Reserve Bank of India (RBI) governor D. Subbarao must be congratulated for standing up to a government ordinance that dramatically increases the finance ministry’s influence over financial supervision. Pranab Mukherjee’s assurance that his ministry will not interfere in the autonomy of the regulators will simply not wash because the proposed Financial Stability and Development Council (FSDC), whose decisions will be binding on the regulators, will be chaired by himself. No wonder Subbarao is concerned that it will erode the central bank’s autonomy; no wonder there’s a feeling that the finance ministry is setting itself up as a super regulator.
The debate about whether to have a single super regulator or multiple regulators is a red herring, distracting attention from a thinly disguised power grab. Consider, for instance, what happened to the US and the UK during the financial crisis, the former with a plethora of regulators, the latter with a single super regulator—the once much-acclaimed Financial Services Authority. Neither of these regulatory models was able to save the financial systems in their respective countries from imploding. The one lesson that the crisis has unequivocally taught us is that it doesn’t really matter what kind of regulator you have—it’s the financial system that’s key.
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Fierce debates used to rage over whether regulation should be sectoral, as in different regulators for different kinds of institutions or whether it should be functional, that is different regulators for different markets. Opinion then veered around to what was called the “twin peaks” model or regulation by objectives, with one regulator in charge of financial stability and another supervising conduct of business by financial entities—transparency, customer and investor protection. But the financial crisis showed that irrespective of the regulatory model they had, the financial system in most advanced countries passed through very difficult times, with a few exceptions such as Canada. One reason was lax supervision, especially of mortgage lending practices and opaque derivatives. Another was cross-border contagion. The Dutch banking system, which had the twin peaks regulatory model, with the central bank in charge of financial stability, was badly hit simply because the financial system formed such a large part of its economy and because the foreign claims of Dutch banks were very high.
Illustration by Shyamal Banerjee/Mint
On the other hand the banking system in India was relatively unaffected by the crisis, because our banks didn’t have much of a foreign exposure. Former RBI governor Y.V. Reddy’s role in resisting pressure to liberalize the financial system and in nipping a real estate bubble in the bud has been praised throughout the world, with Nobel laureate Joseph Stiglitz saying that the US wouldn’t have had the subprime problem if Reddy would have been the governor of the US Federal Reserve. Simply put, those countries that have been the worst affected by the crisis are those in which the financial system was supposedly the most liberal and “developed”. The regulatory model was of no importance. What’s more, most of the Western countries had independent central banks, proving that central bank independence is no guarantee of financial stability.
That said, there’s certainly a case for a body that will oversee financial stability. In India, that job has been done commendably so far by the central bank. On the other hand, making the finance ministry the final authority in the financial sector is fraught with risk: consider the numerous handouts to lobby groups in the Union Budget, the large fiscal deficit and the tendency to use banks for political objectives, one example being the farm loan waiver. The government already has too much influence over financial regulators—the top regulators are usually from the Indian Administrative Service and there have been serious misgivings over RBI’s lack independence.
What about the finance minister’s contention that FSDC will be used only for more effective coordination? There too putting the government in charge is a problem, seen recently in the way it succumbed to lobbying against the decision by the Securities and Exchange Board of India (Sebi) to get tough on the blatant loot of investors through unit-linked insurance plans. Small wonder, reports say Sebi is against government interference in disputes between regulators.
In fact, there’s nothing new in this decision to give statutory teeth to the regulatory coordination committee. Way back in 2001, the Deepak Parekh Advisory Group on Securities Market Regulation had recommended that the committee be given legal status. Even earlier, in a speech in 1999, Y.V. Reddy laid out what came to be called the Reddy formula for regulation. He recommended an “umbrella regulatory legislation which creates an apex regulatory authority without disturbing the existing jurisdiction.” He went on to say: “The apex financial regulatory authority may be constituted, by statute with the governor of the Reserve Bank of India as chairman and the members could be chairmen of the three regulatory agencies. The apex body should also include some outside experts on a part-time basis. Finance secretary could be a permanent special invitee or a regular member without voting rights as in the case of the RBI board. The apex authority could have by law, jurisdiction to assign regulatory gaps to one of the agencies; arbitrate on regulatory overlaps and ensure regulatory co-ordination.” Eleven years later, the finance minister wants to set up what Reddy suggested, but with himself as chairman. We should call this particular spade a bloody shovel.
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome firstname.lastname@example.org