Dr. Shah, thanks a lot for agreeing to do this interview. We will talk about the regulatory architecture of India’s financial system. Let me begin by stating that the regulatory architecture of India’s financial system has undergone quite a lot of change over the last two decades or so. Two decades ago, all we had was the RBI as the banking regulator and Ministry of Finance for all the other financial sectors. But today we have most regulatory agencies in place and their role also have evolved to increasingly meet the needs of the financial system as it stands today in the modern economy of India. So Dr. Shah, the first question for you is, given where the regulatory architecture is, what are your overall thoughts on its strengths and weaknesses?

I classify myself as a critic of many of the things that we do in Indian finance. I have many disagreements and concerns about the way this is going. My conceptual picture is that we inherited a certain system which is a very old regulatory architecture. The bulk of work in financial reform has been about how to tinker at the edges and treat the regulatory architecture – the agencies, the bureaucracies — as a given and somehow try to evolve. So we have done very little by way of changing the basic framework.

I want to emphasise the laws. These things are greatly about law. To give an example, on one hand while we created the IRDA, we did not touch the old Insurance Act which has been there since 1938. Similarly on the securities side, we have the Securities Contract Regulation Act which is a very old piece of legislation, it has been amended repeatedly, but we never questioned the basic framework. Similarly commodity futures are dealt with by something called Forwards Contract Regulation Act and an agency called the Forward Markets Commission, which goes back to the 1950s, but we never really questioned that.

And most of all is the RBI, where the legislation was done in 1934. These laws are completely out of touch with India’s needs today. Law ends up defining the DNA of the agency. It is hard to obtain fundamental change in the agency without questioning the law. That’s why we have a huge problem on our hands.

So what I am hearing you say is that, there seems to be kind of a sunk cost thinking going on here, where the policy maker is essentially saying, “this is what we’ve got and let’s see how we can improve this iteratively”, but with very little thinking on the fundamental structure of architecture itself. So in your view, what kind of issues does this create for the functioning of the financial system itself, because we know that the demands for the financial systems have changed significantly in the last decade itself because the real economy has undergone such a major shift. So what kind of issues do you see emerging from this situation?

I don’t want to be harsh on this because it is better to make progress than to not make progress. I always admire and support people who will actually say: “Ok fine, given this hand of cards let’s make the best of this”. And in many ways the things which have got done in the last 20 years reflect these kinds of instincts. But there are different questions which need to be addressed, so I want to focus on a few grand themes.

The first grand theme is that of conflicts of interest. How do you structure an agency? How do you think about the work that you must give an agency outside the government? It is a very important question and not enough thought has been devoted to it. I think one important issue which must guide our thinking on this is that of conflicts of interest. Let me take an example. Suppose you have a minister who is in-charge of food and agriculture and the same minister is in-charge of commodity futures regulation. Then I would say this is conflict of interest because the goals of the minister of agriculture might often not be conducive with a free, fair and honest commodities futures market. So in these arrangements, there is a conflict of interest.

Let us take another example. You have a Central Bank which is an investment banker to the government and you have the Central Bank which does the monetary policy. I think there is an inherent conflict of interest here. 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.

Similarly consider a Central Bank who is also a banking regulator, I think it’s a conflict of interest because one part of banking regulation is about thinking asset-liability mismatches and the interest rate mismatches of the banks. Now suppose you have mistakes in your banking regulation and the banks are holding a lot of maturity mismatches (this has been the case in India many times). Now when you have these mistakes and you are a standalone banking regulator, you would say ‘hey this is dangerous, lets go fix it’ whereas if you are a banking regulator that is attached to the central bank then your bias will be `don’t allow the interest rates to go up too much, because then, some of the banks will go bust’. You try to cover up for the mistakes of banking regulation by using your central bank function. So by bundling banking regulation and monetary policy into the same agency, you have a conflict to interest.

Modern thinking in public administration involves a principal-agent perspective. It is the people of India who elect the Parlimentarians and that is the accountability of the administration of the Government of India. When the Government of India creates an external body, why should that external body work for the people of India? That is the agency question. We have to create an array of accountability mechanisms through which we make sure that these agencies actually do their job, do a good job, and work for the people of India. And the first checkpoint I would put into that is this question of conflict of interest. It is impossible for an agency to do its job if it is conflicted at the outset. So we must create clean agencies, which have a well-defined job. Such an agency can be held accountable for that job.

