The US and Europe need to tighten their banking regulation and supervision

- Risk of dollar funding becoming more expensive

- India should take advantage of G20 chairmanship to promote Reserve Bank banking practices

The storm that destabilized the banking system in the US and Europe has now subsided. But this does not mean that there is relief. As sudden as this storm was in March, it could happen again at any time. A banking failure in the US and the near-failure of major banks in Europe will certainly affect the various economies. In such a situation, the world cannot remain untouched. As with monetary policy, we need to look at how banking instability in developed countries affects the rest of the world. Growth rates are expected to slow down in America and Europe. Slow credit growth will impact the Gross Domestic Product (GDP) and it will come down. A slowdown in America and Europe will also affect export demand, which will have an impact on the economies of other countries. Capital flows will become more uncertain and dollar funding will become more expensive for developing economies.

The International Monetary Fund's latest forecast of global growth at just 2.8 percent is just 0.1 percent below the January 2023 estimate. This seems optimistic as it is slightly smaller than the shock experienced in the banking sector. Failure to manage risk in banking will cost the world economy. Bank management and bank boards have been waiting for a long time. Now it is time to face the basic facts.

First, bank management takes unnecessary risks. The high liquidity on which banks operate also leads to higher payouts for risky bets for managers. Second, relying solely on bank boards to rein in bank management risk is wrong. The history of bank failures includes several bank board failures. Boards, whether banks or non-banking companies, do not have much incentive to perform. The wisdom and guidance that the Board's annual report speaks of does not appear.

Banking regulators and supervisors are responsible for monitoring the volatility of banks. Regulation should provide a framework where risk-taking should be avoided. Monitoring should ensure compliance. In both cases, US and European regulators are waiting. The failure of Silicon Valley Bank can be largely attributed to a failure to manage interest rates and market risk. The bank collected short-term deposits and invested them in long-term government securities. When interest rates began to rise, the value of government securities held by banks began to fall. But these were not the only risks facing Silicon Valley Bank. Credit risk also increased. The bank gave huge loans to startups. Liquidity risk was also very high. A major portion of the deposits were high value corporate deposits, known as bulk deposits in the Indian regulatory domain. This nature is volatile as compared to retail deposits.

It would be reasonable to suggest that the Indian banking system is better prepared to deal with these risks. Market risks like those experienced by Silicon Valley banks are unlikely to recur in the Indian banking system. The average holding of government securities in the Indian banking system is 29 percent of liabilities. Most holdings are held to maturity and are free from market risk.

The Reserve Bank keeps a close eye on the risk of centralization. It has set strict norms regarding the risk of borrowers. It is restricted when it comes to sensitive sectors like real estate, commodity and capital market. The Reserve Bank draws its immediate attention to any additional risks facing any industry sector or product. RBI's oversight of boards and management is more thorough than elsewhere. RBI approval is required for appointments to the posts of Chairman and Managing Director of banks. Generally it allows a tenure of three years but this period may be shorter. There are norms for board members of banks and members of audit and risk management committees. Most regulators limit their role to setting the pay and allowance ratios of chief executive officers. Apart from this, the Reserve Bank also does the work of exchange of fixed income of the Chief Executive Officer.

Two reports that the Reserve Bank provides to bank management are worth noting. Annual Financial Monitoring Report and Risk Assessment Report. This exposes the full extent of risk, system and process deficiencies and board performance and compliance deficiencies etc. Even those sitting on the boards of banks will speak of the high quality of these reports. RBI has also started examining the business model of banks. Reserve Bank Governor Shaktikanta Das also admitted this recently. Obviously this will be seen as micro management but it will also bring stability to the banking sector.

Western and other economies cannot bear such risk again and again. The US and Europe need to tighten their banking regulation and supervision. India should take advantage of the G20 chairmanship to promote the banking practices of the Reserve Bank so that other banking systems can benefit.