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Illustration: Jayachandran / Mint

Illustration: Jayachandran / Mint

Regulating financial stability

Regulating financial stability

Policy reform is invariably contextual; as is the announcement, during this year’s Budget, about setting up the Financial Stability and Development Council (FSDC). The council will “strengthen and institutionalize the mechanism for maintaining financial stability", monitor “…macro-prudential supervision of the economy…functioning of large financial conglomerates, and…inter-regulatory coordination issues". In other words, the new entity will be assigned tasks that have largely been the domain of the Reserve Bank of India (RBI).

The recent financial crisis has sparked off an interesting debate in which India has been cited as a remarkable success. To date, 26 banks have failed in the US, exposing the poor regulation and supervision of the banking system. In the UK, a giant such as Northern Rock tanked, revealing the glaring absence of information flows between the central bank and the financial supervision agency. Little wonder, then, that there is an attempt to charge “some" agency with a financial stability mandate in these countries.

Illustration: Jayachandran / Mint

India emerged largely unscathed. RBI—chided for its conservatism and caution—has reasons to be self-confident. Therefore, the move to change India’s regulatory structure calls for a close examination.

FSDC will institutionalize financial stability. But RBI already has a financial stability unit whose primary task is to identify and analyse potential risks. Will FSDC, with its “full-time secretariat", improve upon the present arrangement wherein RBI has in place multidisciplinary teams from diverse departments—banking supervision and regulation, financial markets and so on? How will FSDC tap the rich resource pool from RBI and other regulators? More importantly, how will it “administer" financial stability? This is one of the key functions of the central bank. Have possible areas of overlap—and conflict—been identified?

Macro-prudential supervision is a specialized, complex and sensitive task as it deals with risks to the financial system as a whole. This role is being executed by RBI with insights gathered from its economic analysis, market operations performed in pursuit of monetary policy as well as supervision and regulation of banks and non-banks. The risks on account of informational deficiencies are huge. As things stand, practically all macro-prudential tools—the central bank interest rate, tools for moderating credit creation and overall riskiness of the financial system, capital and leverage ratios, margin and provisioning requirements—lie with RBI. Duplicating such a mechanism is a formidable task. Reportedly, FSDC will have the power to issue advisories. It is imperative that RBI and FSDC do not function at cross-purposes, particularly as monetary policy decisions and macro-prudential policy can diverge, indicating the nuanced nature of decision-taking. How this will be ensured is not at all clear.

In the world of financial conglomerates—whose size, leverage, financial strength and interconnectedness are threats to systemic stability—financial and macroeconomic stability are interlinked and almost indistinct. In fact, the notion of “too-big-to-fail" financial institutions itself is being reworked; solutions to reduce systemic risk arising from these entities range from caps on size to restrictions upon, and firewalling of, specific activities.

Turf wars are inevitable. Inter-regulatory coordination—critical because India’s financial system is in transition—is now done by the high-level coordination committee, chaired by the RBI governor. Conflicts—such as regarding regulation of interest rate and currency futures—arise because one regulator is mandated to implement a certain public policy, which has decided that the rupee shall not be fully convertible and interest rates not fully deregulated. RBI will still be needed to intervene in, and regulate, some markets to implement public policy.

This larger picture will not change with the creation of FSDC. Where there is a conflict of opinion between RBI and FSDC, which of them will prevail? Lack of clarity on these issues has sparked off concern that creating FSDC may pave the way for erosion of the autonomy of the central bank.

India cushioned itself from the global financial crisis through prudential oversight and a calibrated approach to financial liberalization. A vigilant central bank avoided many of the financial excesses observed in other countries in the build-up to the crisis. During the crisis, coordinated action by different regulators enabled India to handle volatility in the financial markets due to the sudden reversal of capital flows and the ensuing liquidity and credit crunch. Exchange rate and other price movements were moderated exceptionally well for India’s stage of financial market development. This contrasts sharply with the volatility and other troubles that many other emerging market countries faced. India’s success is rooted in a sound and resilient financial system, of which banks are the dominant segment.

This is not to say that there is no scope for improvement. As the complexities of the financial sector increase, constant vigil and change is called for. While others learn from the Indian experience, India itself needs to build upon its own successful model.

It would be premature to presume that FSDC will, ipso facto, “strengthen" the existing arrangement—where the central bank occupies centre stage. For that to happen, the ambiguities in the proposed new arrangement require to be addressed. A major reform in the financial sector—which is what FSDC is—calls for a clear enunciation of goals, road map and, of course, a wider debate.

Renu Kohli was, until recently, with the International Monetary Fund, and is a former RBI staffer. Comments are welcome at theirview@livemint.com

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