Following the annual central bankers’ meeting at Jackson Hole, Wyoming, in the US, The Economist magazine in its 27 August issue predicts that the global financial crisis of 2008 will be a cathartic event for central banks. The responsibilities of central banks, it suggests, are certain to include financial stability in the future; inter alia, this will not merely broaden the scope of central banking and monetary policy, but will also place greater discretion with central banks, considering that financial stability is difficult to define and even harder to measure. Put all this together and you get the larger picture: One, it blows the death bugle of the narrow, inflation-targeting central bank that had reached iconic status though never embraced by all. Two, central banking will be anything but rule-based as central banks marry price stability with regulation to give birth to something called “macroprudential regulation”.
Illustration: Jayachandran/ Mint
The post-crisis evolution of central banks’ responsibilities is relevant for India because some reform proposals that gained currency in the pre-crisis years need to be revisited; in the light of actual central bank responses globally during the crisis, and—to the extent that India is influenced by intellectual debates and developments abroad— the post-crisis, fresh rethinking at international fora must be injected into the old role models. The first of these is inflation targeting. The days when central banks could ignore asset price bubbles and systemic risks are over and, as part of the lessons learnt, financial stability has willy-nilly broadened the mandate of central banks. The second is the overarching financial stability and development authority (FSDA) proposed to replace the high level committee on capital markets (HLCC).
Consider “macroprudential or systemic regulation”—this considers risks to the financial system as a whole—on the need for which there is broad unanimity. With whom shall vest the authority to regulate a financial entity whose “size, leverage and interconnectedness” poses a threat to financial stability, asked Stanley Fischer, a respected economist-cum-central banker, at Jackson Hole. He noted that most countries assigned this responsibility to the central bank.
Two, Fischer pointed out that central banks had most of the macroprudential tools, viz. “the central bank interest rate, tools aimed at the rate of credit creation and the overall riskiness of the financial system like capital and leverage ratios, as well as more specific regulatory tools like margin and provisioning requirements, etc”. Three, he said the links between “financial and macroeconomic stability” require close coordination and steady, accurate information flows to facilitate quick decision-taking. As a practitioner, he noted that information flows were faster in the within-organization model than the inter-agency committee system. Last, he brought out the difficulties in coordinating decisions between monetary and macroprudential policy in a twin-agency system.
These deliberations underscore the sweep of the charge when considering the optimal institutional arrangements for financial stability. Reverting to the proposed institutional overhaul in India, the idea underlying the creation of FSDA is “regulatory convergence”, to facilitate quicker decision-making while regulating financial conglomerates in multiple domains. These objectives will be realized through another layer at the top (headed by the finance minister), with other regulators in the second tier.
It is unclear how this structure will facilitate quicker decision-taking. Will layering, for example, make information flow faster from the Reserve Bank of India’s (RBI) banking regulation and supervision departments, its financial markets department (money, bond and forex markets), the banking sector (under RBI’s charge) and the Securities and Exchange Board of India (Sebi) in any threat to financial stability across multiple agencies?
More important, the systemically important institutions, which financial conglomerates typically are, will be regulated by this agency. Will the responsibility for systemic stability henceforth vest with FSDA, and by implication, the treasury? Or will the Reserve Bank have more responsibilities than the others? What if macroprudential policy (for example, risk-concentration across sectors, activities, assets and so on) diverges from the inflation objective? As pointed out by Fischer in the context of preparing for future crises, coordinating monetary policy decisions (under the central bank) with macroprudential policy (under the control of the treasury or a separate agency) can be very difficult. Add to these issues some more pointed reforms in the offing—a fresh review of the size of systemically important institutions, the need to check their excessive growth, the necessity of stricter regulation (higher capital and leverage ratios for these institutions) and so on—and we get the broad direction of future financial regulation to contain systemic risks.
How do these issues touch India? They do and they don’t! They do because proposed reform may shift the responsibility of systemic regulation away from the central bank, narrowing its mandate at a time when nearly every central bank, which did not already have financial stability as its charge, is getting charged with it. And they don’t because the Reserve Bank is already discharging these responsibilities. Whichever way the wind blows, it is important that pre-crisis reform proposals be vetted with the post-crisis lessons on financial stability, of which macroprudential or systemic regulation is the centrepiece. There is a need to think through the optimal institutional structure carefully. And there is no one role model to follow. If at all, the UK model is tarnished with its poor information flows, regulatory gaps and supervisory lapses exposed in the 2008 crisis. And the US doesn’t really have one; its successive banking crises and high degree of bank failures are testimony to the lacuna.
Institutions evolve, shaped as they are, by existing structures, needs, preferences and explicit choices. The impetus for institutional reform is either failure or to keep pace with changing times and situations; it was the latter that led to the proposal of a financial sector oversight agency in the Rajan committee report. But the times have changed again, and how!
Renu Kohli was until recently with the International Monetary Fund. Comments are welcome at firstname.lastname@example.org