“We need to design a financial regulatory architecture that serves the people and the economy of India”

What is the state of financial regulatory architecture in India? Is the regulatory architecture optimal for the modern financial system that the Indian economy needs? What do the recent changes in the regulatory architecture mean for the financial system? How can the regulators be better prepared to take on the challenges for the next 10 years?

Dr Ajay Shah, Professor at the National Institute for Public Policy and Research answers these questions and more in a detailed conversation with Suyash Rai of IFMR Finance Foundation. This interview is the second in a series of posts on the theme “Regulatory architecture of India’s financial system”. IFMR Blog will continue to feature this theme through the next three weeks.

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Click to read the transcript of the complete interview.

Brief summary of the discussion:

The basic framework of the regulatory architecture in India has largely remained unchanged over past few decades, the RBI being a case in point where the last legislation was done in 1934. The laws behind the current architecture are completely out of touch with India’s needs today.

On Issues with regulatory architecture

One of the many things that need attention today is the issue of conflict of interest. If the Central Bank is an investment banker to the government and is also in charge of the monetary policy, there is an inherent conflict of interest. In order to serve the function of being an investment bank, the central bank may like to make the interest rate as low as possible. This would persistently generate an inflation bias.

The issue of conflict of interest is the first check-point that an elected government should deploy. An agency with multiple functions would not have accountability because, unless there are clear, sharp functions, conflict of interest is bound to arise.

The financial system should evolve based on efficiency and productivity considerations and the financial regulatory system should be re-designed to suit the needs of the “modern, efficient, capable financial system”. But today, the opposite is true where the financial firms are forced to redesign themselves to suit the architecture. This imposes cost and inefficiencies on the economy.

On Multiple regulators and the FSDC

Though in many places multiple regulators have problems talking to each other, in India, the problems are much more acute. This is where an agency like the Financial Stability and Development Council (FSDC) comes in handy. In a financial system, there are bound to be “cross cutting issues” – consumer protection or most importantly, financial stability. This is important because, when things get bad, they affect markets in a complex manner.

The impact of cross-cutting issues is not just when there is a crisis. The prevention side of systemic risk is also inherently cross-cutting. The heart and soul of financial stability thinking is to look at the overall financial system, look at the inter-connections that cut across all elements of finance. And no one regulatory agency in India is capable of doing that because by their very nature, each regulatory agency tends to be a silo. Since the RBI does a lot regulation and supervision work, it makes sense to place financial stability work under the FSDC.

Was India ‘isolated’ from the recent crisis?

India is integrated weakly into the world economy and so to that extent, we were a little less affected by the crisis. Having said that, the shock was quite a big one for India. In September and October 2008, the very operating procedure of monetary policy of RBI broke down. The call money rate went to 15% even though the repo and the reverse repo were far, far below. I can’t think of too many countries in the world, where the very operating procedure of monetary policy broke down in this fashion. If you take the seasonally adjusted quarter on quarter growth for GDP, in the pre-crisis period it was at the peak of 12%, in the crisis it dropped all the way to 4%. An 8 percentage point drop of GDP growth is pretty bad by international standards.

Not just India, but many other countries were equally unaffected. Canada, for example, whose economy is tightly connected to the US economy, experienced no big crisis. Australia is also another case in point.

On Vision for the regulatory architecture

First, monetary economics is not finance and the two should be kept separate. RBI should be a narrow agency that does only one thing and that is to choose short term interest rate. Second, it makes sense to unify all regulation and supervision of securities market into one agency.

From an Indian political perspective, it would be advisable to have a single very strong agency doing too many things. This is good in the longer term when the process of appointment is much more efficient. But I would be unhappy if there was a single very strong agency doing too many things, because in India, we will run into trouble on the appointment process and the entire field of Indian finance could choke for a few years if the wrong people are put in charge of an agency. I am pessimistic about the appointment process. The reasonable way to see it is to imagine that there are 3-4 agencies and 1-2 of them will always have low quality people at the top and 1-2 will have high quality people at the top, so at any point in time we will end up making progress in some areas and there will be a creative tension between these multiple agencies who will have different views on various questions. If we unify too much into a single agency, then I think that’s too much concentration of power.

The job of a banking regulator is not to regulate all the activities of a bank. For example, when a bank does depository participant business, the depository participant activity is regulated by SEBI. When the bank trades on an exchange, this is regulated by SEBI. So, a regulator should be charged with enforcing only one of the many laws of the land.

On challenges impeding realisation of the vision

The first challenge that needs to be overcome is that of creating intellectual consensus around issues related to reforming the regulatory architecture. The second is getting the Financial Sector Legislative Reforms Commission (FSLRC) right. Justice Srikrishna and his fellow commission members have an immense burden of responsibility on their shoulders to do a great job of this. The third piece to this is the bureaucratic politics that shape this process.

We need a series of top quality academic papers that will answer one question at a time. For example, one research pointed to fairly high levels of unhedged interest rate exposure in the banks of India, which suggests that the regulation and supervision of interest rates was not being done properly. These are valuable raw materials for thinking policy. But there is not much research happening in this area. That is a key problem that we need to overcome.

[The views expressed above are Dr. Ajay Shah's and do not necessarily reflect the views of IFMR Trust or its associate entities.]