Saturday, Oct 25, 2014

Starting afresh isn’t simple

Raghuram-Rajan 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.
Posted: July 4, 2014 12:01 am | Updated: July 4, 2014 12:02 am

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 continued…

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