Market crashes and failures of institutions can take a significant toll on the economy. The widening and deepening of the financial sector in the economy have proven to play a significant role not only for economic growth but also for its wider positive impact on society. Financialization of the economy also opens up the door for large scale disruptions in the case of market failures.
Given these imperatives, smooth functioning of the financial market is not only desired but more like an absolute necessity. Regulating and monitoring the financial sector has always been one of the tops most agenda for policymakers. And the focus of the regulatory design is not to have excess regulations or micro-management.
A robust umbrella of the regulatory environment should ensure a self-correcting mechanism through better transparency and timely communication. This enables all stakeholders to identify and price the risks involved. This both keeps a check on systemic failure as well as reduces the cost in the event of a failure.
While capital norms and other prudential guidelines have to a large extent played a role in the prevention of disruptions, but even now and then there have been instances of market failures.
The Shadow banking sector in India has established its importance in the eco-system by both complementing and substituting the commercial banks. Commercial banks have enabled financial inclusion by providing access to bank accounts for savings, for somebody at the bottom of the pyramid.
And shadow banks have significantly enhanced credit access to those through tailor-made products suiting the needs of borrowers by creating a granular system for underwriting.
The financial accelerator model (Bernanke, Gertler and Gilchrist ) emphasizes the multiplier effect owing to improving access to finance. On the contrary, sudden stop or inaccessibility of finance creates havoc in the real economy. This is more of an adverse loop, where weak market accessibility adversely impacts the financing environment, subsequently, that spills over into the asset side, followed by the impact on the real economy, and further feeds into the market condition.
Therefore, developing a robust ecosystem for shadow banking is necessary for sustainable and inclusive growth.
Shadow banking sector are mostly dependent on commercial banks and market for liability financing. While conventional bank financing is lesser exposed to the market condition, on the other hand, market-based financing is susceptible to market volatilities. And in India, due to multiple factors like the structure of the balance of payment, the lesser loss absorption capacity of the economy and relatively lesser developed fixed income market, market condition is more prone to abrupt volatilities.
In general, investors tend to build higher risk premia, and perception plays a big role in that. And the perception of risk is no less critical than the actual risk. And the perception risk is mostly based on adequate and timely availability of information.
In one to one transactions like in the case of bank loan or Private equity, the information flow is relatively smooth and more granular. But for market-based financing, dissemination of information faces multiple roadblocks and often creates noise, which can trigger volatility.
Incrementally the importance of financial stability and targeted intervention to reduce the volatility has become state of the art for the central banks, what we have been observing amidst pandemic.
However, any intervention raises various challenges, like morale hazards, adverse selection, intertemporal consequences and choice of instruments etc. Many of these impediments could be addressed by a holistic approach and consistency in disseminating information.
In India, the need for an hour is to develop information and data custodian for shadow bankings. RBI being the regulator and custodian of banking sector data has demonstrated impeccable track records over the decades. It can actually mirror the approach for the Shadow banking sector.
Like, for commercial banks, RBI releases data with the frequency from daily to annual with proper structures and interval. Regular releases of banking system data have enabled the development of better stability in the banking system.
However, in the case of shadow banking, it has been annually or half-yearly (FSR). Though the listed entities publish financial results on a quarterly basis, the disclosures are not entirely uniform and methodologies are not consistent. Moreover, it doesn’t give a complete view of the sector as a whole. And the whole is indeed more than the sum of its parts.
Keeping in mind the criticalities of both liability and the asset side, this information could be made available at different intervals:
There is no doubt, intervention from the regulator is needed during crisis time to reduce undue volatility, but a self-developed system is good for sustainable development.
Macroprudential policies play a larger role in the financial sector, as they enable policymakers to be counter-cyclical while being cognizant of the integrated nature of the financial sector. Poor information disclosure is also the result of agency principal problem, and sudden fall creates more disruption than orderly destruction.
The market has the potential to enforce better practices through the reward and punishment mechanism reflected in the credit spread.
- By Soumyajit Niyogi Associate Director at India Ratings & Research – A Fitch Group Company