Financial stability - a cautionary tale

Although RBI's reading has been correct, it went along with the pro-stock market sentiment last October when it permitted banks to invest more in markets.

By C. R. L. Narasimhan

What makes for financial stability, a key goal of public policy? The Reserve Bank of India report on Currency and Finance (January 20) discusses the issue with clarity - and in the light of what has happened since - with prescience. The stock market turmoil has spilled over into other sectors - banking, commodities to name the two that have been immediately affected. Is it possible to understand what is wrong instead of getting worked up over the outward manifestations of the deep-seated inadequacies? First, look at what the RBI has to say.

The need for stability has come into sharp focus after the currency and financial crises in the 1990s in Mexico and large parts of East and Southeast Asia. A financial system can become fragile and have its weaknesses exposed because of many reasons: weak fundamentals, institutional failures resulting in panic, distorted information flows resulting in asymmetries. It has been the experience of some countries that more than one of these factors have worked in tandem causing a grave crisis. Over the short-term, therefore, it became difficult to say which was the dominant cause. Hence corrective action had to broad-based. Most countries now act proactively to promote stability.

Excesses can cause havoc

Volatility in the financial system is acceptable but excess volatility can destabilise. At the macro level, for instance, it can impact negatively on wealth, bank lending and balance sheets. The wealth effect is obvious: asset holders who gain or lose depending on the volatility alter their consumption - savings patterns. Bank lending is affected by volatility - for example, through increased quantum of loans (in an expansionary phase). Since banks finance a number of borrowers there could be a drastic change in investment and consumption spending. Again, when share prices are rising, banks will have greater collateral for their loans, leading to higher investment spending and aggregate demand. If the transmission system is not effective, there would be uncertainty not only in the asset markets but across the entire financial system. Hence, for a country like India, it is essential to pursue the twin objectives of ensuring price stability as well as financial stability.

For safeguarding financial stability, three inter-related strategies are being pursued: improving the linkages across institutions and markets, promoting the soundness of institutions through prudential regulation and supervision and also ensuring macro economic balance. For ensuring the soundness of banks, the most significant measure has been the introduction of prudential norms relating to income recognition, asset classification and the prescription of capital adequacy norms based on the risk- weighted assets ratio (CRAR). In order to strengthen banking supervision the Board for Financial Supervision (BFS) under the aegis of the RBI was constituted in November 1994 to exercise integrated supervision over all credit institutions.

Short-sighted moves

No discussion on financial stability can ignore measures taken with respect to the stock markets. In the monetary and credit policy statement of October 2000, the RBI issued fresh guidelines on bank financing of equities and investments in shares. Bank boards are required to lay down a prudential ceiling on banks' aggregate exposure to the capital market keeping in view their risk profile.

Second, total exposure to the capital market by way of shares, convertible debentures and units of mutual funds (other than pure debt funds) should not exceed 5 per cent of a bank's total domestic credit as on March 31 of the previous year.

Third, banks may grant advances for subscribing to initial public offerings only to individuals subject to a maximum of Rs. 10 lakhs and such finance extended by banks for IPOs should be reckoned as exposure to the capital market. Fourth, a minimum margin of 25 per cent inclusive of cash margin should be obtained by banks for issue of guarantees on behalf of share brokers.

Finally, banks should also mark to market their investment portfolio in equities like other investments on a quarterly basis and should also disclose their total investments in their annual accounts from the current financial year.(Caution, however, is the buzzword now. The RBI has realised that its stance of October 2000 needs to be modified).

While the RBI has discussed in detail the other ingredients for financial stability and the measures taken so far, it is worth noting that the two topical aspects have to do with volatility not just in an abstract sense but volatility arising from the stock markets. Quite remarkably, the RBI's theoretical dissertation can be actually tested so soon against chaotic conditions of the stock exchanges. While the SEBI is the capital market regulator, the RBI - as shown above - has a crucial stake in reinforcing financial stability.

What are the messages? Excess volatility in stocks has been destabilising: on March 1, the day after the budget stock prices were sharply lower. In the process this stopped the budget's ``feel-good factor'' in its tracks. From then on it has been one continuous and riveting attention on the negative side of the markets and the shenanigans allegedly perpetuated. The role of the SEBI, the capital market regulator, has come in for close scrutiny.

All the investor protection measures to safeguard against systemic failures were stretched to a point where - participating in respect of Kolkata exchange - big worrisome questions were raised. If at all one segment of the financial sector can cause widespread instability and wreck the macro economic balance it is the capital market. All regulatory measures, announced since the sacking of broker directors, drawing up a code for the stock exchange officials and so on, are fire-fighting measures unlikely to bring about stability.

The banking sector has been sucked into the volatility caused crisis. Bank funds far in excess of prudential limits have fuelled the artificial boom. And on the market's downside a few banks are stuck with huge exposures. The public sector Bank of India has been hit by Rs. 137 crores of pay orders of a co- operative bank. One private bank - the Global Trust Bank - apparently has had a close nexus with the big bull Mr. Ketan Parekh. Both parties appear to have benefited. The role of a few other banks is also being investigated. But there will be no tangible gain to the financial system unless the findings of collusion lead policy to change its stance on the stock market. Anyway, a JPC is already engaged in finding out what went wrong and will hopefully suggest remedial measures that can have long lasting effects.

More serious than instances of private banks developing an unholy nexus with brokers, the very basis of the recent RBI guidelines (mentioned above) on bank lending to the stock market ought to be questioned.

The nexus would not have been possible but for the recent relaxation. Until the stock market mechanism is better understood by policy and therefore better regulated, it is dangerous to drag other, more efficiently regulated sectors such as banking into it. The RBI has been right on target in anticipating a stock market-led crisis. Although it has gone back on its October 2000 relaxation permitting larger bank investments in the stock market, it is intriguing as to why it succumbed to pressures in the first place.

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