India and Canada: Regulatory resilience?

Introduction

This paper provides an overview of the banking system in Canada and India. It underlines some of regulatory measures by the Canadian and Indian banks that helped them survive the recent financial crisis better than the banks in the US, the UK and other European countries. Towards the end the paper will summarize the response of the two countries to the financial crisis with emphasis on the banking sector and looks at future opportunities and developments in the banking sector of the two countries. Banking is undoubtedly one of the most regulated industries in the world. This prominence results from the central role that banks play in financial intermediation, the importance of bank capital for bank soundness and the efforts of the international community to adopt common bank capital standards. The aim of this paper is to understand the key sources of Canada and India's resilience to the ongoing financial crisis. This task has important implications. First, it would allow an assessment of the Canadian and Indian Banking sector going forward. Second, understanding the sources of resilience would be useful for countries that may seek to learn from Canada and India's experience.

Canadian Banking Industry

The impact of the credit crisis on Canada appeared serious but clearly mild in comparison with a number of other OECD countries. Funding conditions of Canadian banks weakened and their profitability decreased, but not as severely as in other countries. Public bank recapitalizations were not needed. This fortitude may appear surprising given the high exposure of Canada's economy to the American economy, and therefore stresses the fundamental strengths of Canadian banks (IMF, 2009).

The regulatory and structural factors that reduced Canadian banks' incentives to take risks and helped to their relative vigor during the crisis will be important to investigate. We identify a number of them: stringent capital regulation with higher-than-Basel minimal requirements, limited involvement of Canadian banks in foreign and wholesale activities, valuable franchises, and a conservative mortgage product market (IMF, 2009). Specifically, better-capitalized banks are able to experience greater losses without becoming insolvent, and can maintain access to funding even with uncertainty regarding their asset values due to market conditions (Kiff, 2009).

Regulatory and Structural Environment in Canada

Sound fundamentals of Canadian banks were supported and shaped by regulatory and industry structure that impeded banks from taking excessive risks. This section looks at some important elements from this environment.

Capital Regulation

Bank capital regulation in Canada centers around two key thresholds: minimum risk based capital ratios and a maximum assets-to-capital multiple (inverse leverage). These details are set by The Office of the Superintendent of Financial Institutions or OSFI, which is the primary regulator of federally-regulated banks in Canada.

  • Risk-based capital. The Basel Accord requires internationally active banks to hold tier 1 capital of at least 4 percent and total capital of at least 8 percent of risk weighted assets. Canada imposes capital requirement target that are higher than the Basel minima: tier 1 capital of 7 percent and total capital of 10 percent (IMF, 2009). The targets have been in effect since 1997 (all large domestic banks were in compliance since its inception) and were retained after the implementation of Basel II. Furthermore, at least 75 percent of tier 1 capital must be formed of common equity, and innovative instruments are restricted to 15 percent of tier 1 capital.
  • Assets-to-capital multiple. Over and above the risk-based capital, Canada uses an assets-to-capital multiple (inverse leverage ratio) that is calculated by dividing the bank's total assets by total capital (tiers 1 and 2). The maximum multiple is set at 20, which corresponds to a leverage ratio of 5 percent.

Liquidity Framework in Canada

Liquidity guidelines in Canada specify that banks must keep a stock of highly liquid assets appropriate for their cash flow and funding profile. Banks with more than 10 percent of funding coming from wholesale sources must have internal limits on short-term funding requirements and continuously monitor actual requirements against those limits (IMF, 2009). Currently there is no quantitative liquidity minimum, but rather stress-testing and contingency planning is articulated.

Banking Market Structure

A number of wide-ranging structural factors have likely played a role in Canadian banks' stable retail deposit base and lower risk-taking.

Six large banks dominate the Canadian banking sector. Each national franchise is very profitable and valuable, and banks are keen to preserve it, in turn avoiding excess risks that could compromise the franchise (IMF, 2009). Customers greatly value the capabilities of a nation-wide bank branch network, and therefore this helps shield Canadian banking services from international competition. Moreover, limited external competition reduces pressures to defend or expand market share, again reducing incentives to take risks.

Finally, the Canadian mortgage market is relatively conservative, with a number of factors contributing to the prudence of mortgage lending (Kiff, 2009). Less than 3 percent of mortgages are subprime and less than 30 percent of mortgages are securitized (contrast with about 15% and 60% respectively in America pre-financial meltdown). Mortgages with a loan-to-value ratio of more than 80% must be insured for the entire amount (compared to only the value above 80% as in the U.S.). Lastly, mortgages with a loan-to-value ratio of more than 95% cannot be underwritten by federally regulated banks (IMF, 2009).

