Bindu Ananth [BA]: Let’s start with your overall thoughts on the top issues for financial system design in India

Viral Acharya[VA]: I have three points to make. The first is that we still have a very high penetration of the public sector banks in the financial sector, even though non-bank finance is picking up, bank finance is still crucial in many ways to our economy. What concerns me here is that, especially since the crisis, and the Fall of 2008 when there was a massive exodus of deposits from the private into public sector banks, and these flight of deposits are often permanent, it takes a long time for those who have lost deposits to get them back, so I am concerned that the odds have been stacked against the private sector much more sharply. State owned banks will always be more valuable from the standpoint of investors and depositors than any implicit guarantees that private sector banks may have. So I am concerned that there isn’t a level playing field in the fundamental cost of credit and capital for public sector banks. Of course that then stretches into the way branching licenses are granted, it seems, at least from casual evidence that perhaps rural branches are allocated on a preferential basis to public sector banks and so on.

So I’m not sure whether at a time when we do have 20-25% of private sector banking, we have now many world class companies in our country, why restrict our banks from becoming private and in some sense having the full capacity to capitalise their balance sheet because one unfortunate aspect of government stakes is that of course, capital cannot be raised against that easily. So the public sector banks, even in their current structure might not be at their optimal sizes. I would say this is a good time to think about privatising the sector itself in some significant way. Many countries have done this. Brazil privatised its banking sector, still there is one large public sector bank remaining out there. So that is one big thing I think could and should happen.

Second thing I would say is that across board, for banks as well as non-bank financial corporations, there isn’t a good resolution mechanism in terms of how we are going to deal with failure of financial firms. All evidence everywhere seems to suggest that failures of financial firms could potentially be more contagious. They could have amplifier effects on the real economy and because banks are opaque fundamentally they could also be harder to deal with, if they are not resolved when they are failing, evidence from Japan is that they could continue for a while as ‘zombies’ if not resolved quickly.

So I think while our financial sector is being developed and everyone says we want more forms of financial firms, we want them to have broader scope and we want them to be larger, that transition should not happen in an unmanaged way, which is we should simultaneously be investing quite a bit in a regulatory apparatus, as to how we are going to deal with these institutions when they fail, will we have the right mechanisms to intervene in a prompt and corrective manner, to get them to recapitalise in time or if that isn’t the best option, to get someone else’s capital to acquire these firms in time. I think it’s good to think about what to do in the end game when either an individual or a full scale financial sector resolution has to be done. I would say that’s my second point.

The third point I would raise is that, interestingly, the crisis hit India in a very unexpected manner, you know many of our corporations had External Commercial Borrowings, they were also reliant on banks from abroad for credit and when those banking sectors or countries got hit, they withdrew their savings from Money Market Funds, now we were worried about the Money Market Fund run, whether they would continue supplying short term credit to banks and so on. So it’s clear that even though when looked at in a very direct way our banking sector might look simple, given that our economy is now more complex, our firms are more complex, it is I think, becoming inherently more complex which is a good thing . I think it probably reflects that increasingly more and more financial needs are being met even if we haven’t gone all the way.

What I find substantially lacking however is good data, archives of good data on both Indian banks and the non-banking financial sector, data on credit markets based on various rates on an on-going basis, data which are sometime qualitative and survey based, what are the current credit tightening conditions in the economy, dealers and investment banking – what kind of cost of credit are they facing, are they experiencing a tightness, you can think about small business lending conditions, so both as machine readable data in terms of understanding the behaviour of the financial sector to policy changes to changes in our growth, the conditions of the economy.

Second, data on the conditions in credit market so that we can understand what happens when a crisis takes place, how fragile certain sources of funding in the economy look like, and third do the policy makers and industry itself have almost real-time indicators in the aggregate of the how credit conditions are expanding or tightening? I think these kinds of data can help one understand the financial sector better, help us understand what are the spots of fragility and if we had to move in the direction of council like one that is being proposed that might be able to do macro-prudential surveillance and regulation, what kind of stress-tests do we want to do, what kind of data do we need to analyse that, I think we need to make a big push in data.

