The financial sector reform measures initiated in the aftermath of the global financial crisis are being
implemented by many countries, with the pace and extent of reforms varying across countries and markets.
The standard setting bodies have come out with final recommendations for policy reforms, and these need to
be implemented after extensive study and debate to ensure that adverse impact of unintended consequences do
not outweigh the intended benefits. In the Indian context, final guidelines with respect to Basel III have been
issued and a discussion paper on dynamic provisioning has been released. The unfinished agenda includes
convergence with International Financial Reporting Standards (IFRS), strengthening the oversight mechanism
of the non-banking financial sector, reforms in the Over the Counter (OTC) derivatives market and improving
the resolution framework for financial institutions. The payment and settlement system in the country continues
to be robust, with increasing use of electronic modes of settlement. Certain concerns, viz., settlement lags in
the RTGS System and large uncollateralised intra-day exposures to settlement banks being assumed by the
Clearing Corporation of India Limited (CCIL) need to be addressed. Safety net arrangements have functioned
smoothly, but issues relating to the adequacy and resilience of the deposit insurance fund remain.
Global regulatory reforms gathering pace, but
implementation challenges will need to be addressed
4.1 International initiatives, started after the global
financial crisis, have gathered momentum and the policy
framework for the reforms has crystalised. However,
several implementation challenges are emerging.
4.2 Several countries have announced their respective
national policy frameworks for migration to Basel III
leading to concerns about cross border consistency. Gaps
in implementation are also emerging, for instance, with
respect to putting in place resolution frameworks for
systemically important financial institutions (SIFIs) and
reforms in the OTC derivatives markets. Unintended
consequences of the reform measures might pose
challenges, especially to emerging markets such as India,
which will need to be carefully monitored. One set of
concerns relate to the potential deleveraging induced by
the new capital and liquidity standards, affecting trade
credit, infrastructure and project finance, etc. to
emerging markets. There may not be a market in
emerging economies for certain capital instruments, e.g.
contingent capital instruments, which are being proposed under Basel III. There are also concerns about
the availability of a sufficient quantum of ‘liquid’ assets
prescribed under the Basel III liquidity norms and the
impact of such requirements on domestic financial
markets.
Guidelines reflecting the new international standards
have been issued
4.3 The Reserve Bank, on May 2, 2012, issued final
guidelines on Basel III. The implementation of Basel III
capital requirements will begin on January 1, 2013. The
norms will be fully implemented by March 31, 20181.
Under the new standards, banks will have to
-
maintain total capital of at least 9 per cent,
tier 1 capital of 7 per cent and common equity
tier 1 (CET1) of 5.5 per cent of risk weighted
assets (RWAs) respectively;
-
create a capital conservation buffer in the
form of common equity at 2.5 per cent of
RWAs. The implementation of the capital
conservation buffer will start from March 31,
2015.
4.4 As a prudential measure, the existing capital
adequacy requirement in India is one per cent higher
than the minimum prescribed by the Basel Committee,
and the higher requirement will continue under Basel
III. A more stringent leverage ratio has also been
prescribed based on the fact that most Indian banks have
a relatively comfortable leverage position, much more
than the minimum of 3 per cent proposed by the Basel
Committee. During the period of parallel run, banks
should strive to maintain their existing level of leverage
ratio but, in no case the leverage ratio should fall below
4.5 per cent. A bank whose leverage ratio is below 4.5
per cent may endeavour to bring it above 4.5 per cent
as early as possible. Final leverage ratio requirements
will be prescribed by the Reserve Bank after the parallel
run, taking into account the prescriptions given by the
Basel Committee.
4.5 The implementation of Basel III proposals are
expected to be far reaching. For emerging economies like
India, the implementation comes at a time when credit
demand is expected to pick up, given the compulsions
of growth; the investment needs of infrastructure; and
the demand ushered in by increasing financial inclusion.