When you have conflicts of interests, the agency has no accountability. Why did you not do X? Because I was so busy doing Y. Why did you not do Y? Because I was so busy doing Z. When an agency has many, many functions, it has no accountability, it is not obliged to do anything. It is better to create sharp clear agencies which have sharp clear functions, only then you can hold people accountable. So this is the first class of concerns, about conflict of interest.

The second class of concerns is the way in which the financial system is getting distorted by the regulatory architecture. The way to think about it is that the Government of India exists to serve the people; the financial regulatory architecture exists to serve the people of India. The way we should approach this is: Let the financial system evolve based on considerations of efficiency, productivity and capability and then let us re-design the financial regulatory system to suit the needs of a modern efficient capable financial system. Instead, what we are doing in India is upside down.

We have a legacy financial regulatory architecture, so we have some ancient collection of agencies that don’t particularly have a modern notion about why they exist and what they do. And we are forcing the financial firms to redesign themselves to suit the financial regulatory architecture.

Let me give you an example. What is the way to become an efficient securities firm? To become an efficient securities firm you have to have economies of scale, you have to have economies of scope, so you want to put more and more functions into a single firm and you want to achieve economies of scale and scope. So for example you want a securities firm to be trading on all markets – equities, bonds, currency derivatives, commodity derivatives and so on. But in India that is not feasible because these markets have been split up amongst separate regulators – some part is RBI, some is SEBI, some part is Forward Markets Commission. So what can an Indian financial firm do? The Indian financial firm is forced to break itself in pieces, to create one separate subsidiary that trades in commodity futures market, to create one separate company that becomes a primary dealer, to create one separate company that deals on the equity markets and so on. This leads to a loss of economies of scale and scope which hinders progress. If each of these separate organisations are getting started, they have to figure out from scratch about what they want to do. But actually there are so many areas where a unified team would be far more effective at addressing all these problems.

For example I think the right guys who should be working on Covered Interest Parity Arbitrage on the currency market are the same guys who are working on the Nifty Futures Arbitrage on the equity market [and] are the same guys who are working on Gold Futures Arbitrage on the Commodities Futures Market. So what you really want is 10-20 people who are the arbitrage group inside a securities firm who do all manner of arbitrage. They do Covered Interest Parity Arbitrage on the currency market, they do Onshore and Offshore Arbitrage between the NDFs and the Currency Futures, they do stock futures arbitrage on the Nifty, they arbitrage between the Nifty Forwards on the PN market and the Onshore Nifty.

Instead, what we do in India is that we force the financial firm to reorganise itself as multiple separate companies. This imposes cost. There is this priceless phrase of Percy Mistry: “instead of the financial regulatory establishment adjusting itself to suit the needs of the financial system, we are forcing the financial system to reorganize itself to suit the needs of the financial regulatory establishment”. This is something we really need to change. We need to think from scratch, we need to design a financial regulatory architecture that serves the people of India and serves the economy of India, instead of forcing the Indian financial system to reorganise itself to serve the needs of the financial regulatory system.

Some other issues that many people talk about are regulatory arbitrage, overlaps and gaps. How important are these issues in your view?

The standard theme that many people have emphasized — and this is perhaps why I am not talking too much about it — is the overlaps in regulatory arbitrage. These are important issues and are present everywhere in the world.

What Raghuram Rajan has been emphasizing is that we are actually doing rather badly on inter-regulatory coordination. Everywhere else in the world there are multiple regulators who have problems talking to each other, but the problems that we see in India are much more acute. The extent to which there is a lack of civil conversation between some of the agencies particularly in the recent past, though not so much today, is really astonishing. The unwillingness to meet, the unwillingness to share information.

The individuals manning these agencies are in a bind where they have horrible conflicts of interest. It is very difficult to do their job. And one of their responses is to create these silos and shut off the world and refuse to talk to anybody, because when you talk to somebody else it becomes very, very uncomfortable for you. So part of the problem as to why we appear to be so dysfunctional is not that the individuals are particularly bloody-minded but that the individuals are placed in such a horrible situation, where it is not easy to do your job properly. It’s bad enough handling your own agency, and even harder to face problems emanating from external agencies. So what you try to do is shut them off. It is a design issue which is coming up as a behaviour issue.

There is a lot of merit in the construction of The Financial Stability and Development Council (FSDC). It is still work in progress. It has to turn into a full fledged agency. So far, it is an idea and not an agency. FSDC has to turn into an organization. All of us have to stay engaged and figure out how this organization comes together. But I do share the idea that there will be many, many financial regulators in India and we need FSDC to improve the inter-regulatory coordination and to deal with the question of financial stability.