I think CAFRAL which is being set up under affiliation with RBI to start with at least, I think this could serve an important role in this with respect to the banking and credit markets, through the exchanges and other things we will have data on the capital markets coming, I think we need to create this massive data sets on India wherever possible historically and get researchers the world over analysing these things so that we learn better about our own financial system

BA: At the forthcoming IFMR conference, we are going to have one session where we will spend some time looking at the aggregators in detail; aggregators are, in some sense, large wholesale institutions, large balance sheets, a subset of which could also be systemically important entities. As we go into the conference, what would you say are some of the questions that we should be talking about when it comes to thinking about the wellbeing of aggregators in the country?

VA: Broadly I would say I like the model of aggregation, which is to preserve information advantages of the local banking or local intermediation, whichever way it’s organised, but to get the benefits of diversification of risks at the same time. What the evidence seems to suggest however is, take the example of Fannie-Mae & Freddie Mac, take the example of countries that just had two or three very large banks altogether, almost the size of their GDP or larger, however you don’t want to push the diversification advantage all the way, because 1. many times these entities become unbelievably large for their own good in terms of ability to manage them, 2. they become extremely hard to resolve if you have a full blown crisis and three, they perceive that they are in fact too large and too systemic to ever fail and the cost of this is that they actually overextending intermediation by willing to take whatever kind of loans or underlying credit that the originators might be creating.

So my sense is that local banking generally starts deteriorating in its quality when its end holders, which are often the aggregators, are actually relaxing their credit standards because their risks are not being priced fully, because they might be perceived to be too big to fail or too systemic to fail. So in terms of aggregators, I would say one, we need to create, while the aggregators are developing, say large banks, large insurance firms, other kinds of aggregators for non-bank financial intermediation we should simultaneously invest in building a good regulatory apparatus for them. By that again I meant the same points I mentioned before, how should we capitalise them, the goal should be to focus on if there is an aggregator’s risk which is really the aggregate risk, and so if there is a stress in the aggregate economy, what kind of losses are aggregators going to face and do they have adequate capital to deal with plausibly reasonable stress scenarios, not like the end of the sovereign itself but may be a significant shock to the financial sector?

Second, I think we need to think about resolution of these aggregators, as I said if the aggregator is the aggregator of the entire country by definition it’s hard to resolve them. So we need to think about what is the right architecture, maybe it’s not more than 10% or 15% of the total intermediation size and then, how are you going to deal with them. Do we have some automatic stabiliser; does the regulator have some pool of fund created in good times to deal with any capital injection that might be needed? You need to create a thriving for getting capital from elsewhere, so you might want to do M&A kind of activities at that point as well.

And the third thing that I would highlight on the aggregators is that no matter how hard you try, of course, you have to recognise that whenever you try to regulate an entity, the entity will try to respond to that regulation. They will figure out the rough rules of thumb that the regulators are using and try to get around them, so I think there is some basis for controlling the level of credit right at the end level, this could be in the form of loan to value restrictions, certain things on the quality of the borrowers, it’s very often found that just requiring documentation actually works to the good of the originators themselves because it gives them information. So if you are in a period when credit is relatively easy, it’s tempting to even extend credit where you can’t really document things easily, but forcing some kind of documentation requirements might improve transparency to the aggregators and enable actually the quality control along the pipeline from originator to the aggregator.

So I would say worrying about their resolution and capitalisation, worrying about end level credit itself quality directly is a second line of defence, and broadly speaking I think being prepared for a full blown shock. I would say the regulators shouldn’t be in a position of panic and just being caught by an unexpected shock. They should forecast what’s likely to happen and see if they build can some defence against this.

Nachiket Mor [NM]: Aggregators are institutions that are ultimately warehousing risk. What are your thoughts on the optimal size and structure of these institutions?