Simultaneously meeting the requirements of additional
capital buffers and the growing credit needs of the
economy may pose challenges. As the additional capital
requirements, both equity and non-equity, are likely to
increase over the period of full implementation of Basel
III, this could put pressure on capital markets, increase
the cost of capital and reduce return on equity, in the
short-term for the banking system. The fiscal impact of
the increased capital requirements of public sector banks
has also to be reckoned with. However, in the medium
to long term, the measures are expected to yield net
benefit to the banking system and to the economy at
large. Also, the comfortable capital adequacy position of
banks in India (CRAR at over 14 per cent and core CRAR
at over 10 per cent as on March 31, 2012) under Basel II
implies that banks will migrate to the Basel III
requirements from a position of relative strength. The
extended transitional arrangement for full
implementation of Basel III provides sufficient time to
banks to carefully assess and raise the capital required.
4.6 The case for prescribing forward looking
provisions for credit risk for Indian banks was
highlighted in the previous FSR. The Reserve Bank has
since issued draft guidelines on dynamic provisioning2.
The dynamic provision created during a year has been
quantifi ed as the difference between long run average
expected loss (EL) of the portfolio for one year and the
incremental specific provisions made during the year
(Box 4.1).
Progress in convergence with IFRS has been tardy
4.7 Challenges to the IFRS convergence of the banking
sector arise from a lack of clarity about the convergence
schedule domestically, as also from the uncertainity in
the finalisation of IFRS 9 relating to Financial
Instruments. The uncertainties with respect to IFRS 9
arise, on account of delays in finalising the proposals
relating to impairment and hedge accounting by the
International Accounting Standards Board (IASB) coupled
with recent proposals by IASB to reopen previously
finalised requirements relating to classification and
measurement of financial assets. There are also some
major technical issues arising for Indian banks in the
course of convergence. Differences between the IFRS
and current regulatory guidelines on classification and
measurement of financial assets, focus in the standard
on the business model followed by banks and the
challenges for management in this area, lack of adequate
number of skilled staff and modifications to IT systems
and processes are some of the other challenges that may
need to be tackled in due course. As discussed in
previous FSRs, a Working Group constituted by the
Reserve Bank is examining the implementation issues.
The existing resolution regime in the country may
need a revamp
4.8 The extant rules for resolution do not meet all
the requirements of the Key Attributes of Effective
Resolution Regimes for Financial Institutions adopted
by the Financial Stability Board (FSB)3. In India, there is
no explicit governance arrangement for resolution in
the form of legal and institutional structures. At present,
resolution of a bank is attempted under the Banking Regulation (BR) Act, 1949, through compulsory or
voluntary mergers. One of the fundamental objectives
of any resolution attempt is to protect the interests of
the depositors. However, in the case of compulsory
amalgamation under section 45 of the BR Act, 1949,
shareholders are not completely precluded from getting
compensation.
Box 4.1: Introduction of Dynamic Loan Loss Provisioning Framework for Banks in India
Indian banks make four types of loan loss provisions at present,
viz., (a) general provisions for standard assets; (b) specific
provisions for non performing assets (NPAs); (c) floating
provisions; and (d) provisions against the diminution in the
fair value of a restructured asset. The present provisioning
policy was found to have the following drawbacks, (i) the
rate of standard asset provisions has not been determined
based on any scientific analysis or the credit loss history of
banks; (ii) banks make floating provisions at their discretion
without any pre-determined rules and not all banks make
floating provisions; (iii) though the Reserve Bank has been
following a policy of countercyclical variation of standard
asset provisioning rates, the methodology has been largely
based on current available data and judgement, rather than
on an analysis of credit cycles and loss history, and hence the
provisioning framework does not have countercyclical or cycle
smoothening elements.