I am glad you mentioned the FSDC which is a very exciting development in the financial architecture and we know that it is in the process of defining its role in more detail. What is your view on what a body like FSDC should do in the Indian financial system?

I think there are two elements of the FSDC rationale. The first is that the FSDC should generically go after what I call the cross-cutting issues. There will always be issues that span two agencies. Now you take the present financial regulatory architecture or you take up a future financial regulatory architecture: there will be issues.

Let me take an example. Consider the problem of regulation of distribution (and we saw the problems of IRDA and mutual funds and all that). No matter how you carve out the financial regulatory problem in India, there will be a question which is: “Who deals with the consumer protection problem?” How does the distribution of financial products take place, how do you deal with advice, how do you deal with the problem of financial inclusion, of financial literacy and so on.

These are cross-cutting issues. Each agency could go after it in [it’s] own way. Or is there a role for greater coordination?

For example, do you want uniform rules about distribution of all financial products, otherwise you will have the problems that we saw and continue to see in insurance, where insurance companies are using particularly toxic sales models and other financial regulators in India are being most tuned to their consumers, but in the end are hampering the growth of their own sector because this is a race to the bottom where the worst sales practices give you the highest market share. When you have such cross-cutting issues, how do you create a forum to address them?

And then to the mother of all cross-cutting issues: financial stability. Financial stability is integrally a cross-cutting issue because when things get bad, they get bad in ways that span markets in complex ways. We in India think that we have a tidy system: there is a securities market regulated by SEBI, there is a banking system that is regulated by RBI and so on. But in a crisis all these link up in unexpected ways. Remember that in 2008, we had an interesting set of regulatory responses and emergency actions that took place in order to solve the problem. We had to figure out emergency actions which were linked to banks, real-estate, mutual funds, and money market mutual funds and so on. Crisis management is inherently cross-cutting.

We don’t have well structured war room mechanisms whereby there is a crack team and a standing mechanism through which we are able to bring together all the agencies. Absent this, we are finding it difficult to deal with crises. Financial stability is the mother of all cross-cutting issues.

The way I see it, there are two aspects of financial stability issue. The prevention aspect and then the cure or the fire-fighting aspect. One of course, we need a crack team to respond in an agile and comprehensive way to deal with the stability crisis, like the one we saw recently. But then we also need mechanisms that help mitigate systemic risk. What can the FSDC do to manage systemic risk better than the way it is managed today?

The prevention side is also inherently cross-cutting. What’s happening is that we tend see one silo at a time. Each agency in India thinks only about itself. But actually many of the problems are cross-cutting across silos. We need a creative effort in understanding. 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. It tends to say: “I have this one law, I am administering this law and this is my view of the world”. The heart and soul of financial stability is: Let’s break out of the silos. Let us not think of Indian finance from a silo perspective, let us think of the overall financial system.

To do that, you’ve got to have a bunch of people who are not part of any of the existing agencies.

In some countries financial stability is being done in central banks, and it is important to see that many of those central banks do nothing by way of financial regulation. So that gives them the ability to look above the day-to-day concerns of a financial regulator and take a system perspective. In India, because RBI does a lot of financial regulation and supervision work, it makes sense to place financial stability work under the FSDC.

FSDC is presently convened by the ministry of finance, do you think there are any process level or organization level changes that could improve the functioning of FSDC itself. Currently it’s being hosted by the MoF as we understand it?

In the future maybe we should be thinking about this differently but right now we need to incubate FSDC. Right now we are at a very basic level. Today, FSDC is all of 2 people. This needs to become 20 or 40 people, it needs to develop databases, it needs to get going on a series of research projects, it needs to figure out mechanisms through which it is watching the economy and so on. So it’s very much work-in-progress. As the work takes off, maybe in the future one can think differently about how it should be built.

I think it really makes sense to connect it closely to the Ministry of Finance. Here’s one more reason for this. In a crisis you might well require the inputs of some critical resources. So it helps to have the Finance Secretary and the Finance Minister on the table when those kind of decisions are being made. Another point is that when you have multiple financial regulatory agencies who have a disagreement. E.g. suppose there is a disagreement between IRDA and SEBI: This disagreement could be intractable and you can just go on and on in this state of disagreement. Or you can have the Finance Minister chairing the FSDC which is a way to resolve this conflict. So I think there is merit in keeping this in Finance Ministry.