VA: If you allow naturally a diverse set of institutions to come up, you might actually get a slightly better sharing of risks. When people are getting hit, it’s not like there is only one group of systemic institutions and they all are going to fail at once because they look exactly the same. If there is a run on one, every one interprets there is going to run on everybody. I think the model of having a number of these players out there is a good one, for origination, risk transmission and aggregation. While its useful to have a reasonable size in the aggregator because you need that to be able to aggregate and benefit from aggregation and be able to get reasonably well rated securities and to actually sell them in the capital market etc., there is also this issue of having the right level of competition amongst them or just innovation in what they are doing, how they are doing, thinking about clever methods and so on. I think it’s a somewhat underappreciated fact, and people who talk about, for example, the benefits of GSEs (Government Sponsored Enterprise) in the US, they always keep talking about the benefits of standardisation, but my sense is, they could have done this standardisation just at half-a-trillion or one trillion. You didn’t need to let them grow to five trillion, I don’t know, if from one to five trillion, you’ve got any incremental benefits.

NM: And your concern is that the GSEs might have squashed innovation in the US housing context?

VA: Yes, they might have, because no one else can now get in, once they are like two trillion in size, and they are perceived to be the safest guy out there. The main issue with all these aggregators, (because this comes up when you think about clearing houses of derivatives, mono-lines, AIGs of the world and so on) is really that there will be some aggregate shocks, and even if it is not because of some moral hazard reason, there will be situations in which these aggregators will get hit by, say, the second-loss which they will have to provide.

The key issue to watch out for is that the systemic nature per se must not become a source of value creation.

NM: You mean, they don’t start taking excessive risk on their books because they know that somebody will bail them out.

VA: Exactly. What are your views on the resolution/bankruptcy mechanisms in India for Originators and Aggregators? My understanding is that they are not very well developed?

NM: As far as non-bank originators (NBFCs) are concerned, they do not have access to lender of last resort function. Therefore, their resolution is pretty straight-forward. There is a history of it.

My understanding is that there is a problem is in two places. One is individual bankruptcy is not very clear, particularly if you go down the income spectrum. What is the individual limit, how far can you go, what is the maximum you will be allowed to do? There is no clarity there on what is acceptable practice, both regulatorily as well as politically. The other problem is vis-a-vis Aggregators. Banks, (including cooperative banks) who have access to lender of last resort functionality. I have never seen a bank fail.

VA: It’s always a merger, isn’t it?

NM: Yes. In a way, branch licensing also serves to increase the value of bankrupt institutions. Fortunately now, post SARFESI, corporate bankruptcy has become much easier now. So it’s not that it’s hard to get corporate bankruptcy proceedings in place and RBI realised that to get consensus among bankers was the problem. So they created the corporate debt resolution mechanism, in which if more than 75% of the banks agreed, the balance would have to agree, they wouldn’t have a choice to hold up the proceedings.

VA: My thought was that, maybe while you are actually doing this inclusion work, whether it’s a good time to simultaneously think about possibly, along with advocacy, what kind of institutions we could set up, whether it’s a good time to also think about the very end laws or procedures that are going to be relevant to deal with, say, an individual bankruptcy. Similarly, what is the procedure in place, because sometimes it might be that the best way to resolve an NBFC is not to actually wind it down, but to actually get someone else to acquire them, someone else who has better capitalisation around them etc. Of course, there is a trade-off here, because ultimately in your design, I think it sounds right that you want like a local institution, which has the expertise of servicing?

BA: True, but the capital need not be local

VA: Right, I think it may be worth thinking through these issues a little bit now. The evidence on the personal bankruptcy, I think it’s a delicate balance, and my sense is that by and large I have found that what you just described, like the SARFESI in case of corporations is that, the usual problem, at an individual level, there is a tension here because you want them to take risks but you don’t necessarily want like a full-fledged leverage boom taking place. Now in the context of Europe, what you found is that even though they had a housing boom, no one talks of foreclosure crisis in Europe. That’s because all these bank mortgages have recourse, so they can go after the savings of these households. They have full recourse. US mortgages, by and large they are not. What has happened is, even in states where you can exercise recourse, the lenders typically don’t go, because there’s a very adverse reputational consequence that you are a bank that goes after its customers when they fail, because the law doesn’t require recourse. It’s hard for someone to create a recourse mortgage of their own. The only entity right now in US that’s about recourse is actually Fannie Mae and that’s because of pressure of paying 10% dividend to the US treasury and they’re saying they can’t afford foreclosures.

