Conspicuous omissions and false premises weaken the FSLRC’s prescriptions and render its report untenable.
The Financial Sector Legislative Reforms Commission (FSLRC) in India has completed its work and submitted its report to the Government. First impression is that the Commission has to start its work afresh. Its recommendations are flawed because its basic premises are flawed. It appears to have worked with one aim – stated and unstated in parts – and that is to curb the role of regulators and regulation in financial services. In page 18 (of the 228 pages in Volume 1), the FSLRC states that regulation exists to address market failures. That is wrong. In the case of financial assets, the market structure is inherently unstable and destabilising.
Economics 101 would state that more is demanded at lower prices and less at higher prices. The supply response is the opposite. For financial assets, the supply response is the same but the demand response is the opposite. More is demanded at higher prices and less at lower prices! That is the inherent feature of financial markets. This attitude leads to asset prices being chased higher and credit creation linked to asset prices rises together with asset prices. The whole financial system is pro-cyclical by its sheer nature and it is true to this very date. Hence, regulation is necessary not to address financial market failures. It is necessary because financial markets are not well-functioning markets as defined by economic theory.
On Page 26, the report states that systemic failures were the manifestation of failures over the core tasks of financial regulation. Not only is it a biased statement, it is also largely false. Systemic failures arise due to excessive financialisation of the economy. Excessive financialisation results from political economy decisions of which regulatory forbearance is one. In the United States, it was set in motion in the 1980s and eventually culminated in the major financial crisis of 2008, after enduring several mini-crises along the way. Since no lessons from those mini-crises were learnt, a major crisis occurred in 2008. Since no lesson has been learnt from that crisis either in the United States, another one is a certainty.
Excessive financialisation can be measured in many ways: leverage ratio in the banking system, credit to GDP ratio, financial market capitalization to GDP ratio, share of profits of the financial sector in the overall corporate profits and in the overall GDP, employment growth in the financial services industry, compensation levels in the financial industry relative to non-financial industries and so on. The word ‘financialisation’ occurs only once in Volume 1 of the FSLRC report and that too only on the issue of regulating commodities separately.
Further, on Page 15, the Commission notes that a low-level, fragmented financial sector encourages the growth of twilight zones like shadow banking. Empirical facts do not bear this out. The United States was the epitome of shadow banking. Is the Commission stating that the US was marked by a low-level fragmented financial sector? Shadow banking is an outgrowth of the financialisation of the economy. Besides political economy considerations, the unquestioning use of phrases like innovation and sophistication with reference to the financial sector confer intellectual legitimacy on its unbridled growth resulting in the emergence of twilight zones. The Commission does not appear to have considered these aspects.
Given that financialisation of the economy is an outcome of political economy considerations reflected in executive decisions, extra care must be taken before more powers on financial sector management and regulation are vested with executive organs. The Commission does the opposite. Moreover, on the issue of capital controls, the Commission defeats its own objective of reducing complexity. It splits capital flows into inward and outward and wants to place all inflows under the control of the Government and outflows under the control of the central bank. Some of the Commission members have expressed themselves rather well against this division of labour which has little basis either in concept or in convenience.
Further, in Table 9.3, the Commission states that one of the members of the Financial Stability and Development Council (FSDC) is not the Head of the Central Bank but the ‘Head of the Regulator for Banking and Payments’. Is the Commission trying to suggest that the Reserve Bank of India should not be or would not be the regulator for banking and payments at a future date? This is mischievous.
For a Commission that wanted to put in place a legislative framework for the financial sector that endures for a considerable length of time, it is unfortunate that the Commission chose to recommend that the Finance Minister be appointed the Chairperson of the FSDC, instead of recommending a more transparent and meritocratic process of the government recommending nominees chosen through a public and transparent process, subject to the confirmation of Parliament. Further, given the “paucity of talent and domain expertise in the government” (Page 29), it makes little sense to vest the government with more powers.
The Commission’s proposal is especially unfortunate in the light of the tendency exhibited by the present government to reverse the process of decentralisation and devolution. (A research by Ashok Gulati on the National Food Security Bill, published in December 2012, covers how the procurement process was sought to be re-centralised under the Bill, reducing scope for experimentation and innovative approaches to be adopted by individual States.) More specifically, in the financial sector, the government disregarded the preference of the Governor of the Central Bank for re-appointing his deputy for another term. The government ignored the recommendation of the insurance regulator against raising the exposure of Life Insurance Corporation to individual stocks and sectors.