Advances in credit risk modeling over the last decade or so
have introduced the concept of expected losses (EL) and
unexpected losses (UL) to measure potential losses in a
credit portfolio. It is generally accepted that banks should
cover the unexpected losses by capital and expected losses
by provisions. The EL is generally derived as the mean
of the credit loss distribution. EL-based provisioning has
forward-looking elements as it is capable of incorporating a
through-the-cycle view of the probability of default. The Basel
Committee also supports an EL approach that captures actual
losses more transparently and is also less procyclical than the
current ‘incurred loss’ approach.
The objective of the dynamic provisioning framework is to
smoothen the impact of incurred losses on profits through
the cycle, and not to provide general provisioning cushion
for expected losses. The proposed dynamic provisioning
framework in India consists of two components, viz.,
a. Ex-post specific provisions (SP) made during a year (which
will be debited to the profit and loss account), required as
per RBI guidelines; and
b. Dynamic provisions (DP) equal to αCt – ΔSP i.e., the
difference between the long run average expected loss of
the portfolio for one year and the incremental specific
provisions made during the year (α represents EL and Ct
represents stock of loans).
It is assumed that when the approach is implemented for the
first time, the bank will have adequate SP to cover its NPAs.
Positive value of αCt - ΔSP will increase the credit balance in
DP Account. A negative value will represent a drawdown from
the DP Account. This will generally ensure that every year the
charge to profit and loss on account of specific provisions and
DP is maintained at a level of αCt.
With respect to the implementation of a dynamic provisioning
framework, not all banks can be expected to be on the same
plane. Banks with available capability can introduce a DP
framework based on the theoretical model, while the other
banks can follow the standardised method, which is outlined
in the draft guidelines. Internal estimates based on the data
obtained from a sample of banks reveal that in terms of impact
on the profit and loss of banks, the approach would mean
taking a total provisioning charge to profit and loss account
equivalent to 1.37 per cent of the gross advances annually.
Supervisory data show that during the period from 2003 to
2010, average annual charge to profit and loss on account
of standard asset provisions and specific provisions gross of
write-offs amounted to 1.04 per cent of gross advances, in the
range of 0.58 per cent to 1.87 per cent of the gross advances.
The additional charge is mainly attributed to calibration of α
based on downturn Loss Given Default (LGD).
Regulation (BR) Act, 1949, through compulsory or
voluntary mergers. One of the fundamental objectives
of any resolution attempt is to protect the interests of
the depositors. However, in the case of compulsory
amalgamation under section 45 of the BR Act, 1949,
shareholders are not completely precluded from getting
compensation.
4.9 In order to examine the gaps in the extant
resolution regime for financial institutions in India visà-
vis the ‘key attributes’ and to suggest the nature and
extent of the legislative and regulatory changes needed to address such gaps, a Working Group has been
constituted in the Reserve Bank. The Sub Committee of
the Financial Stability and Development Council (FSDC)
is also deliberating on the issue.
Differences in RWA density could be accentuated as
banks migrate to the Basel II advanced approaches
4.10 From a stability perspective, migration of banks,
particularly large banks with international presence, to
the advanced approaches under Basel II is desirable.
When the banks migrate to these approaches, trends in
RWAs will need to be monitored.
4.11 Capital ratios are key indicators of a bank’s
solvency and resilience. RWAs are key to the computation
of capital ratios of banks with the proportion of RWAs
to Total Assets (RWA density) serving as an indicator of
a bank’s riskiness. However, significant differences in
the RWA density are observed across jurisdictions (Chart
4.1). Such differences are also observed across banks in
the same jurisdiction. For the most part, the differences
in RWA density are risk-based i.e. they reflect the
differences in the riskiness of the underlying portfolio
and of the bank’s business mix. Variations also arise due
to differences in the stage of regulatory evolution – Basel
I, Basel II, rollout of the advances approaches, etc. and
use of national discretion in this regard. Concerns,
however, emerge in respect of the variations which arise
due to differences in interpretation of the standards and
lead to practice-based inconsistencies in the calibration
of risk parameters.