My sense is that ultimately, people will adjust to whatever is the law. But I think it’s probably useful to have the law, whichever direction you lean it towards. I think, in a model when I write down these things what I generally find is that, if there is an aggregate problem, you actually want the flexibility to restructure contracts, you don’t necessarily want to have a case where it’s too tightly structured.

You need a fresh start, basically. You need to be able to tell these small or medium sized enterprises, household borrowers that we are starting the game again, that we are going to rewrite your debt and start again. Usually, that should happen on its own, which is that the banks or the end originators should actually recognise that listen, going after their savings doesn’t help me, because I am actually destroying their ability to operate their business in future. So there, the resolution of these entities, the originators themselves becomes very important, because what you find generally is that, if there isn’t a good mechanism to shut them down, and if there isn’t a good entity that is supervising their losses, they don’t want to take any write-downs, because now they become ‘zombies’. Because they know that when they take write-downs, their creditors will actually run on them and shut them down. Of course this is a delicate sword, the opacity will help because the creditors will give a little bit of leeway. But, we could also have the reverse problem, where they actually continue to let the households, suffer at very high levels of debt, because if they take any write-downs, and they can’t transparently raise capital out there, then its problem because they will face a run.

NM: Very interesting, what I am understanding you say is that there will have to be a good mix of rigidity and flexibility. If the design is too rigid, then over a period of time, it will feed forward into either risk aversion so the whole point of having originators on the ground that can take risks will be defeated, because they know that when things go wrong, they can count for nothing. There will be zero moral hazard but there will be then the whole underlying purpose will disappear. On the other hand, you could get good risk taking, but extreme rigidity in the face of an aggregate shock where for e.g., if the entire monsoon failed for two years in India, now you know it’s an aggregate shock, the right answer would be for the originators to understand that when the talk to their customers they insist on the letter of the contract. Nothing is going to come because the customer doesn’t have anything. If on the other hand, they renegotiate what you are saying is, equally therefore, the rest of the system should have the flexibility to let them renegotiate and allow them the time.

VA: Therefore at some level their capitalisation becomes very important so that they don’t run into this problem. The ‘zombie’ problem arises only if the capitalisation is very small basically, because they you run out very quickly and even if you fail, most likely you will have to merge. Now merger is fine socially, but is terrible for the guy running the NBFC.

NM: And terrible for the guy who borrowed from the NBFC because it’s not as if there is surfeit of players there. Natural limitations of the market will ensure that there is only one credit union serving that community. You shut him down, you basically cut off access.

VA: That is also one of the reasons why to the extent possible, you may want to let mergers happen because you want the capital to flow in rather than saying ok, if this entity fails, now let’s create a new guy from scratch, because you know , the new guy may not able to float capital that easily or raise capital that easily.

NM: So what you are saying, when we look at the recent Andhra experience with microfinance, it is a very interesting microcosm in which this thing played in the way that you felt if you had thought about it earlier it should have not have played out. What happened was, aggregate shock Andhra govt issued an untenable guideline. Banks insisted on repayments from MFIs. Many MFIs have now turned zero capital, undercapitalised, they don’t have the right to go ahead and push customers because that is being prevented by law, so what is the alternative? They will go belly up. Outstanding institutions with no problems of underlying quality of origination are just going to disappear.

BA: Andhra is a bit of a specific situation but if you think about aggregate shocks like rainfall, I guess at least part of it is what is the originator’s capability to manage that risk and therefore to credibly re-negotiate with the customers for example, if there is a rainfall shock in one region, and assuming the originator wants to renegotiate, I think it also goes back to the question of do originators have mechanisms to then transfer out the rainfall risk?

NM: Supposing you renegotiate with your client, and you tell the client I will give you six more months. You have a cash flow problem. What if on the other side, you had borrowed money from a lender, who says I don’t care, you pay me. Then what happens is either you have lots of capital that allows you to renegotiate and honour that guy or alternatively, you die. Because you run out of capital very quickly, how will you fund the reschedulement.

