Financial Market Regulations Should Not Descend To Iatrogenesis

Monetary policy announcements in India are not just about rate decisions; they often come with regulatory tweaks.

To the discerning eye, the repo rate decision in the latest monetary policy by the Reserve Bank of India has been a damp squib. However, the announcements on the regulatory front assume greater significance.

Consider this excerpt from the Governor’s statement at the MPC meeting:
 “On the regulatory front, I would like to mention, especially in the context of some of the proposed regulatory changes pertaining to liquidity coverage ratio (LCR), expected credit loss (ECL) framework for provisioning by banks, and the prudential norms governing projects under implementation, that we will continue to strengthen, rationalise and refine the prudential and conduct-related regulatory framework in the overall interest of the economy”. 

Now, place this alongside a subtle statement made by Jerome Powell recently, while referring to the US Federal Reserve’s rate decisions, to make a point: “The costs of being cautious are very, very low.”

This suggests that while the initial regulatory stances may have stemmed from excessive caution, their reversal indicates that the costs of such caution were not, in fact, very low.

Let us examine these one by one.

Take the issue of project financing. Earlier, India had specialised institutions for long-term lending that catered to these financing needs, such as project financing, but the ecosystem also encouraged and nurtured human skills required for it.

The key concern is the impact of tweaking prudential norms for projects under implementation. Banks are already constrained when financing long-term projects due to liquidity regulation norms. Even if they choose to engage in such lending, sudden changes in prudential norms could severely disrupt their existing project finance decisions. Cash flow projections for ongoing loans are based on financial strategies, cost structures, and liability commitments made at the outset. Any unexpected regulatory shift could upend these carefully planned frameworks, creating uncertainty in long-term project financing.

This implies that the financing cost of long gestation projects is never crystallised. Along with this, the shifting sands on standard asset exposure may just be the proverbial last straw on the camel's back.

The earlier caution on liquidity likely stemmed from lessons learned from Silicon Valley Bank’s troubles and the amplified impact of bank runs in a digital environment, despite the bank’s assets being of sterling quality.

LCR is not an antidote for correlated, synchronised outflows across all deposit classes—rather, it is an insurance for outflows specific to isolated deposit classes. What SVB witnessed was a deposit run across deposit classes. Hence, it is debatable whether the enhanced medicine of LCR addressed the real problem or merely introduced unintended side effects, falling into the category of iatrogenesis.

In fact, the banking business has moved from "storage" to a "moving" business, thanks to the Basel liquidity rules, thus blurring the difference between banks and securities firms.

The impact on the ability to undertake maturity transformation is stark, particularly in jurisdictions with underdeveloped complementary interest rate derivatives markets. In economies where assets are predominantly floating rate while liabilities are fixed, managing earnings volatility requires specialised skill sets to navigate the inherent risks.

Coming to the ECL, the objective is to move from an “incurred losses” approach to an “expected losses” framework for provisioning. This would require specialised skill sets, a good chunk of quality historical data, and, more importantly, strong governance standards, since ECL computations, by their very nature, work better in jurisdictions with good governance. The question is, are our roads ready for driverless cars?

The implementation of ECL presents another challenge. The very need for supervisory stress tests implies that effective capital levels are well above regulatory requirements, raising questions about the necessity and impact of the transition.

If stress tests are doing what they are supposed to and effective capital is in tune with their outcomes, such a process would—as it is supposed to—ease the transition to an ECL-based framework, which, it must be emphasised, is an expected loss measure and not a stressed loss assessment. Of course, it is conceivable that in some cases, ECL requirements can diverge from stressed capital requirements if the stress is localised. That calls for a relook into the supervisory toolkit of stress tests.

Treating the retail lending portfolio as homogeneous, without considering its components or the strengths and weaknesses of individual lenders, leads to blanket macroprudential measures that complicate the supply of quality credit. Often, these measures may also end up “penalising the prudent.”

The broader concern with regulations is whether regulatory tweaks undergo reasonable cost-benefit analyses and to what extent too many overlays on high-level regulations amount to micromanagement. Such interventions often shift accountability away from Boards, reducing their responsibility for the well-being of the regulated entity.

This is evident in recent efforts to tweak regulations on bank-NBFC credit, unsecured credit, and usurious interest rates charged by NBFCs.

A key issue is the lack of a clear definition of what constitutes a usurious rate.

Regulatory interventions are not limited to the RBI. SEBI has also directed asset management companies to deploy funds raised through new fund offerings within 30 business days of allotment.

As John Kay says, “if a regulator as supervisor is, to any degree, to review the business judgments of managers of the regulated entity, it is difficult to resist the argument that there is some shared responsibility for errors in business judgment.”

Regulatory prudence is necessary, but excessive caution and frequent tweaks risk undermining stability rather than strengthening it. Just as in medicine, where interventions must avoid doing more harm than good, financial regulations should be crafted with a clear understanding of their systemic effects.