Ashima Goyal

Missing the wood for the trees

ASHIMA GOYAL | Updated on March 09, 2018

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By seeking to clip the RBI’s wings, the FSLRC is going against global trends.

The financial sector legislative reforms commission’s (FSLRC) recent report is notable for following a principles-based approach with the laudable objective of simplifying India’s financial laws and removing unnecessary overlaps. While the report’s clarity and simple language are commendable, the principles laid out ignore the special features that make the financial sector different. That makes the report fundamentally flawed.

The FSLRC has basically followed the common law tradition in laying down the principles that are to guide regulators, who are, in turn, to draft subordinate regulation to respond to the flux of unfolding events and financial arbitrage. This approach enables a simpler unified financial code to replace earlier sector-specific laws.

At the same time, judges have a major role in this new framework, for interpretation of the principles in response to appeals against regulatory judgments and bye-laws. So the complexity of regulation does not go away, but is simply pushed down to the regulators. That will, then, engender a messy process of appeals, even against rules, that will end up creating greater confusion. The FSCLRC’s approach, therefore, makes the principles, the regulatory and the appellate structure envisaged especially important.

Let us start with the guiding principles that are by themselves very basic, such as equality and competitive neutrality in treatment, for example, of domestic and foreign firms. Consumer protection is given importance. However, regulators are enjoined to qualify this by ensuring that consumers take adequate responsibility for their decisions, while financial innovation, efficiency, access and competition are not compromised. Any obligation on a firm must be consistent with the benefit expected from such obligation. More sophisticated consumers may receive less protection.

Basic PRINCIPLES

The job of micro-prudential regulation is viewed as to reduce the probability of a firm’s failure, while systemic risk is to be addressed by viewing the financial system as a whole. Within this, there is to be special attention on large systematically important financial institutions or SIFIs. This would involve building a system-wide database and analytical capability, while giving the Financial Stability and Development Council (FSDC) statutory powers and making it responsible for systemic aspects.

What the FSLRC guiding principles do not include, though, is a fundamental financial market failure: the tendency to take on too much risk in good times, leading to pro-cyclicality. Since the negative spillover from these on others are not internalised (by those taking on excessive risks), it calls for regulatory intervention.

Also, since risky strategies are widely copied, potential threats cannot be limited to just SIFIs. Therefore, micro-prudential regulations, applying at the firm level, should have a counter-cyclical dimension. And for this to happen, it is not a good idea to separate micro- and macro-prudential regulation. Data collected and information acquired during the first can be useful in designing the second and applying it in a timely fashion.

The FSLRC, however, seeks to separate the two, with macro-prudential regulation being essentially made the responsibility of the FSDC, a committee of regulators. This naturally lends itself to a situation where everyone’s responsibility becomes no one’s responsibility.

Moreover, the FSDC is chaired by the Finance Minister, who will not be immune from political pressures or a tendency to allow things to continue as of now and push trouble into the future. Short-term palliatives, leading to a big, future crisis post-elections, will be preferred to costly, current preventive measures.

As a result, disincentives to prevent risk build-up will not be created; dichotomy in information and decision-making will lead to delay in response to emerging risks. For the FSLRC, a crisis emerges due to human errors, not behavioural aberrations.

TRIED AND TESTED

India today has a system where the lender of last resort and micro-prudential bank regulator is also responsible for financial stability. As a result, the Reserve Bank of India (RBI) could design macro-prudential policies that helped the Indian financial system survive troubled times – including during the 2008 global economic crisis.

When the rest of the world is giving more responsibility for financial stability to their central banks, should we be moving away from a structure that has worked for us, to an all new and potentially unstable design?

The UK’s unified financial regulator, funded by the financial sector, focused on supporting innovation. Yet, Northern Rock crumbled on its watch. Since then, financial regulatory powers have reverted to the Bank of England, which is independent of the financial sector.

There is an argument that Indian regulators have restricted financial innovation. But reducing these impediments is a function that the FSDC, as it exists currently, can very well perform.

It can homogenise compliance requirements that reduce transaction costs, introduce centralised reporting and put in place counter-cyclical prudential measures to discourage risk-taking without necessitating any brute restrictions. Within such a framework of coordination, individual regulators would be free to take care of the special requirement of their sectors, avoiding a one-size-fits-all unified regulatory regime that will never work.

In any case, in a country of India’s size and complexity, it is always better to have some regulatory competition. Mistakes resulting from a regulatory monopoly can be disastrous.

NEGLECTING THE LONG RUN

In other areas, too, such as monetary policy and capital controls, the FSLRC seeks to reduce regulatory independence and give more powers to the Finance Ministry.

The Ministry is to decide on inflows and the RBI on outflows. But international agreements often make it difficult to restrict outflows of foreign capital, which means it is the long-suffering domestic household or firm that will be forced to bear the cost of external volatility.

The Government, as it is, has already been liberalising inflows more rapidly than warranted by real-sector domestic reforms that should have come first.

The debt inflows allowed to finance government subsidies have now become outflows due to external factors, leading to pressure on the rupee and hurting a fledging recovery that seemed under way. If even the remaining controls on inflows are removed, the country will be pushed into a downward spiral.

Markets and politicians both have a short-run perspective, which the FSLRC report actually seeks to strengthen. India’s overburdened legal system will not be able to provide the safeguards expected, as the poor consumer will avoid endless litigation even while the powerful will use it to escape regulation.

The FSLRC report focuses only on financial firms – the trees. In doing so, it misses the wood or the factors affecting behaviour of firms and households, thereby misunderstanding the requirements of a thriving domestic financial forest.

(The author is Professor of Economics, Indira Gandhi Institute for Development Research.)

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Published on June 18, 2013
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