 4.12 In the Indian context, credit risk is by far the
largest component of RWAs representing, on an average,
71 per cent of total RWAs for the banking sector (Chart
4.2). There are, however, significant differences in the
RWA density across banks, though for the scheduled
commercial banks (SCBs) as a whole, RWA density has
been increasing over time (Charts 4.3 and 4.4).
…leading to potential diminishing trust in capital
ratios
4.13 The gradual shift from Basel I to Basel II and to
the Internal Rating Based approaches has enabled banks to benefit to some extent from lower RWAs. Perceived
differences in RWAs within and across countries have,
however, raised questions about the reliability of RWAs
and capital ratios.
4.14 The Basel Committee, as part of its comprehensive
monitoring of the implementation of Basel III, has
proposed, inter alia, to identify areas of material
inconsistencies in the calculation of RWAs. The findings
of the exercise could result in policy recommendations
to address the identified inconsistencies.
Closer monitoring of banks’ interaction with Non
Banking Financial Companies (NBFCs) and Mutual
Funds is warranted...
4.15 International efforts at strengthening the
oversight and regulation of shadow banking activities
continue. The challenge in regulating this segment is to
ensure that all significant players are brought under
regulation, while ensuring that there are no incentives
to migrate to the less stringently regulated segments.
The policy reforms are presently focusing on five key
areas, viz., (a) mitigation of the spill-over effect between
the regular banking system and the shadow banking
system; (b) reducing the susceptibility of money market
funds to ‘runs’; (c) assessing and mitigating systemic
risks posed by other shadow banking entities; (d)
assessing and aligning the incentives associated with
securitisation; and (e) dampening risks and pro-cyclical
incentives associated with secured financing contracts
such as repos, and securities lending that may exacerbate
funding strains in times of ‘runs’4.
... given the interconnectedness between different
segments of the financial system
4.16 The non banking financial sector in the country
comprising, inter alia, NBFCs, mutual funds and
insurance companies, functions within a regulatory
framework appropriate to the activities undertaken by
these entities. Nonetheless, a complete macro mapping
of all kinds of credit intermediation activities would be
warranted in the light of international reforms in this
area. Further, there are concerns posed by the degree of
interconnectedness of these entities with the banking system which could pose credit and liquidity risks
(Chapter V).
4.17 Some concerns are also posed by the degree of
reliance of the mutual funds sector, especially the Money
Market Mutual Funds, on institutional investors. In
times of stress, withdrawal of funds by such investors
could pose severe liquidity strains, as was observed in
2008-2009.
Regulatory gaps being identified and plugged…
4.18 Gaps in the regulation of the non banking
financial sector are being continuously identified and
plugged and the oversight mechanism strengthened.
The need for a regulatory framework for Alternative
Investment (AI) Funds, which had been flagged in
previous FSRs, was discussed by FSDC Sub Committee,
and the Securities and Exchange Board of India (SEBI)
has since put in place a framework for the same. In
cognition of the risks posed to the banking system on
account of their exposure to NBFCs extending gold loans,
exposure limits of banks to NBFCs have been tightened
while loan to value (LTV) ratios have been prescribed on
gold loans extended by NBFCs. Similar LTV ratios have
not been prescribed for the banking system and this
may necessitate a relook, going forward.
Global initiatives for systemically important insurance
companies may not affect Indian companies…
4.19 The International Association of Insurance
Supervisors (IAIS), in conjunction with FSB, is in the
process of developing a methodology to assess the
systemic importance of insurers. The methodology will
take congisance of the nature of insurance activities and
the risks posed to the stability of the financial system.
It is likely to include a range of parameters including
nature of operations of the entity, its size,
interconnectedness and substitutability, and its global
activity. The IAIS is in the process of collating and
analysing data in this regard. The Life Insurance
Corporation of India participated in the first phase of
this exercise. However, only some of the indicators being
considered by the IAIS may be relevant in the Indian
context given the nature of insurance operations in India
and the extant regulatory framework. Further, the level of global operations of Indian companies is limited and
their exposure to complex financial products almost
non-existent.
