Raghuram Rajan took office as the 23rd governor of the Reserve Bank of India (RBI) on 4 September. He gave a good inaugural speech. It was purposeful. It had the stamp of authority. It had vision and audacity. It revealed a man who knew his mind, who had done his homework and who was prepared to lead from the front. All of these have been absent in our political leadership over the last decade. Hence, most of us went ecstatic on reading that speech or on hearing him.

Mint wrote five reports on the inaugural speech of the new governor. Yours truly awarded an A+ to the speech. R. Jagannathan of Firstpost wrote that the new governor hit the first ball for a six!

It is time for cooler and calmer heads to prevail. Better we do it ourselves rather than let others do it for us.

(1) Bank licenses

The issue of introducing competition in the banking sector has to be approached with a different mindset than the one that naturally thinks that competition enhances consumer surplus. In the banking sector, competition has the potential to enhance systemic risk and consumer wealth erosion. As competition squeezes profits, banks resort to expansion into riskier assets and greater deployment of leverage. It is possible if not probable.

If we are going to do so, then all banks must be asked

(a) To prepare a living will (a winding-up plan. It is an idea that the new governor has advocated in his writings post-crisis)

(b) A fund into which they pay to build reserves to pay for any eventual bailout must be created (also his idea)

(c) They should have ample equity base and

(d) There should be tax on super-normal profits earned by financial institutions. (Idea taken from an article written by Mohamed El-Erian in Project Syndicate)

As more financial institutions get created, there should be commensurate beefing up of the regulatory competence and strengthening of their spinal cords. The new governor might himself be well aware of the work of Anat Admati and Andrew Haldane but the regulatory division might not yet have studied them all. They must be essential reading for the regulatory division in RBI. Lobbyists will work on them and on uninformed politicians. Some innocuous clauses might be slipped in or taken out. The governor may not be able to keep tabs on all that happens. The devil may lie in the details.

While the committee to be headed by Bimal Jalan will scrutinize the individual bank license applications, the final decision of the RBI must incorporate the above systemic considerations.

(2) Financial markets

It is one thing not to look at financial markets as competition to banks and it is another thing to ask the question if all financial instruments and trading help to complete markets and provide systemic gains. Given that financial markets’ price discovery process is inherently de-stabilising and given ample liquidity globally, we have a duty to ask ourselves if it is really a loss when speculative trading activity shifted to offshore financial centres like Dubai and Singapore. It will be appropriate for a regulator (the governor of the RBI) to start with a sceptical mindset and shift the burden of proof to the financial sector. The default mode should be caution and not exuberance with respect to the usefulness of financial markets, especially given how the sector itself has evolved in the last thirty years globally and given the sector’s apparent lack of willingness to reform itself.

(3) The Financial Sector Legislative Reforms Commission (FSLRC)

His reference to FSLRC twice in his inaugural remarks is a bit concerning. That commission did a mediocre job, at best. Its recommendations were more aimed at undermining and weakening the institution that the new governor is heading. The final report of the Commission betrayed no understanding of the systemic issues that the global crisis of 2008 threw up. In particular, its recommendations on the monetary policy framework were no longer in tune with evolving thinking even in the West, despite the pervasive regulatory capture. Hence, the Commission’s recommendations on the monetary policy framework are better ignored rather than studied. It is not that difficult for the deputy governor to examine international best practices and to incorporate appropriate elements (if any) into the monetary policy framework of RBI.

A recent Bloomberg essay on how Gary Gensler at the Commodities Futures Trading Commission has been gagged by lobbyists for the financial and energy sectors is a must-read for regulators.

It will be to the good of the governor, to the good of the institution that he heads and to the good of the country if at least some of us raise the bar on intellectual seduction and keep it there.

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