CENTRAL BANKING MODULE E QUIZ 2

Deposit protection helps prevent destabilising runs and protects eligible depositors, but it may reduce depositor incentives to monitor bank risk. If poorly designed, that can increase moral hazard. Capital, liquidity, governance and supervisory requirements help limit risk-taking incentives while preserving confidence.

Microprudential supervision focuses on the soundness of an individual institution. Macroprudential supervision considers system-wide vulnerabilities such as common exposures, interconnectedness, excessive credit growth and procyclicality. Both are needed because individually sound institutions can collectively create systemic risk.

Regulatory capture occurs when a regulator’s decisions are unduly influenced by the interests of the entities it is supposed to regulate, rather than the public interest. Safeguards include transparent processes, conflict-of-interest rules, independent review, strong governance and accountability.

Supervisory data can reveal lending standards, borrower stress, deposit behaviour, funding conditions and bank balance-sheet constraints. This helps explain why a policy-rate change may pass through unevenly to credit and the real economy. Appropriate safeguards are needed for data confidentiality and institutional responsibilities.

Following nationalisation, branch expansion and directed lending to priority and underserved sectors were major features. These policies broadened access but also raised challenges involving efficiency, profitability, directed credit and asset quality, which later reforms sought to address.

Timely recognition and provisioning prevent banks from overstating income and asset values and help ensure that losses are reflected in financial statements. Delayed recognition can conceal deterioration, weaken capital planning and encourage evergreening. Provisioning does not itself recover the loan; it recognises expected or incurred loss under applicable rules.

Concentrated and rate-sensitive funding can leave a bank vulnerable to sudden outflows. Useful controls include monitoring funding concentrations, stress-testing outflows, maintaining liquid assets, diversifying funding sources and preparing contingency funding plans with clear escalation triggers.

Repricing-gap analysis compares the timing of rate-sensitive assets and liabilities, while duration analysis estimates sensitivity of economic value to interest-rate changes. Each has assumptions and limitations; banks may supplement them with earnings simulations, economic-value measures and stress tests.

A net open position creates exposure to exchange-rate movements. Banks should measure positions by currency, set approved limits, monitor exposures in real time where feasible, use authorised hedging instruments, and escalate breaches. Hedging reduces exposure but may introduce counterparty, liquidity or basis risks.

Risk-based supervision looks beyond a single threshold. Weak governance and concentration may create future losses, so the supervisor can intensify monitoring, require credible remediation, assess risk controls and consider proportionate supervisory measures under the applicable framework. Waiting for a capital breach may be too late.

A stronger framework combines adequate capital and provisioning, sound governance, fit-and-proper management, reliable audits, improved risk management, timely reporting and effective supervisory action. Cooperative status does not remove the need for prudential safeguards or depositor protection.

When cooperative governance and banking prudential oversight are divided between authorities, gaps or delays in information-sharing and remedial action can arise. Clear legal powers, coordination, common information and timely enforcement are important. Reforms in India have expanded banking-regulatory powers, but the institutional structure remains relevant to understand.

A troubled institution may transmit stress through interbank exposures, payment obligations, common asset holdings, funding markets and confidence effects. The resulting contagion can impair otherwise sound institutions and disrupt financial services, which is why supervisors assess interconnectedness and systemic importance.

Multiple adverse indicators justify early, proportionate intervention rather than waiting for insolvency. Supervisors may require a credible corrective plan, stronger monitoring, governance improvements, capital or liquidity actions where warranted, and escalation if the institution fails to remediate. Measures depend on applicable rules and the severity of risk.

Basel I introduced an international risk-based capital framework, initially focused mainly on credit risk, with a minimum total capital ratio of 8% of risk-weighted assets for internationally active banks under the original framework. Later amendments and Basel II/III broadened and refined the framework.

Pillar 3 promotes market discipline by requiring meaningful disclosure of a bank’s risk exposures, capital and risk-management arrangements. Investors, counterparties and other market participants can use this information in their decisions. Disclosure complements, rather than replaces, minimum capital and supervisory review.

The capital conservation buffer is designed to be available to absorb losses during stress. When capital falls into the buffer range, restrictions can apply to distributions such as dividends, share buybacks and discretionary bonuses, helping banks conserve capital and continue lending. The exact requirements depend on the jurisdiction’s implementation.

Risk-weighted ratios depend on risk weights and models that may understate exposures or vary across banks. A leverage ratio provides a simple backstop based on a broad exposure measure, helping constrain excessive balance-sheet leverage even when risk-weighted assets appear low.

Global integration can improve diversification and capital allocation, but it also allows shocks to spread rapidly through cross-border funding, common asset holdings, derivatives and confidence channels. Cooperation, information-sharing, consistent standards and credible resolution arrangements help manage cross-border spillovers.

International standards support common minimum expectations, comparability and cooperation across jurisdictions. Basel standards, for example, provide frameworks for capital, supervision and disclosure. Implementation must still reflect domestic law, banking structures and proportionality; international standards do not automatically become domestic law without an applicable process.