks can be a
potential source of systemic contagion, in case of
failure of a bank.
Concentration of Exposure of CCPs to Banks
3.73 SEBI, in its guidelines issued in February 2005,
had specified that the stock exchanges shall lay down
exposure limits either in absolute terms or as
percentage of the Trade Guarantee Fund (TGF) / SGF
that can be exposed to a single bank directly or
indirectly. The total exposure includes guarantees
provided by the bank for itself or for others, as well
as debt or equity securities of the bank which have
been deposited by members towards total liquid
assets.
3.74 Accordingly, National Securities Clearing
Corporation Limited (NSCCL), the clearing house of
the National Stock Exchange (NSE) has specified a
maximum exposure limit of 15 per cent of SGF for a
single bank in respect of bank guarantee and bank
securities that can be accepted as collaterals. These
norms are periodically monitored for adherence to
specified limits. NSCCL accepts collaterals issued by
empanelled banks in the specified forms namely bank
guarantees and fixed deposit receipts. Currently there
are 58 empanelled banks with NSCCL for the purpose,
while Indian Clearing Corporation Limited (ICCL) of
the Bombay Stock Exchange (BSE) accepts Bank
Guarantees issued by Schedule Commercial Banks
only. SEBI also has specified that not more than 5 per
cent of the TGF/SGF or 1 per cent of the total liquid
assets (TLA) deposited with the exchange, whichever
is lower, shall be exposed to any single bank which
has a net worth of less than `5 Biliion and is not rated
P1 (or P1+) or equivalent, by a RBI recognised credit
rating agency or by a reputed foreign credit rating
agency, and not more than 50 per cent of the TGF/
SGF or 10 per cent of the total liquid assets deposited
with the exchanges, whichever is lower, shall be
exposed to all such banks put together.
Possible Concentration Risks Due to Common Set
of Banks
3.75 The exposures of SGFs of NSCCL and ICCL, to
the top five banks (Table 3.2) are adequately
diversified. As per the exposure limits specified by
NSCCL, SGF can have the highest exposure of 75 per
cent to top five banks put together. While the exposure
of the SGF of NSCCL and the exposure of the SGF of
ICCL are individually less than the upper limit, the
fact that four banks are common in the list of top five
banks, makes it even more important that the
exposures limits are monitored on an ongoing basis.
Table 3.2: Exposure of NSCCL and ICCL to top five banks (as on March 31, 2013) |
NSCCL |
ICCL |
Sl.
No. |
Bank Name |
Exposure as
a % of SGF |
Sl.
No. |
Bank Name |
Exposure as
a % of SGF |
1. |
Bank 1 |
8.09 |
1. |
Bank 1 |
7.63 |
2. |
Bank 2 |
4.85 |
2. |
Bank 2 |
6.13 |
3. |
Bank 3 |
4.65 |
3. |
Bank 3 |
3.38 |
4. |
Bank 4 |
2.92 |
4. |
Bank 4 |
1.78 |
5. |
Bank 5 |
1.85 |
5. |
Bank 5 |
1.42 |
Total Exposure to
Top 5 Banks |
22.76 |
Total Exposure to
Top 5 Banks |
20.34 |
Note: In case of BSE exposure is a % of SGF+Total Liquid Assets
Source: NSE & BSE |
|