The adequacy of regulations and efficacy of regulators in preventing the failure of banks and financial institutions (BFIs) has again been under debate after the recent failure of three smaller banks such as the Silicon Valley Bank (SVB), Signature Bank and First Republic Bank, in the US. Some of the issues being debated are whether the regulatory framework in itself sufficient to prevent failure. Should the regulations be principle-based or rule-based?
Inadequacy of Regulations
The regulations introduced after the financial crisis of 2008 were rule-based and were considered inadequate in regard to stress and liquidity tests and risk management. The supervision of banks has not kept pace with their growth. Response time was slow and follow-up of supervisory findings was somewhat tepid. First Republic Bank failed because of run on its deposits following the collapse of SVB and Signature Bank. The failure of these banks also suggests their vulnerability to failure and the failure of regulators to take timely action to prevent a collapse. The management seeded the failure in the first place by ignoring risks in their strategy and operations by neglecting risk management.
India had also witnessed ballooning stress in the loan portfolio of BFIs till 2016, threatening their viability and sustainability. Amidst macroeconomic uncertainty, regulation prevalent then lacked in disciplining lending, portfolio quality, asset-liability mismatch (ALM), liquidity and capital adequacy. Unbridled exuberance of BFIs for lending was also responsible for this malaise.
The factors as mentioned above are generally common to all failing BFIs and centre around actions or inactions of their management and or the regulators. Industry lobbying and political pressure as well are to blame. For instance, these outweighed regulatory wisdom that resulted in the relaxation of stringent regulatory norms for smaller banks in the US in 2019.
Risks are Dynamic
Regulations address the current landscape of risks. However, risks are dynamic. Risks which matter are those that have not yet emerged and may take regulators by surprise or allow little flexibility to respond, such as the pandemic and the steep rise in interest rates in the US. This is one of the cardinal principles of risk management. Regulators in the US were not able to timely foresee and do scenario analysis of the impact of (the unexpected) rise of interest rates on the smaller banks. In India, the RBI at the relevant time could not regulate for implications of the risks emanating from creeping stress in BFIs till the crisis reached the boiling point, exacerbated by uncertainties in macroeconomic conditions. Regulating for growth risks amidst global headwinds and domestic factors has always been a daunting task for regulators.
Moreover, if the regulators attempt to provide for these risks in anticipation, they are criticised as over-reactive and regressive. Such reactions were seen when the RBI attempted to regulate the unbridled growth of microfinance institutions and non-banking financial companies (NBFCs) in the 1990s and early 2000s. Regulations are important but not enough in themselves to prevent failures in BFI.
The approach to regulation whether it should be rule-based or principle-based has also been debated since the history of regulations. The rule-based approach codifies every process and action involved in managing risks and accordingly marshal the behaviour of those regulated for compliance thereof. This approach is criticised as it encourages box-ticking. That volumes of regulations adopted in the US after the financial crisis of 2008 failed to prevent subsequent failures proves the point
Under the principal-based approach, the regulator and BFIs sit together, on a regular basis, to identify existing and potential risks. The regulator then specifies the intention of the regulations for BFIs to guide their processes and actions towards those. Many regulators like the RBI also prescribe threshold levels for capital requirements, liquidity requirements, provisioning requirements and concentration risk. While this is a flexible and robust approach it relies on the ability, wisdom and actions of BFIs.
Governance and Management Failure
The root cause of the failure of BFIs has been poor governance and management, and the pursuit of short-term business while ignoring embedded risks. Risk management and compliance management have not received attention despite the regulatory thrust and imperatives. There has not been enough understanding of the link between risk, liquidity and solvency. For instance, SVB failed as it leveraged interest rate risk with growth in its portfolio and profits, ignoring inherent dangers in case of a steep rise in interest rates This caused run on its deposits. Banks being on the front are better placed to foresee risks, assess their implications and take measures to mitigate those. For example, seeing the pandemic in sight, many BFIs focused on maintaining liquidity to be able to steer through the pandemic. The regulator can only have a roadside view of the risks.
While regulations have constantly been broadening and deepening, BFIs have not responded satisfactorily through internal compliance. The efficacy of risk modelling and supervision by the regulators has not been able to cope with the growing complexity of BFIs operations. They lack the requisite independence, human resources, funds and effective tools. This has weakened their ability to act timely in preventing failure. There are mounting signs of concern before any BFI fails, yet managements and internal and external supervision have not been able to act adequately and in time. Regulator’s supervisory role becomes critical for BFIs which ignores prudence in their governance and operations, without restraining innovation. Unless marshalled and disciplined, these BFIs may become vulnerable to failure. The redeeming feature—be it the global financial crisis of 2008 or the banking crisis arising out of the twin balance sheet in India or due to the 2020 pandemic or the collapse of individual BFIs like SVB, ILFS and Yes Bank—is that regulators have been prompt in limiting or reversing the damage and restoring the health of failed BFI or of the financial sector.