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Financial stability and all that

Financial stability and all that
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First Published: Mon, Mar 22 2010. 01 15 AM IST
Updated: Mon, Mar 22 2010. 11 05 AM IST
Paragraph 37 of this year’s Budget speech announced a plan for a new Financial Stability and Development Council (FSDC). FSDC’s proposed charge would be broad, including monitoring macro prudential supervision of the economy, inter-regulatory coordination issues, financial literacy and financial inclusion. The possibility of political interference and the extra layer of regulation both raised hackles among some commentators worried about the independence of the Reserve Bank of India (RBI), in particular. But there is both more and less to FSDC than initially met the eye of these commentators, and the worries seem to be misplaced.
It is useful to begin with the situation of India’s financial sector. Considerable strides have been made in the last two decades in this sector, with the creation of new market and new regulatory institutions. These have, undoubtedly, contributed to India’s increased savings and investment rates, and their translation into higher growth. That is what financial intermediation is supposed to do.
At the same time, vast swathes of India’s financial system remain quite underdeveloped, representing a lost opportunity for growth. The recent financial crisis taught us the importance of managing systemic risk, and of regulatory coordination. It did not undermine the case for financial development, especially in a country such as India, which needs to raise and channel large amounts of new capital to productive uses. Certainly, the crisis must not be used as a justification for financial underdevelopment, nor to make a case against financial innovation.
In the context of the functioning of the financial sector, it is important to understand the role of regulation. The main goal of financial regulation is to ensure the smooth, day-to-day functioning of financial markets. In turn, this requires rules that create a level playing field, including equal treatment of market participants, and strong disclosure requirements (about trades and positions held, for example). Rules for financial markets have to be complemented by rules for the assets traded in those markets, whether shares of firms, debt instruments, or more exotic assets such as the many kinds of derivatives. Again, disclosure is a key requirement, in this case about the characteristics of the assets themselves. Disclosure is often backed up by (hopefully) independent evaluations or ratings of the assets—essentially, these try to summarize complex characteristics along one-dimensional scales.
Because the world is uncertain, because people are not angels, and because things can go wrong in ways that are prone to snowball in financial market settings (this snowballing happens because financial assets are all promises, and the financial system is an interlocking web of promises), there is an important backstop role for regulators, to make sure that the system does not collapse under stress. Regulators must also monitor the system for early warnings of stress, so that interventions are early enough to minimize damage.
All of this went wrong in the financial crisis—beginning with the rules for rating and trading derivatives. The lack of disclosure meant that early warnings were also hard to come by (though not impossible). The lessons are (1) design financial markets better, (2) pay attention to the overall health of the financial system. The first task was done very well when Indian equity markets were redesigned from scratch early in the reform period. Unfortunately, efforts to do the same for much of the rest of the financial system have been much too slow and cautious. My own opinion is that RBI, a major regulatory player, could and should have moved faster to develop more of India’s financial markets. This would have had no negative impact on India’s vulnerability to a financial crisis. If anything, well-designed, well-run financial markets are less vulnerable, and easier to monitor.
FSDC is about lesson (2) not (1). Multiple, specialized regulators are necessary—it is more efficient to specialize for day-to-day management. This does not mean that the current assignment of authorities is optimal: Debt management, and probably some other functions, can be moved out of RBI, so it can focus on doing its main job well, regulating the price level. (This may be tied in with bank supervision, since banks are first-line money creators.) In any case, FSDC is fundamentally about regulatory coordination, not front-line regulation. The Budget speech said so. Even the existing High Level Co-ordination Committee will be untouched. There is also an international dimension to FSDC, which was made clear after the speech—India needs to have a unified approach to international discussions of regulatory reform of finance, in the Group of Twenty and elsewhere.
Add in the social goals of financial education and promotion of financial inclusion, which will ultimately be driven by reducing transaction costs in financial intermediation—again an area where existing regulators need to speed up their efforts. Combine with the new Financial Sector Legislative Reforms Commission, which will modernize archaic laws, and FSDC and all that is clearly a “good thing”.
Nirvikar Singh is a professor of economics at the University of California, Santa Cruz. Your comments are welcome at eyeonindia@livemint.com
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First Published: Mon, Mar 22 2010. 01 15 AM IST
More Topics: Eye on India | Nirvikar Singh | RBI | India | Markets |