October 2018
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Financial Stability – Are We Barking at All Right Trees?

By R. Gandhi, Deputy Governor , RBI

The global financial crisis had brought in paradigm shifts in many areas viz., regulation, governance and mind-set, amongst others…all in pursuance of a sustainable financial system and a system that should be sub-serving the real sector rather than self-serving. I am not sure whether we are done with the post crisis learning curve or are still somewhere on it.

The second issue that comes to my mind is the need to bring a perspective to the concept of stability – stability which is dynamic and not static. One may wonder if ‘dynamic stability’ is an oxymoron, but a peep into the heavens would tell us that it is not, as our own solar system and the planets are in a state of dynamic stability. On the other hand, the reason why I bring the concept of dynamic stability into the discussion is that we should not tend to view financial stability as an issue of importance only in post crisis periods; instead it should be imbibed as a discipline by itself. Besides, we can’t ignore Minsky’s famous words of wisdom – “stability creates its own instability”. The best evidence for this comes from the days of great moderation, during which period, growth and inflation in the developed world became less volatile, interest rates were low resulting in search for yield and development of structured financial products starting with securitisation – without concern for financial stability; at least it appears so in hindsight.

Regulation vs innovation

The global financial crisis also brought into the fore the conflicts between regulation and innovation. The reason why we, the regulators, faced the flak for the crisis was that we were perceived to be too inadequate to understand and address the excesses committed by an industry in the name of innovation. While it is necessary to align the policy environment and innovation strategies with the available regulatory capacity, the latter needs to be upgraded to match the natural course of economic development. Sometimes necessary innovations won’t even take off due to the policy making process getting influenced by paradoxes of innovative endeavours such as “success failure paradox” and/or “feedback rigidity paradox”. Financial market innovations commensurate with the economic development and the needs of the real sector, if ignored, can push crucial markets outside the system and hence away from the reach of domestic regulations. Innovation also will not take off in the absence of a supportive culture, understanding and adequate resources to carry it forward. While regulation can provide an enabling environment, it is for the market participants to exploit the opportunities provided, but they have to play the game as per the rules.

Bank Capital Regulations – The efficiency-redundancy paradigm

Let me now turn to some specifics. Being a banking regulator and also given the fact that our financial system is a bank dominated one, my focus will be largely on the banking sector, barring some generalisations panning the entire financial system. The evolving bank capital regulations have been more guided by the fact that financial institutions in the developed world ventured into risky innovations with the help of excessive leverage and an ex-ante insufficient capital. The process of re-regulation went through the global standards setting mechanisms, primarily under the Basel Committee and Financial Stability Board. The result is that we got into an ‘efficiency-redundancy trade-off’ debate which is all the more relevant to jurisdictions that are much less complex and are wanting financial inclusion and deepening. While it is important for the Emerging Markets and Developing Economies (EMDEs) to learn from the mistakes of others, we probably need much simpler regulatory approaches given our not so complex financial systems and also in view of the need to expand and extend the coverage and reach of financial services, given our much underpenetrated financial services industry.

(Courtesy: rbi.org.in)