BIS Papers No 62

Financial sector regulation for growth, equity and stability Proceedings of a conference organised by the BIS and CAFRAL in Mumbai, 1516 November 2011

Monetary and Economic Department

January 2012

Papers in this volume were prepared for a conference organised by the BIS and the Centre for Advanced Financial Research and Learning (CAFRAL) in Mumbai on 1516 November 2011. The views expressed are those of the authors and do not necessarily reflect the views of the BIS or the institutions represented at the meeting. Individual papers (or excerpts thereof) may be reproduced or translated with the authorisation of the authors concerned.

This publication is available on the BIS website (www.bis.org) and the CAFRAL website (www.cafral.org.in).

Bank for International Settlements and CAFRAL 2012. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated.

ISSN 1609-0381 (print) ISBN 92-9131-088-3 (print)

ISSN 1682-7651 (online) ISBN 92-9197-088-3 (online)

http://www.bis.org/http://www.cafral.org.in/

BIS Papers No 62 iii

Preface

The failure of regulation and the short-sightedness of the private sector were the root causes of the crisis. The balance of emphasis has shifted from encouraging innovation designed to yield short-term gains for a few to ensuring sustainable financial sector development that helps many. How can we make this new orientation operational? What does this enhanced regulation mean for growth and for equity? Are the implications of regulatory reforms different for emerging market economies (EMEs) whose growth momentum was dented by the crisis? In tailoring regulatory reforms, how can we harmonise the interests of the advanced and emerging economies? Addressing these questions was the main thrust of CAFRALs inaugural international conference, organised jointly with BIS, on "Financial Sector Regulation for Growth, Equity and Stability in the Post Crisis World" on 1516 November 2011 in Mumbai.

The conference provided a forum for central bankers, financial sector regulators, academics and practitioners from both developed and emerging markets to deliberate on several dimensions of these issues. There was much discussion on some controversial questions. The discussions illuminated not only the multidimensional linkages between the financial sector and the sovereign but also the influence of the international financial architecture on global financial stability. We need to work hard to better understand these connections.

The key message that emerged from the discussions is that the costs of financial instability in terms of lost growth and foregone welfare can be huge and that it is therefore right for regulatory reforms to give primacy to securing financial stability. Banks must serve the real sector, and not the other way round. Participants also agreed that the financial sector development which serves the needs of the real sector provides sustainable earnings for financial firms. Higher capital requirements for financial institutions may raise the cost of credit in the short-term. But these costs will fall over time: better capitalised banks will find they can fund themselves more cheaply. They will also be able to increase their market share at the expense of poorly capitalised banks. The benefits of financial stability will surely outweigh the loss of short-term gains.

A consensus also developed around the incorporation of equity as an explicit objective of financial policy, especially in countries with a large population of those without access to formal financial services. There was, however, a lively debate on how best to achieve this in practice. Supervisory authorities worldwide have to refine and develop their macroprudential toolkit. The macroeconomic aspects of systemic risk that arise from global influences require special attention in EMEs. Pragmatic capital account management will accordingly have to form an integral part of policy in many countries. But such measures should provide a clear and predictable framework of rules that help the private sector nurture the more stable forms of capital movement. International capital mobility offers many gains if the risks are managed effectively.

We are indeed happy that the papers presented and the proceedings of the conference are being made available to a wider audience through this publication.

D Subbarao Jaime Caruana Governor General Manager Reserve Bank of India Bank for International Settlements

iv BIS Papers No 62

Acknowledgements

Particular thanks are due to Louisa Wagner of the BIS and K. Kanakasabapathy (former Advisor Reserve Bank of India) who co-ordinated the preparation of the papers and discussion summaries for publication under a very tight deadline. We are also grateful to Blaise Gadanecz and Nigel Hulbert for editing these papers.

BIS Papers No 62 v

Contents

Preface .................................................................................................................................. iii

Acknowledgements ................................................................................................................ iv

Programme ........................................................................................................................... vii

List of participants .................................................................................................................. ix

Financial Sector Regulation for Growth, Equity and Stability in the Post Crisis World Opening address

Duvvuri Subbarao ......................................................................................................... 1

Jaime Caruana ............................................................................................................. 9

Overview Usha Thorat ................................................................................................................ 21

Special address: Financial sector regulation and macroeconomic policy YV Reddy .................................................................................................................. 29

Summary of the discussion .................................................................................................. 39

Financial Sector Regulation for Growth Chairs initial remarks

Andrew Sheng ............................................................................................................ 41

Implications for Growth and Financial Sector Regulation Anand Sinha ............................................................................................................... 45

Summary of the discussion .................................................................................................. 85

Financial Sector Regulation for Equity Chairs initial remarks

Stephany Griffith-Jones .............................................................................................. 89

Too big to fail vs Too small to be counted M S Sriram, Vaibhav Chaturvedi and Annapurna Neti ................................................ 93

Summary of the discussion ................................................................................................ 119

Financial Sector Regulation for Stability Chairs initial remarks

John Lipsky ............................................................................................................... 123

Macroprudential policies in EMEs: theory and practice Philip Turner ............................................................................................................. 125

Summary of the discussion ................................................................................................ 141

BIS Papers No 62 vii

CAFRALBIS Conference on

Financial Sector Regulation for Growth, Equity and Stability in the Post Crisis World

1516 November 2011, Mumbai

Day 1 15 November 2011

11.4512.45 Inaugural session - Addresses by D. Subbarao, Governor, RBI and Jaime Caruana, General Manager, BIS

14.0016.00 Session I on Financial Sector Regulation and implications for Growth in the Post Crisis World Chair: Andrew Sheng, Chief Adviser to the China Banking Regulatory Commission

Background paper presented by : Anand Sinha, DG, RBI Outline: In developing economies, financial sector policies are expected to be tuned to sub-serve the broad objective of ensuring growth with equity. This session will discuss the regulatory philosophy in relation to growth and development in the pre-crisis, mid-crisis and post-crisis periods with a focus on emerging market economies (EMEs). Beginning with a review of studies regarding macro-economic impact of Basel III capital and liquidity regulations, the background paper will explore a model for India for the assessment of macro-economic impact of these measures. Specific questions that could be explored in this session are : Will the new regulatory approaches and measures impinge and run

counter to the growth objective? The needs of the trade and the infrastructure sector being so vital to

growth what are the implications of the capital leverage and liquidity requirements for these sectors? What are the specific factors that would weigh in the calibration of macro prudential measures for EMEs?

What are the specific difficulties that are likely to be faced by EMEs in the implementation of Basel 3?

16.3018.30 Session II on Implications of the Evolving Regulatory Framework for Equity in the post crisis World Chair: Stephany Griffith-Jones, Financial Markets