Potential mis-selling under the Bancassurance model
will need to be addressed
4.20 Bancassurance refers to the insurance distribution
model where insurance products are sold through the
bank branch network. The model has acquired popularity
in the Indian context as many large banking groups in
the country are also promoters of insurance companies.
Further, the geographical reach of banks has made them
ideal vehicles for the distribution of insurance products.
Instances of mis-selling of insurance products through
this delivery channel have been evidenced, though there
are extant regulatory requirements mandating that bank
staff handling the sale of insurance products be
adequately trained. There is also some anecdotal
evidence of insurance products being sold as a ‘package’
along with banking products such as deposits and loans,
raising issues of conflict of interest. The proposed regulations on Investment Advisors by SEBI and on
Bancassurance by the Insurance Regulatory and
Development Authority (IRDA) are likely to address the
issue. Concerted efforts to educate customers in this
regard will also be necessary.
Financial Market Infrastructure (FMI)
The country’s FMI functioned smoothly despite
heightened market volatility
4.21 The payment and settlement systems in the
country remained robust and continued to function
without any major disruption. The FMI displayed a
significant degree of resilience, with central
counterparties in different segments managing the
impact of heightened volatility in various markets,
including the foreign exchange markets (Box 4.2).
Liberalisation of access criteria provided a fillip to
electronic payment systems
4.22 The shift towards electronic modes of settlement
continued, with the value of transactions settled through the Real Time Gross Settlement (RTGS) system
accounting for over 74 per cent of total settlement values
as at end March 2012. Volume wise, the share of retail
electronic transactions grew from 37 per cent in March
2011 to about 45 per cent in March 2012.
Box 4.2: Increased volatility in the foreign exchange market and CCIL’s US$/INR settlement
The year 2011-12, and especially the period under review,
witnessed heightened volatility (Chapter 2). The increased
volatility and the sharp depreciation in the value of the
Indian rupee resulted in significant changes in the marked
to market (MTM) margin liability of the members of CCIL’s
forex segment, with the impact depending on the net currency
positions of the participants.
Managing the risks necessitated increase in initial margins
and, in also in some instances of increase in variation
margins. On a few occasions, heightened intraday volatility
resulted in the margin cover being reduced by more than 50 per cent warranting the collection of intraday MTM margins
(Table 4.1 and Chart 4.5).
Table 4.1: Details of Imposition of Volatility Margin during 2011-12 |
Date |
Forex Forward
Segment (%) |
Forex Settlement
segment (%) |
22-Sep-11 to 26-Sep-11 |
37.5 |
0.25 |
28-Oct-11 to 31-Oct-11 |
5.0 |
- |
09-Nov-11 to 11-Nov-11 |
2.5 |
- |
01-Dec-11 to 02-Dec-11 |
5.0 |
- |
16-Dec-11 to 19-Dec-11 |
27.5 |
0.25 |
27-Jan-12 to 30-Jan-12 |
2.5 |
- |
4.23 The migration of payment transactions to RTGS
and National Electronic Fund Transfer (NEFT) settlement
modes is likely to gain impetus from the liberalisation
of access criteria to electronic payment systems5. So far,
the centralised electronic payment systems provided for
only direct membership. The sub-membership route has
been enabled for all licensed banks to participate in
NEFT and RTGS systems. Such sub-membership would
be an alternate mechanism to licensed banks which have
the technological capabilities but are not participating
in centralised payment systems on account of access
criteria or cost considerations.
