By: Ashima Goyal
Weeding out obsolete and conflicting laws should be made a national objective to be followed with vigour in a number of areas, not just in finance. The Financial Sector Legislative Reforms Commission (FSLRC) made an early start on this and offers many useful suggestions. The RBI has recently announced timelines for regulatory approvals and delivery of services following these suggestions. The concept of deemed approval, if timelines are not met, should also be adopted.
The underlying FSLRC philosophy seems to be to jettison the past and start afresh, whether in laws or regulatory structure. But this limits its usefulness — since past learning is lost, with both the domestic and international contexts ignored — to building for a future that comes from nowhere.
Moreover, principles must be above reproach in a principles-based approach. As RBI governor Raghuram Rajan has recently argued, the regulatory division proposed, with all trading to go to a new unified financial agency, is arbitrary since it will split regulation of debt products and of credit. The government securities market could be set back, and the conduct of monetary policy harmed.
Principles such as competitive neutrality in treatment, for example of domestic and foreign firms, and consumer protection are unexceptional. But qualifications tend to privilege firms by requiring, for instance, that consumers take adequate responsibility for their decisions, while financial innovation, efficiency, access and competition are not compromised. Any obligation on a firm is expected to be consistent with the benefit expected from such obligation.
The FSLRC views a financial crisis as due to human errors more than behavioural aberrations, so that micro-prudential regulation is adequate to safeguard firms. Systemic spillovers are thought to occur from failures of large systematically important financial institutions (SIFIs). They are to be made the responsibility of the Financial Stability and Development Council (FSDC).
But behavioural aspects are important. Too much risk is taken in good times without internalising negative spillovers on others. These risky strategies are widely copied, so SIFIs are not the only potential threats. Therefore, micro-prudential regulations, applying at the firm level, should work in tandem with macro-prudential regulation. Information acquired during the first helps in the design and timely application of the second. The FSLRC’s proposed restructuring would result in a serious loss of information and hinder regulation.
The experience of the global financial crisis made most countries give their central banks more responsibility for financial stability. The UK had shifted to a financial-sector funded unified financial regulator, focused on supporting innovation. The FSLRC wants to follow this experiment. But the UK found it worked poorly and returned powers to an independent Bank of England. The FSLRC is not able to establish the case for moving away from the current system, in which the RBI could implement innovative protective macro-prudential policies, to a design that proved unstable elsewhere.
In the financial system, a delicate balance has to be maintained between conflicting interests. The FSLRC seeks to tilt the balance towards financial firms, political representatives and the legal community. This is dangerous because the first two have a short-run perspective. Since the latter has severe capacity constraints in India, the poor would remain unprotected while the rich would find avoiding regulation easier.
It is in the short run that financial risks build up. For a long time after Independence, the RBI was forced to help finance the government’s development expenditure. It maintained financial stability by squeezing the private sector. The measure of independence established with great difficulty by the reforms should not be reversed.
Cash-starved and growth-hungry governments are often tempted to ease foreign borrowing. Again, this is a soft short-term option that, without complementary domestic reforms, creates long-term risks. The FSLRC wants the finance ministry to decide on inflows and the RBI on outflows. But international agreements often make it difficult to restrict outflows of foreign capital, so the RBI will be asked to ensure a stable balance of payments without the necessary instruments. The FSLRC also advocates a monetary policy committee, with appointments made by the government, giving populist pressures an entry.
Coordination is poor among Indian financial regulators. But the FSDC is better suited to improve these aspects rather than enact macro-prudential policy, where timing is crucial. It can homogenise compliance requirements to reduce transaction costs, introduce centralised reporting, and encourage innovation. In a country of India’s size and complexity, some regulatory competition is healthier than an error-prone, one size fits all, unified regulatory regime. Adequate democratic oversight can be imposed through transparency and accountability to Parliament.
The simplification that the FSLRC promises is also illusory. Sector-specific laws are to be replaced by a simpler principle-based unified financial code. This will guide regulators, who are to draft subordinate regulation as required, but subject to judicial oversight. So the complexity of regulation does not go away, but is simply pushed down to a messy process of appeals, even against rules and policy decisions. Rajan correctly fears this will harm the exercise of regulatory judgement, which is essential when financial contracts are incomplete and so cannot be proved in court.
The army of FSLRC lawyers would have been better employed in deleting obsolete laws to come up with a modern simplified set, rather than pointing us to a system with absent laws and a messy architecture to interpret doubtful principles.
The writer is professor of economics, Indira Gandhi Institute for Development Research, Mumbai