Canadian Banking System: Current Crisis, Outlook and Opportunities

Benefiting from tight capital requirements, stringent government restrictions and limited subprime exposure, Canada's banking system has been able to weather the global sub-prime crisis. This resilience has allowed Canadian banks to keep lending to companies and households through the credit crisis, keeping Canadian credit markets less impaired than those of other countries and being able to support Canadian domestic demand. In 2008, the World Economic Forum ranked Canada's banking system the healthiest in the world.

In addition, the Canadian governments at various levels are in a good position to react in case of near-future difficulties. Both the Federal Government and that of most provinces have shown important budget surpluses over recent months. In addition, the governments of Québec, Ontario for example have already begun an important investment program in infrastructures, thus contributing significantly to future economic growth. However, if the financial crisis was to impact the economy more severely over the coming months, it would be necessary to act quickly. Additional measures could then be implemented: intensification of public works, targeted industry support program or the influx of emergency help for households.

Canadian banks strong capitalization may serve the country as it looks to take advantage of opportunities that other American and European competing banks cannot seize. The Toronto Dominion Bank, for example, which was the 15th-largest bank in North America in 2008 is now the fifth-largest. It hasn't grown in size; the others have all decreased in size. All the same, however, Canadian financial institutions are not completely immunized against the effects of the financial crisis; this environment will continue to affect Canadian households and businesses for coming years.

Indian Banking Sector

The Indian banking sector is growing at a fast pace with the Indian economy. The financial services penetration, growing middle class population and economic growth are benefiting the banking sector in terms of earnings growth and credit growth. The profit pool of the Indian banking industry is estimated to increase to US$20 billion by 2010 and to US$40 billion by 2015. The credit market is estimated to reach US$ 23 trillion by 2050 and India is expected to become the third largest banking hub by 2040(Cygnus Business Consulting & Research report).

In 2005 - 06 it was for the first time that investment by the commercial banks in government securities declined in absolute terms in any single year. Although currently the economy is facing the problem of slowdown but with interest rate cuts and liquidity infusion by RBI into the system again the credit is bound to grow. But at the same time there are some challenges faced by Indian banking sector which are:

  • Threat of risks from internalization
  • Implementation of Basel II norms
  • Improvement of advanced risk management systems
  • Implementation of new accounting standards and reporting norms
  • Enhancement of transparency
  • Enhancement of customer support
  • Improvement of information technology infrastructure set up and internet banking.
  • Need for more capital for expansion purposes.
  • Meeting large financing demand for infrastructure projects.
  • Rural and SME financing.

The Indian banking sector is divided into following categories based on ownership

  • Public sector banks
  • Private sector banks
  • Co-Operative - These banks are old, small and are generally concentrated in a particular geographical area.
  • Old Private Sector Banks - They are the private sector banks who have survived the nationalization of Indian banks
  • Regional Rural Banks: Promoted by larger banks with specific mandate for rural upliftment
  • Foreign Banks: Operate under many restrictions.

The Indian banking system has proved to be relatively insulated from the factors leading to the turmoil in the global banking industry. The tight liquidity in the Indian market is qualitatively different from the global liquidity crunch, which was caused by a crisis of confidence in banks lending to each other. The problems of global banks arose mainly due to exposure to sub-prime mortgage lending and investments in complex collateralized debt obligations whose values have dramatically fallen. Globally, banks have also been affected by the freeze in the inter-bank lending market due to confidence-related issues. On both counts however, Indian banks have had limited vulnerability. On the first hand, Indian banks' global exposure is relatively small, with international assets at about 6% of the total assets. Even banks with international operations have less than 11% of their total assets outside India. On the second, Indian banks' dependence on international funding is also low. It will be important to review regulatory and structural factors that may have reduced Indian banks' incentives to take risks and contributed to their relative resilience during the turmoil. We identify a number of them: stringent capital requirement with higher-than-Basel minimal requirements, limited involvement of Indian banks in foreign activities, non-existent mortgage product market and limited exposure to equity markets amongst others. The Central Bank, known as the Reserve Bank of India (RBI) used a variety of instruments such as Market Stabilization Scheme bonds, Liquid Adjustment Facility, Cash Reserve Ratio and Statutory Liquidity Ratio levers to ensure banks functioned in a well-regulated environment. Specifically, better-capitalized banks are able to sustain higher losses without becoming insolvent, and can maintain access to funding in the midst of market uncertainty about their asset values.