Risks minimised in RTGS… but efficacy of intraday
liquidity management varies across participants
4.24 RTGS systems permit transactions to be settled
deal by deal and in real time, thus attempting to
eliminate systemic and settlement risks. Specifically,
RTGS can substantially contribute to the reduction in
the duration of credit and liquidity exposures in
payment and settlement systems. In the Indian context,
an empirical analysis of the settlement lags in the RTGS6 reveals that 70 per cent of average daily transactions
(constituting 65 per cent of the average daily settlement
amount) are settled instantaneously (Chart 4.6). This is
facilitated by proactive intraday liquidity management
by banks7, provision of intraday liquidity by the central
bank and the ‘double duty’ performed by prudential
reserve balances maintained by banks. Nevertheless,
nearly 25 per cent of transactions (by amount) are settled
with a lag of more than one minute while 15 per cent
are settled with a lag of more than 10 minutes. There
are also large variations observed with respect to
settlement lags amongst different participants of the
RTGS system. The underlying trends, especially with
regard to the outliers will need to be carefully monitored
(Charts 4.7 and 4.8).
Designated settlement banks (DSBs) of CCIL act as
quasi payment systems….
4.25 Quasi-payment systems are generally defined as
“Commercial institutions responsible for clearing and
settling payments on behalf of customers which
represent, by value, a substantial percentage of payments
…. being settled across the books of the institution
rather than through an organised payment system”.8 Risks posed by such institutions are similar to those
posed by systemically important payment systems.
4.26 The risks arising from the concentration of
associate members in the Collateralised Borrowing and
Lending Obligation (CBLO) and securities segments of
CCIL in two DSBs were highlighted in the FSR of
December 2011. The risks are exacerbated by the fact
that the DSBs themselves are large participants (with
proprietary positions) in most market segments. An
analysis of the settlement volumes indicates that
associate members account for a significant proportion
of the settlement volumes (Chart 4.9). The DSBs, thus,
act as quasi payment settlement systems and the risks
they pose to the overall system will need to be monitored.
….necessitating CCIL to assume large intraday
exposures to the DSBs
4.27 The large settlement values of the associate
members result in CCIL assuming significant intraday
exposures to the DSBs (on account of the pay-in made
by the associate members to the DSB) (Chart 4.10). CCIL
has sanctioned limits for each of the DSBs, which are
uncollateralised. There are also instances of exposure
to the DSBs being in excess of the limits. Failure of one
or more DSBs could pose systemic concerns and the
trends in this regard need to be assessed vis-à-vis CCIL’s
financial resources, its liquidity and credit risk
management framework and extant regulatory
prescriptions on the capital adequacy norms for banks’
exposures to central counterparties (CCPs)9. The Basel
Committee is also working on the issues related to the
appropriate capitalisation of banks’ exposure to CCPs.
At present, exposures to CCPs under Basel II attract zero
exposure value.
 4.28 Available evidence suggests that the DSBs, in turn,
extend intraday liquidity to the associate members
including equity market players. If the associated risks
are not rigorously managed by the DSBs, they could
further exacerbate the risks faced by the CCP. Going
forward, however, the Basel III liquidity risk framework,
which incorporates effective management of intraday
liquidity, may alleviate these risks.
OTC Derivative markets
Delays in implementing OTC derivative market
reforms observed internationally
4.29 Several issues and challenges facing the OTC
markets in India, viz., skewed participation structure,
need for greater standardisation, introduction of central
clearing, etc., were highlighted in previous FSRs. Even
as these issues remain relevant, challenges are posed by
the international reforms agenda for OTC derivatives
viz., “all standardised OTC derivative contracts be traded
on exchanges or electronic trading platforms, where
appropriate, and cleared through central counterparties
by end-2012”. The FSB has observed delays in both rule
making and implementation of the reform process across
G20 jurisdictions. Certain exceptions for some derivative
products, e.g. foreign exchange forwards, are, however,
under consideration.
