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Dr Viral Acharya on aggregation of risks in a financial system

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In a conversation with Nachiket Mor and Bindu Ananth, Dr. Viral Acharya, Professor of Finance at the New York University Stern School of Business, speaks on issues centring around aggregation of risks in a financial system, with an emphasis on those particularly relevant to the Indian financial system.

In particular, Dr. Acharya fleshes out three salient, and against-the-grain-of-current-thinking, points.

One, while scale does play an important role in allowing aggregators (Banks, Insurance companies, Monolines, other Government Sponsored Enterprises) to efficiently discharge their primary function as warehouses of risk, financial system designers must guard against the possibility that that systemic nature per se does not become a source of value creation (ie. through them consequently knowing that they have become “too big to fail” and therefore beginning to take on higher risk). To guard against this, financial system designers must thus encourage a diverse set of institutions to come up to play the role of aggregators. Thinking through resolution mechanisms for aggregators upfront and setting those rules of the game are extremely crucial. While corporate bankruptcy has become clearer post-SARFESI, individual and aggregator resolution mechanisms remain unspecified in India.

Two, while ensuring capital adequacy for aggregators is vital, Basel-type static capital requirements may not be adequate. He speaks at length about the formula proposed by him and others at the Stern school regarding setting capital adequacy in a manner that ensures aggregators remain well-capitalised in “plausible but sufficiently severe stress scenarios”. But where worst-case outcomes do materialise, two options are open: (a) allowing some aggregators to fail; and (b) using taxpayer’s money (ex-post, not ex-ante) to inject public capital into the system as the last resort.

Three, a fine balance needs to be struck between rigidity and flexibility in credit enforcement proceedings (be they at the ultimate firm / individual level or at any other level in the chain of transmission of risk). Too rigid an approach would defeat the purpose of the entire enterprise (namely, the orderly transfer of risk at market-determined prices to those who are most willing to hold it); too flexible an approach may lead to laxity in honouring of commitments. At the same time, he strongly emphasises that in an end-game situation where there is a “big blow-out”, the ultimate bearer of the risk has to be the aggregator – in other words, the present blame game in the American context on the “originate and distribute” model being flawed is invalid as the better option is to ensure that the design encourages aggregators to price in the cost of their being the ultimate risk-holder and thus impose arms-length discipline on originators (who are themselves of course ensured to be adequately capitalised, and who do provide credit enhancement in their risk-transfer transactions with aggregators to ensure their local information is appropriately factored in).

Dr. Acharya signs off making a few further points of importance to the regulatory structure of India: (a) that there might be a need for a separate regulator of systemic risks/systemically important institutions (in the way Dodd-Frank legislation has done for the US) – over and above prudential regulators and consumer protection regulators; and (b) states in India’s federal set-up should be subject to a minimum, non-negotiable standard in matters such as consumer protection to prevent a race-to-the-bottom situation where they end up competing to dilute regulation (c) the lack of a level playing field between private and public sector financial institutions will need to be addressed.

The entire chat transcript is available here. Prof. Acharya has recently co-authored a book “Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance” that looks at the US experience with GSEs in detail.

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