Regulatory and Structural Environment in India

Sound fundamentals of Indian banks were complemented, and in part caused, by regulatory and industry structure that discouraged banks from taking excessive risks. This section describes some features of that environment:

Ownership:

Currently India has 88 scheduled commercial banks - 29 private banks, 31 foreign banks and 28 public sector banks. While India's financial reforms have been comprehensive and in line with global trends, one unique feature is that, unlike with other former planned economies such as Hungary and Poland, the Indian Government did not engage in a drastic privatization of public-sector banks. Rather, it chose a gradual approach toward restructuring these banks by enhancing competition through entry deregulation of foreign and domestic banks. With respect to privatizing banks, moreover, the World Bank (2001) takes the view that privatization can yield real benefits to economies provided that an appropriate accounting, legal and regulatory infrastructure is in place. It should be noted that premature privatization may give rise to banking crises. With Public Sector banks being the dominant players in the sector and government closely monitoring the Banking sector, there was reduced risk of bank runs and people loosing confidence in Indian Banks. Also PSB's are more conservative in their approach and have guarantees from the government of India.

Cautious approach to liberalization of Financial Sector:

The Indian government took a calibrated approach to the opening up of capital account and the financial sector even though the current account was has been fully opened over the 1990's. This has been consistent with the weight of empirical evidence with regard to benefits that can be gained by the liberalizing the capital account especially in emerging economies. Maximum benefits are achieved by opening to Foreign Direct Investment followed by portfolio equity investment where as benefits emanating from external debt flows are questionable until more financial market development had taken place. There are ceilings in India with respect to External Commercial Borrowings that are adjusted from time to time according to the macro economic situations. Also there are upper limits on portfolio investment in government bonds and securities. Due to this there was no excessive dependence on foreign borrowings.

Banking Regulations:

Capital Requirement Based Regulations:

  1. Indian banks have been better capitalised having higher proportion of Tier 1 capital. The banks will soon be migrating to Basel 2 norms to keep harmony with international standards. The RBI has instructed the Indian banks to follow the Standardised Approach for credit risk and Basic Indicator Approach for operational risk. The banks will have to maintain minimum capital-to-risk-weighted asset ratio (CRAR) of 9%. Though, RBI can prescribe higher levels under Pillar II on the basis of risk profile and risk management systems. As per RBI, PSU banks in India will require an amount of Rs 2980 billion of additional capital to maintain a CRAR of 12 per cent by March 2010. The banks will have to bring Tier I CRAR to at least 6 per cent before March 31, 2010. The Indian banks have better capital cushion compared to banks in US and Europe, thus making them more stable and less risky.
  2. The Reserve Bank of India imposes prudential limits on the banks' purchased inter-bank liabilities which are linked to their net worth so that banks rely more on stable sources of funding. The current crisis has demonstrated that too much dependence on borrowed funds increase the vulnerability of the banks manifold.
  3. The Central Bank of India also monitors the incremental credit deposit ratio which indicates the extent to which banks are funding credit with purchased funds.
  4. Reserve Bank of India also has a policy of dynamic provisioning where it imposes additional prudential measures with respect to particular sectors. When the Central Bank realized that real estate sector was over exposed, banks were cautioned to have proper risk management systems in place to contain the risks. In lieu of rapid increase in loans to the real estate sector, the risk weight on banks' exposure to commercial real estate was increased from 100% to 125% in July 2005 and further to 150 per cent in April 2006. Also when there was strong growth of consumer credit and volatility in the capital markets, RBI increased the risk weight for consumer credit and capital market exposure to 125% from 100%.

Liquidity Based Regulations:

  1. The Central Bank of India has put restrictions on the overnight unsecured market for accessing of funds by banks and primary dealers. There are also ceilings on borrowing and lending by these entities in the overnight inter-bank call money market. This is to discourage banks from excessive risk taking.
  2. While dealing with asset-liability mismatches both on and off balance sheet items are accounted for. There is also a detailed policy for provision of liquidity support to Special Purpose Vehicles pertaining to securitization of standard assets. Also credit conversion factors, risk weights and provisioning requirements for off balance sheet items are reviewed from time to time.
  3. Statutory Liquidity Ratio: To maintain solvency and control expansion of credit, Indian banks are required to invest a certain percentage of their time and demand liabilities in cash, gold and government securities. This percentage has been around 25% recently.
  4. Cash Reserve Ratio: It is the proportion of deposits that banks have to maintain with the Central Bank of India. The CRR percentage in India hovers around 5%. This is to provide extra liquidity cushion in times of any macro economic crisis and extraordinary situations that can lead to chances of a bank run. It helps banks encounter any unforeseen situation providing it immediate liquidity.

