RBI's approach on too big to fail gives more weightage to factors such as securities issued and bought by banks in India and overlooking risky assets and growing NPAs of the lenders

The financial crisis that hit the world economy at the beginning of the year 2008 was an eye opener. It showed how fragile the entire financial system was and how systemic risks arising from weakness of financial institutions could easily spill over to the real sector. The crisis also highlighted the need to have a re-look at the financial institutions and monitor risks posed by these financial institutions. Many large financial institutions, which looked infallible before financial crises, failed during the crisis giving rise to the fear that such financial institutions require closer monitoring and could pose serious systemic threat in future. With the crisis in the background, the concept of, “too big to fail” gained significance. Though the term, “too big to fail” was used in earlier crises as well, it assumed significance post-2008 crisis. Federal Reserve Chair Ben Bernanke defined the term in 2010: "A too-big-to-fail firm is one whose size, complexity, interconnectedness, and critical functions are such that, should the firm go unexpectedly into liquidation, the rest of the financial system and the economy would face severe adverse consequences.”
 

Basel Committee on “too big to fail”:  Post financial crisis of 2008, the Basel Committee on Banking Supervision (BCBS), adopted a series of reforms to improve the resilience of banks and banking systems. In order to ensure that banking system has enough resilience, the committee started working on two key areas which included assessment methodology for globally systemically important bank and how these banks can develop additional loss absorption capacity.
 

BCSB came out with an indicator-based approach to identify systemically important banks. The selected indicators are chosen to reflect the different aspects of what generates negative externalities and makes a bank critical for the stability of the financial system. The advantage of the multiple indicator-based measurement approach is that it encompasses many dimensions of systemic importance, is relatively simple, and is more robust than currently available model-based measurement approaches and methodologies that only rely on a small set of indicators. The selected indicators reflect the size of banks, their inter-connectedness, the lack of readily available substitutes for the services they provide, their global (cross-jurisdictional) activity and their complexity.
 

As per Basel Committee’s indicator based measurement approach, 20% equal weightage has been given to five critical factors which are cross-jurisdictional activities, size, interconnectedness, substitutability and complexity which is explained in the chart below:
 

Source:Basel
 

For each bank, the score for a particular indicator is calculated by dividing the individual bank amount by the aggregate amount summed across all banks in the sample for a given indicator.The score is then weighted by the indicator weighting within each category. Then, all the weighted scores are added. For example, the size indicator for a bank that accounts for 10% of the sample aggregate size variable will contribute 0.10 to the total score for the bank (as each of the five categories is normalised to a score of one). Similarly, a bank that accounts for 10% of aggregate cross-jurisdictional claims would receive a score of 0.05. Summing the scores for the 12 indicators gives the total score for the bank. The maximum possible total score (ie if there were only one bank in the world) is 5.
 

Additionally in order to find out this category of bank, BASEL approach says that banks need to be identified from list of 75 largest banks based on leverage ratio prescribed by Basel. Banks can be added in this list depending upon descretion used by national supervisor.
 

RBI approach on “too big to fail”: Based on the Basel approach, the Reserve Bank of India (RBI) has also decided to identify banks which are domestic systematically important. The RBI draft document says, “The banks will be selected for computation of systemic importance based on the analysis of their size (based on Basel III Leverage Ratio Exposure Measure) as a percentage of GDP. The banks having size as a percentage of GDP beyond, 2% will be selected in the sample of banks. As foreign banks in India have smaller balance sheet size, none of them would automatically get selected in the sample. However foreign banks are quite active in the derivatives market and so the specialised services provided by these banks might not be easily substituted by domestic banks. It is therefore appropriate to include a few large foreign banks also in the sample of banks to compute the systemic importance. The total assets of the banks selected for the sample would constitute 100% of the GDP. For this purpose, latest GDP figure released by Central Statistical Office, Government of India will be used”.
 

The broad comparison between RBI and Basel approach is given in the table below.
 

Source: RBI
 

While cross-jurisdictional activity is considered as a key factor for determining the risks posed by globally systemically important banks, for domestic banks size has been given a higher weightage by RBI. Cross jurisdictional activity has been given a weightage by RBI in sub-indicators and it has replaced level 3 assets by cross jurisdictional factors. RBI prescribes additional capital requirements for too big to fail to banks as follows:

Source: RBI
 

Apparently RBI’s approach on too big to fail gives more weightage to factors such as trading books of the banks in India. Under all three heads of interconnectedness, substitutability and complexity, the focus is more on market securities which include securities issued by the banks as well as securities which banks have purchased. The key aspect of core banking business is not explicitly mentioned. Banks in India in the current scenario face threat from rising non performing assets which pose threat to the banking operations. Risky assets in the books of most of the banks such as exposure to real estate sector or lending to various corporate also pose threat to the banking industry. The quality of assets of a bank should definitely be a key criteria in identifying too big to fail status. Also, with banks in India spreading wings across world, cross-jurisdictional liability should have been given a higher weightage.