It becomes evident that in all the past financial crisis situations, central banks (most often the regulators and supervisors) were extremely ill-prepared for the impending crisis. Of course, while their incoherent responses added in a great measure to the uncertainty and panic in the financial system, a major problem was that early warning signals were either not there or, at best, not clearly discernible. Sometimes, these early warning signals were available but ignored and shrouded in conflicts of interest that were at play. This happened, in particular, because of the seamless exchange of people from the financial services industry to the regulatory domain and vice versa, through what is commonly called the revolving door and reverse revolving door phenomenon.
In effect, we had what can be called regulatory and supervisory failure coupled with a serious breakdown in accountability and ethics, right from the grass-roots level to the corporate boardrooms, and regulators and supervisors, who (all) sat and watched as Icarus continued to fly high. In turn, this had an impact not just as disastrous financial consequences, but it also led to a serious erosion of trust in the financial system and all of its constituents, including regulators and supervisors, by the public at large (including customers, depositors, investors, end users and others).
Take the Infrastructure Leasing and Financial Services (IL&FS) case that created havoc in 2018, for instance. The concerned central bank is reported to have flagged the issue of negative net worth of the holding company as long as three years ago—yet they themselves did not act for a good solid three years, by which time much of the damage had been done.
Wonder why the central bank did not act on time in the IL&FS case? Given IL&FS’s huge size and enormous outreach, it was the government of India that decided to supersede the IL&FS board and salvage the company. I truly commend the government of India for its action because the concerned financial service regulator was still playing a wait and watch game.
Having set the context, we can safely argue that, as compared to the past financial crisis situation (e.g., the US subprime of 2007-08), today’s institutions are larger and riskier.
Therefore, we can no longer afford to have regulatory and supervisory failure. Part of the problem is that with the burgeoning growth of institutions and their portfolios, as well as clients, the information coming to the regulators and supervisors is what I would call information overload. The larger the bulk in compliance reporting, the lesser the chance of spotting exceptions and the greater the chance of mismanagement or fraud, leading to a full-blown financial crisis.
That is exactly the case with IL&FS and may be the concerned central bank could not spot all the undesirable happenings among the maze of information flowing from IL&FS—perhaps it was this that prevented them from acting and maybe there were conflicts of interest too. Imagine, if IL&FS had been allowed to collapse, what would have happened? With consolidated debt in excess of Rs1,064 billion as on 31 March 2018 and almost 25% of this debt being in short-term borrowings, I shudder to think about the number of institutions that would have been affected.
If only the central bank had taken concrete steps when the negative net worth had been spotted three years prior to 2018, the IL&FS situation may not have deteriorated to the extent it did in September 2018, when it and its subsidiaries defaulted to SIDBI on their repayment. With so many powerful people on the board of the IL&FS, it could have been easily possible for IL&FS to reach out to the regulator and stall for more time. But that is a mere supposition and stream of thought that needs to be thoroughly investigated by the government of India.
Coming back to the main point, the maze of information flowing from IL&FS may have overwhelmed the concerned central bank and prevented it from acting.
The larger point here is that, with many more institutions today and a lot of information flowing in, off-site supervision will become an even more difficult task. And the advent of COVID-19 makes central banks less able to use on-site supervision and so, they have to rely almost entirely on off-site supervision. Given this situation, off-site supervision will become a very difficult job. Therefore, what can central banks do?
They can use smart RegTech tools that will help them pick up early warning signals about impending crisis situations in the financial services sector, and information on the key aspects that caused the past financial crisis in the first place—things like whether the compensation policy is rewarding the quick deal (short-term) when the risks are medium or long term, or whether conflicts of interest are causing a financial institution (and other stakeholders) to go rogue, or what the real (hidden) leverage of a financial institution is, after taking into account all aspects such as off balance sheet items, etc. All of these are applicable to the 2018 IL&FS case, the 2018 PNB scam, the 2007-08 US subprime and the 2010 Indian microfinance crisis in Andhra Pradesh (AP).
And that is where the current applications of RegTech for regulation and supervision fall short—they primarily center around know your customer (KYC) and anti-money laundering (AML) and other such compliances, and this is akin to skimming the market. To realise the full potential of RegTech (especially machine and deep learning), two crucial things will have to happen.
One, central banks, as well as other regulators and supervisors, will have to remove any ambiguity in rules and circulars to their constituents. The discretionary power of the regulator and supervisor will also have to go so that the rules governing the game are crystal clear and not subject to interpretation and the whims and fancies of the regulator and supervisor.
Two, machine and deep learning, on their part, will have to develop the ability to discern causality (as opposed to mere correlation and association) to have greater predictive ability for regulators and supervisors. It is the fusion of deep domain knowledge of the financial sector and strong technical knowledge with regard to machine and deep learning that can lead to practical, usable regulatory and supervisory tools with enhanced predictive ability.
