Following the IMF-FSB-BIS definition, the FSLRC defines systemic risk as “[a] risk of disruption to financial services that is caused by an impairment of all or parts of the financial system and has the potential to have serious negative consequences for the real economy.” The Commission envisages systemic risk oversight as the fourth pillar of financial regulation, along with consumer protection, micro-prudential regulation and resolution.
However, unlike the other pillars, systemic risk oversight presents two unique challenges. First, mitigation of systemic risk requires a comprehensive system-wide perspective of the consequences of failure of an individual entity. Second, responses to systemic risk events often require inter-regulatory coordination that combines diverse perspectives. The Commission thus believes that monitoring and addressing of systemic risk must not lie with any specific sector regulator but with the Financial Stability and Development Council (FSDC).
Institutional architecture
The FSDC is envisaged as a council of regulatory agencies which will allow it to utilise the expertise of all regulatory agencies. The FSDC board will be headed by the Minister of Finance, Central Government. Other members of the board will be the head of the regulator for banking and payments, the head of the regulator for other financial sectors, the chief executive of the resolution corporation, the chief executive of the FSDC and an administrative law member. It will be served by an executive committee chaired by the regulator for banking and payments, which will have managerial and administrative control.
Systemic Risk Regulation process
Systemic Risk regulation is envisioned as a five-element process:
- Data, Research and Analysis: The first step in the process is to gather information from all sectors of the financial system. For this purpose, the FSLRC recommends the creation of a system-wide, unified database which will be operated by the Financial Data Management Centre (FDMC). The FDMC will be housed within the FSDC and will collect data from all regulated entities and other financial firms. Using the data so collected, the FSDC will conduct a research programme that will identify the interconnectedness and systemic risk concerns in the financial system, provide quick response to systemic risk events and develop systemic risk indicators among other research objectives.
- Identification of Systemically Important Financial Institutions (SIFIs): The FSDC will formulate the methodology to identify SIFIs, which will then be applied to FMDC’s database to designate systemically important firms and conglomerates. Such institutions will face a higher level of regulation and supervision and will be monitored carefully by the FSDC.
- Formulation and implementation of system-wide measures: The Commission recommends the creation of a counter-cyclical capital buffer, which can be applied to large parts of or the entire financial system. As systemic risk builds up, the FSDC can increase the capital requirements. Such a decision will require all the regulatory agencies to formulate regulations and translate them into action. As research in the nascent field of systemic risk develops, the Commission recommends that new measures of systemic risk be included in the Indian Financial Code (IFC) through appropriate amendments in Parliament.
- Inter-regulatory agency co-ordination: The Commission believes that the FSDC will strive to improve inter-regulatory agency co-ordination by implementing measures such as establishment of joint-working groups, cross staffing initiatives and resolution of disputes. The board of FSDC will be empowered to create its own dispute resolution process to solve disputes between FSDC members and other regulatory agencies. The FSDC is also expected to reduce regulatory uncertainty by promoting consistency in principles and practices adopted by regulators in the areas of rule-making and enforcement.
- Crisis Management: This element of systemic risk oversight will be spearheaded by the Ministry of Finance, Central Government. During a systemic risk event, the FSDC is expected to assist the Ministry of Finance in efficient crisis management by providing research that seeks to understand and resolve the crisis, implementing system wide measures such as the counter-cyclical buffer and assisting regulators in their efforts to solve the crisis. Ministry of Finance will need to consult the FSDC before making decisions regarding financial assistance or other extraordinary assistance to financial service providers. The actions of the FSDC will be subject to a post-crisis audit to ensure accountability.
The recommendations of the FSLRC are keeping in line with international experience. For example, US has established the Financial Stability Oversight Committee and the European Union (EU) has established the European Systemic Risk Board for systemic risk oversight. The creation of an independent statutory body to tackle systemic risk events will improve our capacity and readiness to deal with financial crises like the 2008 financial crisis.
Note: Given our focus on Systemic Risk in this post, do also read Ajay Shah’s blog post on “Dr. Subbarao’s comments about FSLRC’s treatment of systemic risk“.
One Response
The FSLRC assumes that systemic risks arise from within. But significant risks arise outside such as the volatilities in currencies, flight of capital, asset bubbles, inflation and economic stagnation. Financial institutions thrive on a stable and growing economy – regulation can do little if any with the risk factors outside the financial system. FSDC should have the ability to influence fiscal, trade and general economic policy so that other risk factors are also dealt with to whatever extent feasible.
The idea that enough capital will contain any risk – whether cyclical or counter cyclical – is laughable. Eventually we might come to a conclusion that capital funds should be 100% or more of the risk exposures of a bank.
Early warning systems that inform of abnormal developments in the external risk environment are necessary. FSDC should build indicators that enable it to assess such risks and deal with the same. Executive remuneration in financial institutions should be tracked and profit based incentives that induce high risk behaviour should be curbed.