Rethinking regulation of the financial sector: What does this mean for India?

The 2008 global economic crisis is increasingly turning into a social and a political crisis as well. The activities of financial sector institutions and their regulators have been at the centre of the global crisis.

Raguram Rajan’s lucid and incisive book Fault Lines: How Hidden Fractures Still Threaten the World Economy (Princeton University Press, 2010) details how the transparent, contractually based, arm’s-length financial system of the US, which has been widely regarded as having sufficient checks and balances against systemic failure, nevertheless became the epicentre of the ongoing global economic crisis. The book is too complex
to be reviewed here, but the following discussion does draw on the ideas contained in the book.

The global economic crisis has led to rethinking of widely held assumptions and practices about monetary policy, economic management, nature of the financial system (in much of the world, relationship banking, in which there is close involvement of banks with the borrowers, particularly the corporate entities), and financial sector regulation. The earlier system-wide major crisis had occurred largely in countries with relationship-based system.
In rethinking financial sector regulation, the objective is not to make banking ‘boring’, with no product, process, or technological innovation. Instead, as the Financial stability Board (FSB), set up in June 2009 at the initiative of the G-20 countries, argued, the ‘…objective is to create a more disciplined and less pro-cyclical financial system that better supports balanced sustainable economic growth’.

The aim of such a system is to mitigate excessive leverage, and one-way bets on risk taking, whereby profits are privately shared, but losses are borne by wider group of stakeholders, including the taxpayers. This implies counter-cyclical regulation of financial sector institutions and entities, but in a way which minimises regulatory arbitrage opportunities. Such a regulation also needs to guard against interaction of the state and the market, or between government intervention in a market such as for housing finance and regulatory failure. In the Indian context, the goal of financial inclusion may potentially create such destabilising interaction. The pursuit of this goal should be carefully planned.

There have been extensive discussions by numerous official committees, both national and multilateral; by informal academic expert groups; and by others, focusing on rethinking financial sector regulation. Globally, there are three areas where such rethinking could assist in harnessing the financial sector for broad-based sustainable economic growth.

The first area of rethinking concerns goals of monetary policy. Conventionally, monetary policies of the central banks have been directed at securing high growth with low steady rate of inflation. The inflation measurement has, however, focused on goods and services and not on the asset prices, and on credit growth in the economy. So, one aspect of rethinking is to include these aspects explicitly into monetary policy decisions, but based on sound analytical and empirical studies.

In Fault Lines, Rajan explicitly credits India’s Reserve Bank of India and European Central Bank with taking credit growth into account in their monetary policy deliberations (p111). But he also warns against excessive conservatism by the regulators concerning financial product and process innovations; and excessively shielding existing financial institutions against competition.

Recent moves by the Indian regulators to permit flexibility in interest rates paid by banks to attract depositors is therefore a positive step towards a more competitive financial sector in India.

For a variety of reasons, including globalisation, technological factors, particularly in the information and communications technology, there has been a weakening link between growth and
employment generation. This has made the task of monetary policy more complex, as easy monetary policies may be pursued beyond the levels necessary for financial stability.

The second area of rethinking concerns what may be termed implementation integrity, i.e., regulatory provisions need to be implemented not just to satisfy the letter but also the spirit to the maximum extent possible.

Such integrity is needed among all stakeholders involved:
> Market participants, as it is their incentive structures and behaviour that the regulators seek to influence;
> Governments, as they need to set appropriate objectives of regulation;
> Supervisors of financial institutions, as their quality of supervision and their motivations have an impact on the assessment of substantive compliance by individual financial entities.

In Fault Lines, Rajan argues for better incentive structures and greater authority in financial institutions for those in charge of risk management; as well as greater role for supervisors in regulatory agencies. The importance of entity based supervision was perhaps underestimated in the lead up to the 2008 global crisis.

In the Indian context, former governor of Reserve Bank of India, Y V Reddy, has argued that bank supervisors (and by implication, supervisors of other financial entities) need to possess necessary skills (requiring changes in recruitment, training, and exposure), motivation, and mandate. When government ownership of banks, insurance companies, and other financial institutions is extensive, as is the case in India, it may be difficult for supervisors to get a clear mandate to prevent excessive risk taking and imprudent behaviour.

The third area of rethinking concerns regulatory coordination, and monitoring of systemic risk. In countries with multiple regulators, such coordination is needed to minimise regulatory arbitrage, and enforce evenhanded regulation among all entities. There have been several proposals for such a high level coordinator. Thus, European Union (EU) has set up new pan-EU watchdogs for the financial sector. US Treasury has proposed setting up a Council of Financial Regulators to improve co-ordination. Some scholars have proposed Systemic Risk Councils.

In India, there have been proposals to formally set up a council comprising relevant financial sector regulators as current informal arrangements have not been effective. The 2010-11 Indian Budget proposed a Financial Stability and Development Council (FSDC) to settle inter-agency disputes. It should be encouraged to focus on minimising regulatory arbitrage opportunities, and ensuring that state dominance in financial sector does not hinder perusal of broad macroeconomic stability and financial stability. More purposeful actions in strengthening fiscal sustainability objectives by the UPA government will lend greater credibility to FSDC.

The Indian regulators need to be even more conscious of ensuring that an appropriate balance is achieved between greater efficiency in financial intermediation and innovations on the one
hand, and probable downside institutional and systemic risks. Given the continuing financial engineering possibilities; emergence of new players, such as government wealth funds, whose importance have increased in the crisis but
who have very different behavioural patterns and motivations and commercial entities; and new high frequency trading and other such practices, this balancing will not be an easy task. But going back to ‘boring’ financial sector is also not an option for India.

The writer is a professor of public policy at the National University of Singapore and can be reached at sppasher@nus.edu.sg. Views are personal.