RegTech is in its infancy and requires significant effort, from both regulators and supervisors and information technology (RegTech) firms, before greater strides can be made with regard to the use of machine and deep learning in regulation and supervision (of financial services) and to specifically achieve the objectives set out above—i.e., provide early warning signals of key aspects going wrong and periodic information on exceptions in key factors, both with a view to preempt and prevent a financial crisis.
Let me give you some examples here.
One aspect is the need for smart RegTech tools to isolate the impact of compensation—in financial conglomerates, investment and commercial banks and other financial institutions—in terms of whether they are rewarding the quick deal and short-term gain, without consideration of the long-term consequences.
In my opinion, the tool should be able to decipher from the maze of data available whether the compensation system and incentives encouraged the big bet—right from senior management through middle to lower management levels—that, in turn, would have a ripple effect on the organizational culture in terms of enhancing needless risk taking. Learning from past crisis situations, regulators and supervisors have to be most concerned with this and RegTech would be playing a crucial and proactive role in regulation and supervision if it can help spot these trends early.
The case of the 2007-08 US subprime financial crisis—where compensation systems directly led to the crisis by encouraging short-term performance with unheard of incentives and compensation, when, in reality, the risks were mostly medium- and long-term—is still fresh in our memories. Likewise, the 2018 IL&FS case—where the key management personnel got hefty compensation in 2017-18 when IL&FS had a consolidated debt in excess of Rs1,064 billion (as at March 31, 2018) and loss of Rs18.87 billion during 2017-18—is something that cannot be forgotten. The key management personnel were Ravi Parthasarathy, Hari Sankaran and Arun K Saha in 2017-18. Ravi Parthasarathy received over Rs204 million as total emoluments while Hari Sankaran and Arun K Saha received about Rs77 million and Rs69 million, respectively.
Smart tools from RegTech will go a long way in helping to understand compensation trends and patterns as they arise and help regulators and supervisors (read as central banks and banking supervisors) keep in check excessive risk taking by firms that leads to crisis situations. The presence of such a tool will help make regulation and supervision more effective, efficient and timely in terms of action on the ground.
Yet another example comes from the FCIC report
: “In the years leading up to the crisis, too many financial institutions … borrowed to the hilt, leaving them vulnerable to financial distress or ruin if the value of their investments declined even modestly. For example, as of 2007, the five major investment banks—Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley—were operating with extraordinarily thin capital. By one measure, their leverage ratios were as high as 40 to 1, meaning for every $40 in assets, there was only $1 in capital to cover losses. Less than a 3% drop in asset values could wipe out a firm. To make matters worse, much of their borrowing was short-term, in the overnight market—meaning the borrowing had to be renewed each and every day. For example, at the end of 2007, Bear Stearns had $11.8 billion in equity and $383.6 billion in liabilities and was borrowing as much as $ 70 billion in the overnight market. It was the equivalent of a small business with $50,000 in equity borrowing $1.6 million, with $296,750 of that due each and every day.”
The similarity of the above to the IL&FS case which came almost a decade later (in September 2018) should not be missed. Specifically, in the IL&FS case, it would be an understatement if I said that the concerned central bank in India could not spot the excessive leverage of IL&FS—its debt as on 31 March 2018 of over Rs1064 billion was layered on equity of just Rs 69 billion. If that is not excessive leverage, I wonder what is.
And what needs to be noted is that this leverage was well disguised and hidden—in derivatives positions, in off-balance-sheet entities, through window dressing of financial reports, etc. The larger point here is that if regulators and supervisors could have had access to smart RegTech tools that would have alerted them of the IL&FS case much earlier, a lot of damage could have been avoided. Thus, a smart tool to help unearth the (real) hidden leverage of investment banks and other financial institutions would add great value. This again is a fantastic opportunity to create smart tools for better and more effective regulation and supervision of banks and FIs.
The crucial aspect of conflicts of interest, responsible for the 2007-08 US subprime crisis, is another case in point. Conflicts of interests are a major regulatory concern because where conflicts of interest exist corruption could rear its ugly head (if the conflicts of interest are not well identified in a timely manner, they cannot be managed appropriately).
Here are some examples of conflicts of interest from the FCIC report with regard to the 2007-08 US subprime crisis: a) conflicts of interest among rating agencies in evaluating collateralized debt obligation (CDO) deals; b) underwriters assisting collateralized debt obligation (CDO) managers in selecting collateral; c) hedge fund managers selecting collateral from their funds to place in CDOs that they offered to other investors; d) a conflict faced by a large financial conglomerate in offering ‘liquidity puts’ that gave it huge fees in the short term but placed significant financial risk on it in the long term; and e) the settlement that the securities and exchanges commission (SEC) reached with a large investment bank, in which that firm paid $550 million to settle charges filed by the SEC, and acknowledged that disclosures made in marketing a subprime mortgage product contained incomplete (potentially misleading) information.