With this record of a government headed by a former governor of the central bank, the Commission should have strongly come out against the vesting of additional discretionary powers in the hands of the government. In fact, these acts of government and its constant badgering of the central bank to cut interest rates do not serve as a ‘peaceful’ background to the work of the Commission (Page 15). If anything, the Commission has conducted and concluded its work at a time of maximum government overreach and differences with regulators and the central bank. It is difficult to believe that these differences have not affected the Commission’s work, impairing its objectivity.
That is why the dissenting note of P.J. Nayak on the proposed ‘capture of the regulatory architecture’ by the government deserves our attention:
This transfer of powers collectively constitutes a profound shift in the exercise of regulatory powers away from (primarily) RBI to the Finance Ministry. The Finance Ministry thereby becomes a new dominant regulator. To rearrange the regulatory architecture in this manner, requiring new institution-building while emasculating the existing tradition of regulators working independently of the Government, appears unwise. There is no convincing evidence which confirms that regulatory agencies have underperformed on account of their very distance from the Government; indeed, many would argue that this distance is desirable and has helped to bring skills (and a fluctuating level of independence) into financial regulation.
On monetary policy, the Commission “recognises that there is broad consensus at an international scale on the need for a central bank to have a clear focus on price stability”. That is not true. Post 2008, there is a rethink. Internet search would reveal that very few central banks have an explicit inflation target. Price stability has to be defined broadly enough to include asset prices. The Commission helpfully suggests nominal GDP targeting as a potential monetary policy goal. Thankfully, it has chosen not to elevate it to the status of a recommended policy goal. The Commission recommends that the Government set a medium term monetary policy goal for the Central Bank. It has no provision for a process of public consultation on the setting of this monetary policy goal. Is it safe to assume that Indian governments would set sound monetary policy goals, especially in the absence of any public scrutiny of the process of goal-setting and the goal itself?
Presently, the RBI correctly adopts an eclectic approach in the context of the extraordinary combination of challenges Indian economy faces and the unusual global monetary policy configuration. Unfortunately, it has come in for ad hominem attacks from some individuals who have assisted the Commission in its work. Therefore, it is possible that the Commission’s recommendations on the constitution of a Monetary Policy Committee (MPC) and the latitude granted the government in nominating five members to this seven-member committee (two in consultation with the Governor of the Reserve Bank of India) are not objective.
Secondly, the level of detail that the Commission has gone into in determining the research and information access for the monetary policy committee members is disturbingly extraordinary. This is what the Commission states: “MPC members would have access to relevant information within the central bank, other than information about individual financial firms that is related to the supervisory process.” The Commission appears to be going out of its way to exclude information available to the central bank from its role as the banking sector supervisor.
We wonder whether it is a prelude to eventually proposing, at the time of the framing of the legislation or at a later date, to strip the Reserve Bank of India of its role as the micro-prudential regulator for the banking sector. Unfortunately, the sentence flagged above strengthens our suspicion already aroused by the Commission’s proposals set out in Table 9.3 on the constitution of the FSDC (see my comment on Page 2 of this note on this aspect).
