Saturday, June 15, 2013

A helicopter tour of systemic risk regulation in the draft Indian Financial Code

The field of financial regulation has traditionally focused on consumer protection, microprudential regulation and resolution. However, the 2008 financial crisis highlighted systemic risk as another important dimension of financial regulatory governance. Subsequently, governments and lawmakers worldwide have pursued regulatory strategies to avoid systemic crises and provide for systemic oversight.

At present, Indian law is silent on the subject of systemic risk. RBI often implies that it has been doing work on `financial stability', however at present, there is no legal mandate, no powers, and no actions.

To some extent, systemic crises are the manifestation of failures in the core tasks of financial regulation, consumer protection, micro-prudential regulation and resolution. Proper functioning of these core tasks, as envisaged in the draft Indian Financial Code, will reduce systemic risk, but not eliminate it. There is thus a strong need for a legal strategy for systemic risk regulation. This has been done for the first time in India in the draft Indian Financial Code.

You should of course read the draft Code and the underlying report. However, in order to help you get a hang of how the FSLRC thinks about systemic risk, here is a bird's eye view which points you to the right places in the Code.

We now turn to the sections of the IFC that directly deal with systemic risk:

S. 2(36), page 3
introduces the phrase `the Council' which is used in the IFC to refer to the Financial Stability and Development Council (FSDC).
S. 2(78), page 7
defines a `financial system crisis'.
S. 2(154), page 13
defines `systemic risk'.
S. 20, page 19
sets up the FSDC as a statutory body. A careful study of the composition of the FSDC in S.21 shows that the day-to-day functions of the FSDC will be run by a Chief Executive. There will also be an administrative law member to ensure that regulatory governance norms are followed.
S.65, page 34
is an example of the inter-regulatory co-ordination function of the FSDC. Where two regulators are to take joint action under the IFC, but are unable to reach a consensus, they must work with the FSDC to figure out a solution. While inter-regulatory coordination can be an issue in many contexts (e.g. SEBI/IRDA on ULIPs), it is certainly a dimension of systemic risk where the thinking and work cut across all regulators.
S.141(1)(a)(iii), page 66
asks that when regulators such as RBI and UFA are regulating SIFIs, they should take the relevance of the systemic risk perspective into account. There is no role for FSDC in what they do here.
S.141(1)(k), page 67
asks that micro-prudential regulation should be mindful of systemic risk and particularly pro-cyclical consequences of regulation.
S.187(1)(c), page 86
asks that Infrastructure Institutions (such as exchanges, depositories etc., defined in S.183, page 85) are obliged to promote the objective of the FSDC to mitigate systemic risk, when they write bye-laws (which will be approved by the UFA and not FSDC).
S.221, page 96
sets up the Resolution Corporation at the level of the entire financial system and details its objectives.
S.224(1), page 96
asks that the officers and employees of the Resolution Corporation have knowledge and expertise in resolution of SIFIs.
S.287(2), page 121
asks the Resolution Corporation to consult with the FSDC where the Resolution Corporation is contemplating certain resolution measures against a SIFI.
S.290, page 122
defines the objectives of FSDC. The agency will pursue the objective of fostering the stability and resilience of the financial system by, (a) identifying and monitoring systemic risk, and (b) taking all required action to eliminate or mitigate systemic risk.
S.291, page 122
says that the FSDC consists of its board, an executive committee, a secretariat and a data centre. Of particular importance is the data centre, which is defined in S.294.
S.295, page 123
sets out the five main activities of the FSDC. It will study data and do research on the financial system; it will designate certain financial firms as SIFIs; it will formulate and implement system-wide measures, it will promote inter-regulatory cooperation, and it will assist the Ministry of Finance and all other agencies during a systemic crisis.
S.296, page 123
establishes principles that must guide the FSDC. These principles ensure that systemic risk regulation does not degenerate into achieving the silence of a graveyard.
S.297, page 123 and 124
sets forth the analysis and research objectives of the FSDC. Accordingly, S.298 gives the FSDC the powers to obtain relevant data.
S.299, page 124
sets up the legal process through which the FSDC will determine the criteria to designate certain financial firms as SIFIs. A financial firm can be adversely affected when it is designated as a SIFI, hence the full legal process of an order is required.
S.300, page 125
sets up the legal process through which firms would be designated as SIFIs.
S.301, page 125
asks the FSDC to issue policy frameworks and regulations for implementing system-wide measures, in the class of those defined in the Third Schedule (page 185). In the future, if other system-wide measures are thought useful, Parliament would have to approve amendments to the Third Schedule to add such measures.
S.302, page 125 and 126
sets up the legal process through which the FSDC will ensure the implementation of system-wide measures.
S.306, page 127
asks the FSDC to identify what parameters it would use to determine a financial system crisis. S.306(4) asks the Council to assist the Government and regulatory agencies as specified in S.306(5) (through analysis of data, providing advice, and assisting in efforts).
S.307 to S.313, page 128 and 129
constructs the Financial Data Management Centre (FDMC), a single database about the entire Indian financial system, which allows the regulators to have a full picture about the state of the financial system at any point in time, and particularly during a crisis. As a side effect, the unification of all supervisory data filings to FDMC also leads to de-duplication of data and reduces costs for financial firms. This database is essential for thinking about systemic risk (i.e. about the overall financial system) and is conspicuously absent in India today.
S.345 and S.346, page 141
define the lender of last resort (LOLR) functions of the central bank. S.345 (temporary liquidity assistance) relates to assistance given to participants in the central bank's payment system, and S.346 (ELA) is about lending against collateral to a more broad class of financial firms.
S.362, page 147
defines the notion of an emergency, which can motivate capital controls against inflows under S.365. Similar provisions for outward flows are specified in S.368.

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