VA: When this is happening across the board, the need to renegotiate at the very end level, you need to give them a fresh start because otherwise, you are killing its growth in the first place. This is the scenario in which the aggregator is going to most likely take a second loss because these guys need to renegotiate. This is an ideal scenario. Sometimes you want the aggregator to actually be hitting its aggregate loss in the sense that they are the ones who actually absorb it. This is the real benefit of them actually diversifying risks across. In spite of that, you could have just a massive aggregate shock because of whatever uncertainty we discussed. So the real risk I have observed is often not at the small NBFC that is actually doing the origination and then maintaining etc. because really that’s in some sense if they blow up it’s the end of the story for that guy.

Once in your model the end game of when there is a big blow-out who is the ultimate bearer of the risk, it’s going to be the aggregator. Unless the aggregator, because they don’t want to take the second loss, also now start pushing down the zombie problem or the aggregator starts betting on systemic risks in good times, saying who cares what my second loss is going to be, I am always taken care of. Then they will ensure they will not actually put the right arms-length discipline on the NBFCs who are selling them the risk for pooling and securitising. Everyone in the US is blaming the ‘originate and distribute model’. Our view is exactly the opposite. Our view is that originate and distribute is how we should be managing these risks. There is no way that you can get the benefits of pooling and the liquidity the capital market can provide for securitisation and at the level of an individual originator.

What is really important is to ensure that in the pipeline of this securitisation, the end guy who is actually the bearer of risk, they are basically regulated in a prudential manner, because if they feel they can do hara-kiri and just gamble then all the incentives along the pipeline to NBFC and then from NBFC to the SME or the borrower is going to get completely corrupted, because it’s all going to be how much is the aggregator charging in the end for the risk that they are taking on and if they are taking on a ton of risk, they don’t care about what risk they are pushing out in the market, because they are ultimately, even if they take second loss, they are going to get subsidised. They are going to let the quality of origination deteriorate along the entire pipeline.

BA: So you don’t think in the US crisis, the moral hazard originated at the originator’s level which is to say that for whatever reason because they didn’t have enough capital riding on it they didn’t monitor that portfolios well and so on? Is that a view that you are rejecting?

VA: No, I am saying that you have to deal with their capitalisation also but the aggregator will also actually impose very important discipline on the originator.

NM: In India, there is a reverse concern. The Regulator worries that if the credit enhancement is given by the originator, then the incentive for the aggregator to do any due diligence on the asset disappears.

VA: No there has to be some credit enhancement from the originator, because there is a moral hazard there and ultimately you want the local guy because the local guy knows. I was just saying that if the aggregator however has the right incentives, he will actually require the right credit enhancement from the originator, saying listen, I can’t take all of your risk because ultimately information is with you. So how am I going to know whether you are selling me the right stuff or not?

My big thought was that ultimately in the end, something like this according to me can blow up in a big way only if the aggregators are basically not holding adequate capital and because they are systemically important they might have incentives not to hold adequate capital on their own. If their resolution of what is going to happen when they fail is not adequately spelled out, it’s very vague and ultimately it will become an issue that goes straight back into the govt or something, then most likely the will perceive that we will get some injection of some form somewhere. And then they might actually be willing to start accepting certain kinds of loose practices in the chain down as well.

I was just saying that while you are developing the model, it may be worth thinking about suppose in the end game, the second loss piece gets hit and some creditors of the aggregators starts getting worried do we have a resolution mechanism to deal with this problem that has enough play.

NM: Enough but not too much, so that one can be somewhat countercyclical but not overly so.

VA: My sense is that whenever you have an aggregator, you can always design a state of the world in which they are too systemic for them to fail completely.

NM: One point you’re making is don’t let the systematically important aggregator to get so big that there is no innovation, there is a sense in which there is a limit beyond which whether it is 10 per cent of financial system size or 5 per cent and the US has a 10 per cent limit for banks. You cannot get bigger than 10 per cent of assets. Is that the kind of thing you have in mind?