Others:

  1. In India complex structures including synthetic derivatives are not permitted till now.
  2. In India, the banks could not increase their capital/stock market exposure beyond the statutory 5% limit. Thus the stock market crash during the credit crisis did not have any direct impact on the banks. And thus they were shielded from the stock market crash. Though, some of the banks now are seeking RBI's nod to increase their exposure beyond 5% limit.
  3. There has been consistent tightening of regulation and supervision on Non-Banking Financial Companies so that there is no regulatory arbitrage between these and banks so that banks do not use NBFC's as a vehicle to circumvent bank regulations. For NBFC's also the capital adequacy ratios and prudential exposure limits have been progressively brought nearer to that applicable in case of banks. Regulatory interventions are more in case of deposit taking NBFC's than in case of non-deposit taking NBFC's. This has helped control excessive leverage in the sector.

Indian Banking System: Current Crisis, Outlook and Opportunities

The Indian Banking system has had to pursue several changes in its system to adapt to global crises, although it was relatively less affected. The government response was fiscal stimulus packages (accounting to about 3% of GDP) while the Reserve Bank's action comprised monetary accommodation and counter cyclical regulatory forbearance. Taken together these measures have represented over $75 billion or a 7% of total GDP. However, the Indian economy is back on a strong growth path. In India, the measures taken by regulators helped to protect the country from much of the negative impact, by preventing "risky" financial instruments such as collateralised debt obligations (CDOs), from being traded in the country. The relative robustness of India's banking system has given its banks the luxury of being able to be very selective when choosing talent, especially to fill the more niche roles or to support the rollout of exotic product lines.

With the implementation and acceptance of Basel II norms banks would be able to capture operational risks better and therefore may need additional capital.Also Indian banks are very small in size compared to global peers. This would put more pressure on the smaller banks to raise capital and hence this can lead to consolidation in the Indian banking industry. Foreign banks can enhance their presence, provided RBI opens up the banking industry. It is also an excellent opportunity for Indian Banks to takeover/merge with smaller Indian banks. Consolidation will help by increasing customer base and creating new opportunities in the financial services sector. Due to consolidation processes there could be changes in the ownership pattern of the public sector banks in the medium and long term. Although the concentration of assets in the banking sector is very much dispersed when compared to pre reforms (liberalization) era which calls for consolidation among Indian banks, the regulator will have to formulate policy to ensure that the consolidation does not undermine competition in the future. Foreign Banks would bring more competition that would improve service and prices for the consumer. Competition would drive Indian banks towards greater efficiencies. They would also bring skills that are needed in the Indian economy, and the talent they bring to India, or train in India, would become part of the domestic labour pool, leading to cross-fertilization.

Conclusion

Canada and India's banking system has done more than survive this financial crisis in comparison to other developed and developing nations. One of the important elements in both India and Canada's banking success during the crisis was effective bank capital regulation. It can be noted that besides providing a capital cushion, the binding capital requirements have beneficial influences on banks. Higher capital requirements restrict rapid balance sheet expansion that may lead to reckless investments. Similarly, banks constrained in balance sheet size engage less in wholesale operations, as retail operations can satisfy a greater fraction of their investment needs. Finally, banks subject to more rigorous capital requirements than elsewhere are less competitive internationally; they have lower incentives for foreign expansion except in cases where they can have a distinct competitive advantage (IMF, 2009).

Canada and India's banking stability has positioned each country to reap varying benefits. For example, some Canadian banks are well positioned to leverage their reputation for financial stability. They are currently enjoying a time of international praise for their leadership, risk management practices and operating platforms. With the relative strength of the Canadian banks and high capital, now may be an ideal time to leverage their reputation and consider expansion outside of Canada.

Over the coming year, financial services regulatory reform will pick up steam. There is no question that banks around the world will be required to hold more capital compared to historical levels and there will probably be new leverage ratios (PwC, 2009). Many agree that the ability of the Canadian and Indian banks to successfully manage through this regulatory reform will determine whether they continue to emerge as leaders. Canadian banks already abide by many of the rules being considered globally and India is starting from a solid position.

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