Judicial review of decisions may make RBI ‘paper tiger’: Raghuram Rajan

Mumbai: Reserve Bank of India (RBI) governor Raghuram Rajan on Tuesday slammed proposals by a high-level committee to open up all regulatory decisions to a judicial review and to merge all financial sector regulators into a single entity.

The first recommendation by the Financial Sector Legislative Reforms Commission (FSLRC) risks reducing RBI and other regulators to a “paper tiger”, said Rajan, who described the proposal for a unified financial sector watchdog as “somewhat schizophrenic”.

FSLRC, formed in 2011 to examine the regulatory architecture, in its report submitted in October 2012 recommended the formation of a Financial Sector Appellate Tribunal to review regulatory decisions.

It also called for the creation of a unified financial agency, termed by analysts as the ‘super regulator”, for oversight of capital markets, insurance, commodities futures trading and pension funds.

The panel also recommended that some functions, such as management of internal capital flows and regulation of organized financial trading—bonds, currencies and derivatives trading—be moved away from RBI, which would function purely as the country’s monetary authority and a regulator of banks.

At a banking conclave organized by State Bank of India, Rajan questioned the need for increased judicial oversight of regulators. He argued that it may be dangerous to ask tribunals to make judgments that they “simply do not have the capability, experience, or information to make, and where precise evidence may be lacking”.

The tribunal will “undermine the very purpose of a regulator”, Rajan said, adding that this will imply that people trust the tribunal’s judgment but not that of the regulator.

Such an entity could also interfere with the regulator’s functioning.

“... past experience suggests that entities like to justify their existence, and if set up, a tribunal will intervene more than necessary,” Rajan said.

Elaborating on the perils of excessive oversight, Rajan said that not everything a regulator does can be proven in a court of law.

“....a lot of regulatory action stems from the regulator exercising sound judgment based on years of experience. In doing so, it fills in the gaps in laws, contracts, and even regulations. Not everything the regulator does can be proven in a court of law,” said Rajan, adding that there were a range of decisions where regulatory judgment should not be second-guessed.

Constant questioning of regulatory decisions could also paralyse the system and create distortions, as much-needed regulations are held up and participants exploit loopholes, RBI governor warned, adding that this could eventually damage the respect commanded by regulators in the country.

“...to the extent that private parties with their high-priced lawyers can check the regulator, that healthy respect dissipates. So the final danger is that the regulator could become a paper tiger, and lose its power of influencing good behaviour, even in areas that are not subject to judicial review,” the central banker said.

Economist Ajay Shah, who was part of FSLRC, said judicial scrutiny could improve the functioning of a regulator, saying that the functioning of the capital market regulator Securities and Exchange Board of India (Sebi), for instance, had improved after the formation of the Securities Appellate Board (SAT) that adjudicates over petitions challenging Sebi decisions.

“Why should not that be the case with RBI? There are incompetent judges and there are incompetent regulators. Why should you favour one over the other?” Shah added. “Judicial scrutiny is part of the liberal democracy, it is in our Constitution and everyone will have to abide by it.”

In his speech at the banking conclave, Rajan alluded to SAT, saying that so long as a tribunal only questioned administrative decisions such as the size of penalties imposed by a regulator, there was no problem.

“But if it goes beyond, and starts entertaining questions about policy, the functioning of a regulator like the RBI, which has to constantly make judgments intended to minimize systemic risk, will be greatly impaired,” Rajan said, adding that it was better to revisit these issues a few years from now when both regulation and oversight mechanisms are better developed.

Some economists agreed with Rajan’s arguments.

The recommendations of FSLRC cannot be accepted in their entirety, said Ashima Goyal, professor of economics at the Indira Gandhi Institute for Development Research.

“Our judiciary system is not strong enough for such an oversight. If the recommendations have to be accepted, it has to be through a gradual pathway. We need to have our institutions strengthened, and under Dr. Rajan, we are moving to a lot of financial innovation. The recommendations, if hastily accepted, will upset a lot of things,” Goyal said.

Rajan’s critique of the FSLRC report also extended to its central recommendation of creating a unified regulator. “The FSLRC’s recommendations seem somewhat schizophrenic here,” said Rajan.

He added that on the one hand the FSLRC spoke of synergies in uniting some regulators under one entity, but it also suggested breaking up other regulators “with attendant loss of synergies”.

According to the RBI governor, FSLRC has taken a “somewhat idealistic view” of the benefits of reorganization of the regulatory architecture, saying that creating a unified regulator may not always unlock synergies.

“I too shared such a view, but I now believe it is too extreme. Silos within a large bureaucratic regulator may prevent synergies from being exploited, while frequent inter-regulatory meetings can allow regulators to capture many of available synergies between their activities,” he said.

In 2008, the Report of the Committee on Financial Sector Reforms, prepared by a panel chaired by Rajan, had said that while it could be “premature to move fully towards a single regulator at the moment”, the regulatory structures can be streamlined.

The committee had advised a reduction in the number of regulators, saying that it felt it was “prudent to start the process of unifying regulation and supervision at certain levels …”

Rajan said he was not averse to giving up certain mandates of RBI, for example, managing the borrowing programme of the government.

Later, answering questions from the audience, Rajan said: “Regulatory freedom, flexibility is required. You shouldn’t give in one hand and take away everything from both hands. If we go much faster from where we are now, we may intrude on regulatory flexibility.” He added “Don’t be excessively ambitious in moving from zero to hundred. Halfway houses are not terrible.”