4.30 In the case of India, the market for OTC derivatives
has developed in a calibrated manner along with, in
most cases, a concomitant regulatory framework. CCP
arrangements already exist in the country for foreign
exchange forward contracts involving the domestic
currency. Similar arrangements are being contemplated
for other products. However, markets such as that for
Credit Defaults Swaps are in a nascent stage and extant
volumes do not warrant centralised settlements. The
existing reporting arrangements for OTC derivatives
encompass foreign exchange, interest rate, government
securities, corporate bonds and money market
instruments and are being strengthened, as was
discussed in previous FSRs. Going forward, the key priority for Indian markets would be greater
standardisation of OTC products, introduction of central
clearing arrangements for a greater number of such
products and reporting of all OTC trades to the trade
repository.
Volumes in the Interest Rate Swap (IRS) market in
India could warrant centralised settlement….
4.31 Low volumes in some derivative markets make it
challenging to introduce guaranteed clearing for such
products. A recent Bank of England report10, which
attempts to construct a definition for “central clearing
eligibility” of a product, observed that liquidity is a key
determinant in a central counterparty’s decision to clear
a product and that the systemic risk reduction benefits
of central clearing can be achieved only when contracts
meet this eligibility criteria.
4.32 In the Indian context, IRS, launched in 1999, is
the only OTC derivative product where the market
volumes have grown substantially. The growth has been
particularly marked in the case of the overnight index
swap based on the overnight money market index (Chart
4.11). The participation structure in the market,
however, remains skewed with foreign banks dominating
the IRS market11.
…but will necessitate robust risk management by the
CCP and potentially onerous margin requirements
4.33 Central clearing of IRS trades will shift the primary
responsibility of managing counterparty risks to the CCP.
It is, thus, critical that the CCP has adequate financial
resources and exercises effective risk control. The CCP
will need to, inter alia, design margin and other risk
management requirements which account for the
complexity of the underlying instruments and maintain
sufficient liquid resources to ensure settlement under
a wide range of potential stress scenarios. Further, the
overall cost to participants of central clearing of
derivative transactions will need to be assessed as
margin requirements could be very high for some banks
during volatile times. As all positions will need to be
collateralised, shifting IRS transactions to a CCP could
entail large collateral requirements.
4.34 The concentration risks arising from the gamut
of activities carried out by CCIL have been flagged in
previous FSRs. Additionally, entrusting the responsibility
of centralised clearing of IRS trades or any other OTC
derivative trades to CCIL could add to these risks and
will have to be contingent on a thorough assessment of
its ability and financial resources, including liquidity
resources, to handle extreme market situations.
Bilateral margins for OTC derivatives may have
systemic implications
4.35 Migration of all OTC derivative contracts to central
clearing will be challenging and may also not be desirable
as OTC products can perform a valuable function of
offering customised contracts to suit individual hedging
requirements. These contracts, however, will continue
to engender counterparty and systemic risks. Bilateral
margins on non-centrally cleared products are, thus,
being contemplated internationally to reduce the
systemic risks arising from such products and for
creating incentives for centralised clearing. Such margins
may need to be considered in the Indian context also,
after weighing the advantages against the systemic
implications of the increased collateral requirements.
The potential benefits of margin requirements could be
partially offset by the impact arising from the need to provide high-quality, liquid collateral, especially at a time
when the Basel III liquidity requirements will create
additional demand for similar securities. IMF’s recent
Global Financial Stability Report (April 2012) has also
highlighted that “heightened uncertainty, regulatory
reforms and the extraordinary post-crisis responses of
central banks in the advanced economies have been
driving up demand for safe assets… even as the supply
of such assets has contracted,… with negative
implications for global financial stability”.
New and demanding international standards issued
for FMIs……
4.36 New international standards for payment, clearing
and settlement systems were issued in April 2012 by
the Committee on Payment and Settlement Systems
(CPSS) and the Technical Committee of the International
Organization of Securities Commissions (IOSCO)13. The
new standards (called “principles”) will be applicable to
all systemically important payment systems, central
securities depositories, securities settlement systems,
central counterparties and trade repositories (collectively
“financial market infrastructures” or “FMIs”). The set of
24 principles is designed to ensure that the essential
infrastructure supporting global financial markets is
robust and better placed to withstand financial shocks.
