We have covered in our earlier posts, two of the three functional sessions of the IFMR Financial Systems Design Conference 2011, namely Origination and Risk Aggregation. This post summarises the third: Risk Transmission.
Risk transmission in the financial system involves the movement/assignment of risk from one entity to another, in return for a compensatory payment at a market-determined rate. In a well-functioning financial system, risk moves in an orderly manner between those who are originating it and those who are best placed to manage it, thus improving the overall capability to manage risk. The conference reviewed the existence and robustness of risk transfer mechanisms for individuals, firms and financial institutions in the Indian financial system.
The Conference participants discussed in particular, the process by which risk is transferred from originators (of financial services) to risk aggregators (financial institutions and capital markets) and the types of risks that must be retained versus the types of risks that must be transferred.
While a number of obstacles impede the creation of well-functioning risk transmission markets, its creation will fundamentally hinge on:
(a) Clearly understanding and identifying the risks to be transferred;
(b) Developing appropriate instruments for transferring risks;
(c) Creating capability to measure and price risks; and
(d) Designing and implementing a legal and regulatory framework for contract enforceability and resolution.
Characterising the present state of risk transmission in India
Conference participants highlighted the extent to which risk transmission markets in India remain under-developed, for firms, financial institutions and, particularly, for individuals. They attributed the present gaps in the infrastructure for risk transmission to a variety of reasons:
- For households, while risk transfer products exist, the key gap seems to be in high-quality distribution of those. Concerns with insurance and mutual fund selling processes and incentives have become severe in recent times. Absent this distribution infrastructure, households will continue to under-insure and under-invest.
- There continue to be barriers for broad-based participation in a number of these markets.
- Unavailability of certain risk transmission products on account of regulatory reasons (ex: Indian Treasury Bill Futures, inflation indexed bonds).
- Absence of enabling public infrastructure for designing some risk transmission products. For instance, India has not invested enough in high quality rainfall measurement stations and this has impacted the availability of good data for designing rainfall insurance contracts.
- Limited availability of certain risk transmission products on account of various environmental and infrastructural hurdles affecting accurate and efficient discovery of their prices. (ex: catastrophe insurance)
Watch video of Dr. Rangarajan K. Sundaram‘s keynote address on Risk Transmission.
Several ideas emerged during the course of participants’ discussions on how best risk transmission mechanisms can be reinforced to function at an optimal level.
1. Make transparent the quantum and nature of risks assumed by market participants
An important overall observation was that development of risk transfer mechanisms must be preceded by much more “paranoia” regarding risk management, particularly by government owned financial entities. There was a need to make transparent the embedded risks (ex: ALM mismatch) for large financial institutions, so that risk management and risk transfer are taken seriously.
Participants felt that current regulatory approaches (particularly for banks) use caps, limits and other such fiat-based measures disproportionately and do not adequately leverage market-based mechanisms to manage risk. While rating agencies provide an important third-party view on risk, conference participants felt there was really no alternative to building robust internal risk management capabilities. Financial Institutions must focus on putting in place plans for dealing with reasonably expected failures (“known unknowns”).
2. Manage moral hazard in credit risk transfer markets
Participants felt that it was important to keep in mind moral hazard while designing risk transfer products, particularly for credit risk. In the specific context of securitisation markets, conference participants felt there was a need to be cautious about pure “originate to distribute” models. The concern was that this would create excessive moral hazard for the originator. It was discussed that the originator must retain ownership of credit risk in some form, thereby ensuring that it has the incentive to monitor credit risk, thus rooting out an instance of moral hazard in risk transmission.
3. Continue to focus on addressing missing markets for risk transmission
While important steps have been taken, participants felt that building risk transmission markets must continue to be an important financial policy objective. From a legal perspective, development of good resolution mechanisms is integral to the development of risk transfer markets. While the SARFAESI Act has been beneficial for banks vis-a-vis corporate lending, a lot more work is required on this front. Participants also noted the near total absence of thinking on the issue of household/personal bankruptcies, and the need to meet unaddressed risks, such as inflation.
In developing a vision for risk transmission within the financial system, participants formulated the following:
“To design, develop and sustain effective mechanisms that enable transfer of risk from households and originators to institutions than can better manage these risks.”
A more detailed summary of the deliberations on Transmission is available here.