A decade later and in a different continent (Asia) and country (India), it is strange that the five-star board of one of the largest shadow banks, IL&FS, approved huge payouts to its top three key management personnel (as noted earlier) in 2017-18—a year in which the consolidated debt of IL&FS rose to a whopping around Rs 1064 billion and the year’s losses touched about Rs 18.87 billion. One cannot understand the logic behind this and I would say that the agencies which are probing this matter should look for potential conflicts of interest across stakeholders. Again, the larger point I am making here is that the availability of a smart RegTech tool could have helped isolate these aspects as and when they occurred and helped the concerned central bank take action.
In other words, this is where RegTech could provide a smart tool to help regulators and supervisors sift through all compliance and other data and themselves construct an ‘index’ of conflicts of interest—for financial conglomerates and institutions—which could serve as the basis for an effective conflicts risk governance framework. This, too, represents a chance to get analytical tools for better regulation and supervision.
To summarize, since COVID-19 will drastically reduce the incidence of on-site supervision of banks and FIs in the days and months to come, conversely, it should enhance greater reliance of central banks on off-site supervision. With larger-sized institutions and a whole lot of information coming in, it may be eventually very difficult for the central banking supervisors to make meaningful analysis of the data.
This is where COVID-19 presents an opportunity for the creation and use of smart RegTech tools on lots of aspects, and regulators and supervisors could benefit from such smart tools for understanding issues that caused the 2007-08 US subprime financial crisis, or the 2010 Indian microfinance crisis in Andhra Pradesh or the 2018 financial sector crisis in India—be it the IL&FS situation or the case of fraudulent and fake letters of undertaking issued by the Punjab National Bank.
In short, RegTech could provide smart tools for understanding all the issues that caused past financial crisis situations, and there are huge untapped opportunities for information technology (RegTech) firms with the resources, willingness and ability to create path-breaking applications. Thus, RegTech could help develop a large number of useful applications for central banks and other financial sector regulators and supervisors worldwide.
Before I sign off, I would like to quote Cassius from Julius Caesar: “The fault, dear Brutus, is not in our stars, but in ourselves.”
Just as this above quote states, all of the financial crisis situations we have encountered—whether the US subprime (2007-08) or the Indian microfinance crisis in Andhra Pradesh in 2010 or the Indian financial sector crisis in 2018 (e.g., the IL&FS crisis or the PNB LoU scam)—were not caused by computer models or algorithms or earthquakes or tsunamis. They were created by human action and inaction. All these crisis situations had early warning signals that the captains of the ship (i.e., the public stewards of the financial system) failed to read and act upon. Theirs was not a mere stumble but rather a huge missed step.
Part of the problem is that the massive burgeoning growth (be it in toxic mortgages or daily/short-term borrowings secured by these mortgages, or in microfinance loans or other activity as in the case of IL&FS) left the already thin regulatory architecture stranded, as they were perhaps dealing with larger volumes of increasingly complex sets of data than before. And the situation gets compounded today because of COVID-19 which has placed great constraints on the on-site supervision of banks and FIs by central banking supervisors, who will have to almost exclusively rely on off-site supervision.
Under such trying circumstances and especially, given the huge financial sector stress that COVID-19 is likely to cause, RegTech, if structured to ask the right questions and bring out the right insights, could be greatly beneficial for regulators and supervisors who are already overwhelmed by such data.
Without a doubt, the time is ripe now for RegTech to take the lead in facilitating better regulation and supervision of traditional and new age financial institutions worldwide. Otherwise, these financial institutions, which are perhaps at least ten times larger and ten times riskier than those present in 2007/8, could cause newer crisis situations, which in turn could set back the economies of individual countries and the world back by at least a decade. And of course, if RegTech is to facilitate effective regulation and supervision in real time, the regulatory and supervisory framework must be made accountable and free of conflicts of interest—aspects related to this are discussed in a subsequent article.
(Ramesh S Arunachalam is author of 12 critically acclaimed books. His latest release in January 2020 is titled, “Powering India to Double Digit Growth: Five Key Steps To A Robust Economy”. Apart from being an author, Ramesh provides strategic advice on a wide variety of financial sector/economic development issues. He has worked on over 311 assignments with multi-laterals, governments, private sector, banks, NBFCs, regulators, supervisors, MFIs and other stakeholders in 31 countries globally in five continents and 640 districts of India during the last 31 years.