Need for Regulation

Rationale for Regulation of Banking Sector Social objectives Confidence building need for banking sector Protect existing/probable customers from –Ignorance (information) –Market power

Asymmetric Information Banks reduce certain asymmetric information present in the financial market –Introduces other difficulties into the market such as risk Regulation addresses causes of asymmetric information –Balances market risk such as interest rate risk, foreign exchange rate risk, etc.

Deposit Insurance Regulation reduces the risk of banks from not meeting deposit obligations of customers Reduces the bank’s reputation risk Prevents depositors from withdrawing funds if not needed Cost of depository insurance is mandatory for the banks

Problems to Banks Deposit insurance gives less incentive to the banks to be careful in fund utilization Depositors do not select banks based on their ability but based on the insurance that is uniformly provided by all banks Banks do not address the risk faced by utilization of depositor’s funds Depositors do not monitor banks Does not prevent banks from identifying customers who may not be valuable to the bank

Regulatory Support Provide financial support to banks when they incur a large loss Provide assistance to support the bank in maintaining its reputation Help vulnerable banks in maintaining its functions Regulatory supervision reducing risk taking activity of banks

Bank Supervision Limited ownership Supervisory control –Asset risk –Loan monitoring –Capital adequacy –Management risk Disclosure –Financial statements

Bank Supervision Consumer protection –Terms of credit –Free disclosure –Discrimination Competition –Restricted entry for new players Health of banks –Monitoring bank’s costs –Increasing efficiency

Scope for Regulation Decline in profitability of banks Increase in interest rate in the economy Increase in innovative bank products Changes in borrowing practices of banks (using short term resources for lending on long term projects)

Failure of Regulations The concept of “big banks cannot fail” Encourage inefficiency present in the banking system Failure to control risky operations of banks Inability to control inflation

Regulatory Interventions Capital Adequacy Asset Quality Management Quality –Ability of the bank to face changing environment Comparison of earnings of banks in terms of industry returns Protect the liquidity position of the bank

Financial Crisis of Banks Significant causes –Sub-prime lending –Initiate banking products and distribute model –Financial engineering such as derivatives –Role of credit rating agencies –Slack regulation –Large global imbalances Fundamental cause –Obligatory monetary policy

Impact of Financial Crisis of Banks in India Changing trends in capital flows Impact on industrial production Impact on services Impact on exports and imports Impact on stock market Impact on foreign exchange

Differentiating Global Financial Crisis and Indian Financial Position No subprime lending No exotic derivative instruments No bank losses threatening capital No credit crunch for the banks No mistrust between banks

Reserve Bank of India Policy Expanding Rupee liquidity –Changes in Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) –Special repo window under Liquidity Adjustment Facility (LAF) for banks –Special refinance to banks without collateral –Pre announced open market operations Change in repo and reverse repo rates

Reserve Bank of India Policy Managing foreign exchange liquidity –Interest rate ceiling on Non Resident External (NRE) and Foreign Currency Non Resident (FCNR(B)) deposits –External Commercial Borrowings (ECB) norms relaxed –Allowing corporate firms to buy back Foreign Currency Convertible Bonds (FCCBs) –Rupee-Dollar swap facility for banks with overseas branches

Reserve Bank of India Policy Encouraging flow of credit –Exporters Extension of period for export credit Expansion in refinance –Dynamic provisioning Contra cyclical adjustment of prudential norms –Loan restructuring

Regulatory Cycle