We hope it is not the case but lest that risk became reality, it is important to present international evidence that argues overwhelmingly in favour of keeping the two together:
One of my friends has a nice analogy. As the lender of last resort, you are never sure who is going to come through the door and ask for a date. When you meet your date on a Friday night and your date is AIG, the question at hand is whether you’d like to know something about them before you have to pay $85 billion to buy them dinner. If we mandate that the Fed is not involved in supervision then we make hasty, uninformed decisions inevitable when it is called upon as a lender of last resort…
…First, having direct information on the condition of the banking system can improve the conduct of monetary policy and the central bank’s information on the condition of the economy can improve the supervisory process. A pair of papers by Peek, Rosengren and Tootell (1999, 2009) establishes these two-way synergies.14 Their first paper shows that confidential bank supervisory information could improve the forecasts of inflation and unemployment that are presented at FOMC meetings and are the starting point for many policy discussions. The more recent paper demonstrates that bank supervisory models based on banking data alone can be improved by including the macroeconomic forecasts that are presented to the FOMC in their monetary policy deliberations. (Source: Testimony on “Examining the Link Between Fed Bank Supervision and Monetary Policy”, House Financial Services Committee, Anil K Kashyap (March 17, 2010))
…Although it may be possible to obtain this information without direct supervisory responsibility, it likely would be costly to separate supervisory and monetary policy responsibilities, unless the central bank continues to be fully apprised of all information obtained through the examination process. While this point is relevant in developed as well as developing countries, it is particularly so in countries with less developed capital markets that have been especially hard hit by the simultaneous occurrence of banking and economic crises (Caprio and Klingebiel 1996). The supervisory information in those countries not only may be useful in forecasting the economy in general, but may be particularly critical to other important functions of the central bank such as maintaining the payments system and crisis management, given the much larger role played by banks in their credit markets. Our results indicate that access to all the information available through bank exams should be important considerations as countries consider the role of their central bank. (Source: Is Bank Supervision Central to Central Banking? By Joe Peek, Eric S. Rosengren and Geoffrey M. B. Tootell (Mimeo, Federal Reserve Bank of Boston, July 1997))
First, an important nexus exists among monetary policy responsibilities, bank supervision responsibilities, and concerns about financial instability… it is important for the Federal Reserve to understand both the problems being experienced by financial intermediaries and the associated risk that banking problems could result in contagious failures that might lead to significantly more severe outcomes than are generated in most macroeconomic models… Second, supervisory policy and programs to promote financial stability are likely to be improved when integrated with monetary policy. The stress tests conducted on banks earlier this year show the advantage of using scenario analysis and macroeconomic assumptions to better understand the risk exposures of individual financial institutions and of groups of financial institutions.
Whatever regulatory reform is adopted, it should exploit the synergies between monetary policy, supervisory policy, and policies to promote financial stability. While policy makers are still collecting “lessons learned” from the recent crisis, it is clear that the economic outcome would have been much worse had the central bank not had the access to the knowledge about, and the hands-on experience with, financial institutions and financial markets required to take immediate actions to stabilize financial markets and the real economy…
…Furthermore, much more research needs to be focused on achieving an improved understanding of how future crises can be avoided, and if they do occur, how their impacts can be mitigated through the exploitation of the symbiosis shown to be present among monetary policy, bank supervisory policy, and concerns about financial instability. (Source: Is Financial Stability Central to Central Banking? By Joe Peek – University of Kentucky, Eric S. Rosengren – Federal Reserve Bank of Boston and Geoffrey M. B. Tootell – Federal Reserve Bank of Boston (October 2009))
Indeed, the last-mentioned reference not only underscores the importance of keeping monetary policy makers informed of the content of the findings of banking supervisors but also of the importance of assigning a primary or even a leadership role to the central bank in overseeing and ensuring systemic financial stability. In this regard, the proposal to vest the chairmanship of the proposed FSDC with the Finance Minister of the day (most likely a political appointee and a non-technocrat) looks doubly regressive.
To the best of our knowledge, the Commission has not consulted central banks in many developing countries – not even other BRIC members. It has not consulted critics of the financial system in the UK and US such as Andrew Haldane, Thomas Hoenig and Richard Fisher. These experts have strong empirical research under girding their views. It has not consulted market participants on either side of the aisle – buy-side and sell-side. It does not seem to have spoken to the Swiss National Bank that has progressed the most since 2008 in regulating systemically important financial institutions.
In sum, the hypothesis that India’s financial sector has been repressed by overzealous regulators has informed the Commission’s work (“If laws are poorly drafted, there is a possibility of excessive delegation by Parliament, where a regulatory agency is given sweeping powers to draft regulations” – Page 21). It has taken no cognisance of the persistent and enormous fiscal deficit, administered interest rates on certain types of savings, sector-specific lending targets, pervasive government ownership of the banking system, political and administrative interference as factors that have held back financial sector development. It is important to examine the reasons behind this enormous oversight on the part of the Commission.
Conspicuous omissions and false premises weaken the Commission’s prescriptions and render them untenable. The work on formulating a comprehensive and conceptually sound legislative and regulatory framework for India’s financial sector marked by objectivity and free of conflicts of interest has to begin afresh.
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