VA: Basically I am saying is that you could make a GSE kind of argument, that no, I really want to exploit diversification so much that I really want one entity across the whole country. But according to me, that brings with it a very serious concern, that if you have a very bad cycle or an aggregate shock all across, you have no choice but to bail out this entity, because the whole country goes down. But that will also happen sometimes, the bigger problem is that they may actually create this possibility rather than actually guarding against it because they know that they are going to get bailed out. Whereas now, if you allow for some geographic diversification but keep enough aggregators across the country, yes you are compromising on some benefits of reducing cost of capital.

You are just creating one giant, its failure is going to create a havoc basically.

NM: In some ways what you are saying is, the regulation of aggregators is key because that is what we’ll feel. Even in the way we are thinking of, if RBI tomorrow tells me I have no regulatory capacity to manage 12000 NBFCs, what we are saying to them you don’t have to manage. It is the aggregators who are acting as internal regulators. You don’t have to get into and say I will manage 12000 NBFCs.

VA: Exactly. At the extreme level, you could push the argument to say why doesn’t the RBI directly go and regulate what corporations are doing. It’s one less layer because now you have another finance company but suppose you suppress the household and just think of the finance company itself as the real economy, yes, we don’t want RBI to go and regulate operations because ultimately you want to regulate these big pockets of risk and ensure they are pricing risk in the right way because then they will do the right thing down the road.

NM: I think it’s a very powerful point you are making. Incentives of aggregators to adequately monitor all its counterparties, whether it is NBFCs or companies, must be preserved. RBI must not try to undermine those monitoring mechanisms.

My question is, in what way, are there models or ideas we can look at? How does one design this? Because the experience of regulation of aggregators very much seems to be in the opposite side. One direction is to make aggregator performance fully transparent, through publishing NAVs and so on. But with that will come rigidity because then it becomes so visible that the aggregator will lose all sense of flexibility. They will simply become like a mutual fund. But that’s not what you’re saying. You’re saying there is a benefit to having a bank-like structure and an RBI type regulator because then they can collaboratively sit down and ask the question what is the right response? And the response may not be easily anticipated. The rainfall risk, we know it is a known uncertainty, we can hedge against it. But there may be un-hedgeable uncertainties that come up, aggregate shocks that we have not planned for. You have any ideas as to who has done this well?

BA: As an add on to the question, in your own assessment where are some of the weak spots in aggregator regulation in India that you think we should be anxious about?

VA: Personally my view is that the Dodd-Frank even though it has many pitfalls is actually not a bad model for aggregator regulation, because it requires two things. It says that the two critical things are what capital and liquidity requirements you are going to require of the aggregator in good times. It actually requires that the aggregators should be clearly identified by the regulator. They need to do some work to figure out which aggregators are systemically important, so that’s the first task they have to do. Then they need to figure out how much capital and liquidity to charge of these aggregators. My sense is it can only be done through a stress test. What you have to take a stand on is that the scenario in which multiple NBFC are going to collapse all across India, hypothetically, let’s say there is a 60 per cent collapse in the stock market for example, or two years contraction of GDP or 40% collapse in house prices across the country, whatever the scenario is, you want to ensure that even in such a stress scenario if the aggregator has to meet capital call for the kind of write downs you would want to allow at the end mortgage. For the second loss, that they should be prepared to take in such a scenario they have to now meet that second loss with some capital call. Now what we have done at NYU is to say let’s assume that as long as the aggregator maintains at least an 8 % capitalisation at that point, so its leverage doesn’t exceed 12.5 is to 1 in the end state.

BA: So, not Basel type static capital requirements?

