It’s broke, fix it

It’s broke, fix it

Article

1.  Ila Patnaik advocates  for an orderly mechanism for resolution of a financial firm. The weaknesses in the India’s financial regulatory architecture need to be corrected to prevent systemic risks.

Important Facts

2.  Infrastructure Leasing and Financial Services (IL&FS) is a large infrastructure finance company which is in distress as its subsidiaries defaulted on their debt. It is a NBFC.
3. A Non Banking Financial Company (NBFC) is a company registered under the Companies Act, 1956 of India, engaged in the business of loans and advances, acquisition of shares, stock, bonds, hire-purchase insurance business or chit-fund business. NBFCs are regulated by RBI.
4. Although RBI regulates the IL&FS but it did not have all the information required to understand the risk in total.  Similarly, when AIG, an insurance company faced distress there was no knowledge of who all will get hurt by its distress.
5. This situation can be prevented if we have established institutions that monitor and regulate systemic risks like systemic risk regulator and resolution corporation.

Lessons from Lehman Brothers crisis

• It revealed that failure of one company can cause a risk to the whole financial system.
• Need of a resolution corporation for banks and NBFCs.
• The financial firms and their real-time networks need to be monitored.

Too big to fail Firms

6. “Too big to fail” describes the concept whereby a business has become so large that a government will provide assistance to prevent its failure because not doing so would have a disastrous ripple effect throughout the economy.
7. It is considered if a firm is large it is too big to fail. Similarly, if a firm is deeply integrated with business of other firms it may be regarded as too networked to fail.
8. To prevent trouble in complex financial firms, the regulator must have the knowledge of who all will get hit if this firm fails and what will be the consequence of such failure. The regulator must have full picture of their assets and liabilities.
9. The Financial Sector Legislative Reform Commission in 2012 had recommended legislative and architectural reforms including a body that would monitor systemic risk.
10. The Budget 2016-17 had proposed The Financial Data and Management Centre to have the legal powers to collect all regulatory data along with sectoral regulators.

The Financial Data and Management Centre

11.Functions of FDMC:

• Standardise data from all financial sector regulators in a single database
• Analyse data and maintain a financial system database.
• Provide analytical insights based on the data to ensure stability in the economy .

Way Forward

13. The IL&FS exposes the weakness in India’s regulatory architecture.
14. Systemic reforms in the financial sector is necessary to ensure financial stability of the Indian economy.