Boosting organizational and systemic resilience
Banking Frontiers|October 2021
Mahesh Kumar Jain, Deputy Governor, Reserve Bank of India, gave a speech titled ‘Building a More Resilient Financial System in India through Governance Improvements’ on June 18, 2021 at the India international Centre, New Delhi. Edited excerpts:

A resilient financial system is one which is able to absorb the impact of endogenous shocks it is exposed to, rebound quickly to the original condition or adapt to new environment, and continue to perform its role of providing financial services. Whereas a stable financial system is one which is able to absorb shocks, a resilient financial system will be able to adapt and reconfigure itself in response to a shock, in addition to absorbing it. Unlike stability, resilience makes no assumptions about the magnitude of possible shocks, but rather looks to build systems that can deal with the entire range of shocks.

MORAL HAZARD AND RESILIENCE

Absence of moral hazard plays a substantial role in building a resilient financial system. Why would a bank invest in building a robust risk management system if in extreme cases, taxpayers’ money would be used to rescue them. Shareholders of a bank will have incentive to seek better governance and risk management capabilities only if their investments are at risk. Similarly, employees of a bank should also have skin in the game.

RESILIENCE IS A COLLECTIVE EFFORT

Building a resilient financial system is a collective effort and cannot be left to regulators alone. While the regulators contribute majorly by framing appropriate regulations, a tick box approach to risk management by the banks would mean that the market’s wisdom is replaced with regulator’s wisdom. Regulations provide for minimum requirements to be met by all regulated entities. Hence, a resilient financial system requires contribution from all stakeholders - depositors, borrowers and investors - to achieve a resilient financial system.

Mahesh Kumar Jain

LEMON PROBLEM – INFORMATION ASYMMETRY

Another important feature of building resilience in the financial system and improving the credit flow is reducing the incidence of ‘lemon problem’, which requires improvement in governance at the borrower level also. A lender who cannot distinguish between the borrowers of good quality and bad quality (the lemons), will only make the loan at an interest rate that reflects the average quality of the good and bad borrowers. As a result, high-quality borrowers will be paying a higher interest rate than they should because low-quality borrowers pay a lower interest rate than they should. Consequently, some high-quality borrowers may drop out of the market, with what would have been profitable investment projects not being undertaken. The ‘lemons problem’ also impedes banks’ ability to anticipate risk build-up in their portfolios due to borrowers withholding information from their lenders.

TOOLS TO ENSURE RESILIENCE

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