VA: Yes, that’s our main departure from Basel; that aggregator regulation should only be about ensuring that these guys remain well capitalised in plausible but sufficiently severe stress scenarios. I am not saying you talk about complete default of the country, because you don’t want to hedge against that state, it’s too expensive. But you do want to default against a reasonable stress scenario, which is the scenario in which you want the system to function well and so the capital requirement for the aggregator will be based, according to me, at a much higher level than saying currently you be 12.5:1 because you want 12.5:1 of leverage not to be exceeded actually in the stress scenario. Now, even in spite of this, there is a chance that worst outcome than that happens. Now in that scenario, you have to have a system in place to deal with the problem. In that scenario, we could have two kinds of outcomes, one is that only some regional aggregators fail. Then you could actually have a resolution mechanism again like an FDIC, you could think about one aggregator potentially taking on the other but subject to the risk that we mentioned that ultimately the goal is not to have just one big aggregator out there. Therefore in the end game, one has to almost accept that there will be states of the world in which you have no choice but to actually inject some public capital into the system. But I feel that is the precise reason you won’t want them to ex-ante hold capital against stress scenario but ex-post you may have to then beyond that stage, if it occurs, you may have really not much of a choice.

Now you may want to counteract this in some way by not being just an aggregator regulator but by thinking about something of what’s happening in the end space. In the housing market, we said that maybe you should actually not allow higher than 80 -85% loan to value ratio.

NM: Because implicitly some capital is preserved there..

VA: Exactly. That now becomes the end regulator’s second line of regulation because they are saying ultimately the aggregator could go bust and in those states, I have to inject capital. Let me just accept it. But now the real risk is that the aggregator exploits that and lets certain kinds of weak loans start to develop in the end game, so now let me just put some kind of a curfew there. And then have two layers of defence and beyond that if it happens we will have to deal with it. But that’s been our model, which is well regulated aggregators with clear resolution authority over them and one big part of resolution authority I would stress is that the regulator of the aggregator should be able to take them over before bankruptcy. You should be able to take them over if their capitalisation goes to 6% because at 6% capitalisation, you may be able to sell it to another aggregator. But if you have let them go below 6% once they would already start reflective zombie kind of behaviour so the incentive problem has been allowed to fester already and it may be very hard for another aggregator to take them on at this point because they now don’t trust at a 3% capitalisation what kind of skeletons are sitting inside.

So there has to be a clear resolution authority which has prompt corrective action. I can predefine what the schedule of penalties is.

NM: What you’re saying is Dodd-Frank has thought through this?

VA: It has thought through this except that what I disagree with them a little bit is that their view is that when one of these aggregators or a SIFI (Systemically Important Financial Institutions) when it fails you want to just do liquidation outright. And then, their thing is that some liquidations will be costly so you may have to inject taxpayer money because there was a political backlash from the aggregators they said no, don’t charge tax, don’t charge any premiums upfront to create a pool of funds in this resolution of aggregators, charge it ex-post. But now that’s a bad incentive design.

So that was the last piece which is that the resolution authority of the aggregator will need some funds. Now you could say this is ultimately tax payer money and I could just draw it down at that point, what we recommend is to actually however take an ex-ante view and set it aside and you could either charge it in the form of capital requirement or you could charge even as a premium if you want, like how deposit insurance premium should be charged, because you are going to need some tax payer fund in a systemic scenario you could have basically designed something like that.

A large bank will also only fail most likely when there is a systemic scenario. Otherwise they should be reaping the benefits of diversification substantially. If they don’t have deposits, their funding structure might not be as fragile as otherwise. In principle you could take account of these things in stress analysis of how much capital they should really be holding. In the US they have also been proposing this thing where the debt of these aggregators has a clause that in a systemic scenario it automatically converts partly or wholly into some equity. So now they will price the aggregator’s systemic risk into the debt.

BA: What are your concluding thoughts on the overall regulatory architecture in India? What changes would you like to see?

VA: There might be a need for a separate regulator of systemic risks/systemically important institutions in the way Dodd-Frank has done. This would be over and above prudential regulators and consumer protection regulators. India also needs to prepare to carry out stress tests of the kind being thought of elsewhere for its systemically important entities.

NM: What is your view on regulation by states, particularly of consumer protection?

VA: There must be a minimum prescribed that is non-negotiable. States can follow more stringent norms but we should guard against a ‘beggar-thy-neighbour’ situation if states compete on diluting regulation. Then, there is the matter of expertise in regulation.