They encompass issues related to the legal basis and the
governance framework of the FMI, its credit, liquidity
and operational risk management framework, settlement
systems, default management, access criteria and the
efficiency and transparency of FMI’s.
…necessitating assessment of compliance of domestic
FMIs with the Principles
4.37 Compared with the current standards, the new
principles pose more stringent requirements in
important areas like financial resources and risk
management procedures of an FMI, default handing and
the mitigation of business and operational risk. In the
Indian context, previous formal assessments observed
the country’s FMIs to be broadly compliant with the
then prevalent international standards e.g. the Core
Principles for Systemically Important Payment Systems,
Recommendations for Securities Settlement Systems and Risk Management Principles for Central
Counterparties. Going forward, the degree to which
domestic FMIs observe the new principles will need to
be evaluated.
Legal amendments will be necessary to ensure orderly
handling of a FMI default
4.38 Given the criticality of the functioning of FMIs,
the risks which FMIs can pose to financial stability in
the event of a default, warrants that an effective
resolution mechanism be put in place to ensure orderly
winding up of such entities. The FSB’s Key Attributes of
Effective Resolution Regimes for financial institutions14 are also applicable for FMIs.
4.39 In the Indian context, currently, there is no
provision in the RBI Act, 1934, or the Payment and
Settlement System (PSS) Act, 2007, which enable the
recapitalisation, orderly winding up or reorganisation
of FMIs regulated by the Reserve Bank. In the absence
of a specific legal mandate, the insolvency proceedings
as laid down under the general law would be applicable.
Compliance with the Key Attributes would necessitate
that the Reserve Bank is conferred with adequate powers
for effective resolution of the FMIs regulated by it, such
as CCPs and payment systems through appropriate
amendments to the PSS Act.
Safety net arrangements
The Coverage and Reserve Ratio of the deposit
insurance fund remains low…
4.40 In India, deposit insurance is mandatory for all
banks. Deposit insurance is provided by the Deposit
Insurance and Credit Guarantee Corporation (DICGC), a
wholly owned subsidiary of the Reserve Bank of India
(Chart 4.12).15 The coverage levels of the deposit
insurance in India, both in terms of absolute amount
and as a percentage of per capita GDP, remain low as
compared to international standards (Chart 4.13). The
Reserve Ratio (ratio of fund balance to insured deposits), which stood at 1.4 per cent as at end March 2012, is also
low as compared to peer emerging market economies,
though a target reserve ratio has not been prescribed for
India (Chart 4.14).
…. Necessitating exploring options to strengthen
DICGC’s fund base
4.41 Bank failures in the Indian context have typically
taken place in the case of banks in the co-operative
sector. DICGC’s fund, as per current coverage levels, may
not be adequate in the event of a large bank failing.
Several options, for instance, income and service tax
exemption for the Corporation, hiking the premium
charged, provision for emergency liquidity support, etc.
may need to be explored with a view to strengthening
the fund.
FSB Peer review of deposit insurance systems throw
up several lessons for DICGC
4.42 The FSB recently undertook a peer review of
deposit insurance systems16 among its member
institutions based on the Basel Committee on Banking
Supervision – International Association of Deposit
Insurers (BCBS-IADI) Core Principle for Effective Deposit
Insurance Systems. Several recommendations of the
peer review report are particularly relevant for India and
will need to be carefully examined. These include:
i. review of coverage levels to ensure that it strikes
an appropriate balance between depositor
protection and market discipline;
ii. prompt depositor reimbursement in situations
when payout is the only choice to deal with a bank failure; this needs to be supported by
comprehensive and prompt access to bank data,
early information access via a single customer
view, and robust information technology
infrastructure;
iii. strengthening the degree of coordination between
the deposit insurance agency and other safety net
players to ensure effective resolution planning
and prompt depositor payment; and
iv. unambiguous and immediate access to reliable
funding sources (including any back-up funding
options) to meet the financing requirements.
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