But in any case that sort of question is going to come later. Our first challenge is to convert the FSDC from concept to reality.

Talking about the recent financial crisis, one perception that I often come across when I talk to people is that India somehow escaped the crisis because of the robustness of its regulatory architecture. Do you share this perception or is there any nuance that is missing here?

I don’t particularly share that view of what happened. Let’s take two steps back and think more generally.

Let us a consider a global trade shock, just for the purpose of argument, where something happens and there is a giant trade shock. Now a country like South Korea, which is well integrated into world trade, would be very badly affected. A country like Burma which has cut itself off from world trade will be less affected.

Because India is weakly integrated into the world economy we were a little less affected.

I am not saying that this is right. One of the causes of mass deprivation in India and of the low-level of per capita GDP in India is 50 years of autarkic policies that have tried to cut India off away from the world. We should integrate more with the world. But to the extent that we are not particularly integrated with the world, it will obviously be the case that we were less affected than compared to some other countries.

The second point is that actually the shock was quite a big one for India and I don’t think we are appreciating how bad things were. So let’s go back to September 2008 and October 2008. Through this period the RBI had a repo rate and a reverse repo rate, so in theory the operating procedure of monetary policy is supposed to ensure that the call money rate and other market based short term rates stay between the repo rate and reverse repo rate. But 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.

So I don’t think that you can support the claim that India was well insulated. 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. We started out from a healthy 12% and at the end we were 4%, basically an 8 percentage points of GDP decline in the rate of GDP growth, which is pretty much like many of the other countries.

The claim is made that none of the banks in India collapsed because of a certain approach to blocking the capabilities and progress in banking in India. But I can show you so many other countries where banks did not collapse. Take Canada, or take Australia: banking in these countries worked. These are not countries hobbled with a 19th century model of banking, the way that it is practiced in India. They have modern, sophisticated, capable banks. And the banks did not collapse. In fact Canada is right next to the United States and tightly connected to the US economy but there was no great crisis in Canadian banks.

So I am not persuaded that there is something wonderful about the Indian approach to financial regulation.

One of the direct consequences of the crisis was that it forced law makers, regulators, and researchers to get into kind of huddles to discuss some fundamental questions about the design of the financial system in general and regulation in particular. Clearly, a considerable amount of research has happened on why and how the crisis happened and what can be learned from that. There is the Turner report, Squam Lake report, many books, like the one brought out by Stern School faculty, The Faultlines book by Professor Rajan and so on and so forth. Another outcome of the crisis was that major policy changes happened in some of the countries. We saw the Dodd Frank Act being passed in the US, proposed abolition of the FSA in the UK, across the world and some countries have seen very, very significant changes since the crisis. So the question for you is, what can India learn from the insights emerging from research as well as the policy shifts happening in some of these more developed economies in the West? As you said, India is still in somewhat of a rudimentary stage as far as development of financial system is concerned and there is a lot that is yet to be done and perhaps there is an opportunity for us not to make the same mistakes that people made elsewhere.

I would use a three-part categorisation. The first is the things that have been assimilated outside India, where we were already on track. The second is the things where new knowledge has been produced outside which has reiterated our sense of the things that we have to do, but these things are not on track. And the third is completely new ideas which has got emphasized because of the crisis.

Under category I, about things where our thinking was different anyway compared to the rest of the world. Consider something like the OTC derivatives market. In the US, the old approach was that the OTC derivatives market should be completely unregulated while the exchange traded credit derivatives market was regulated by the SEC and the CFTC. The OTC derivatives market was essentially kept completely out of the regulatory purview. Now, that was never something that was proposed or emphasized in India. Nobody was ever proposing that the OTC derivatives market should have a free run.

Under category II are things that we knew were an issue but now need to be amplified. I would place things like the importance of the resolution process for financial firms. In India we have long worried that we actually don’t have a decent deposit insurance corporation. We need to bring about serious capability to watch large complex financial firms, and to be able to pre-emptively shut them down before they get into trouble, before they go bankrupt. We need to actually look beyond banks narrowly speaking and go after the resolution problem of financial conglomerates more broadly, to think of large complex financial firms and create the capability to be able to close them down. That, I think, is a big to-do that we have to work on, where honestly very little work has been done so far in India.

In terms of the 3rd piece of what we need to do, which is different from what we were doing earlier, is system thinking. Traditionally in India, the logic has been that our silo architecture is a very damaging thing because it imposes cost and complexity on the financial firms. But in addition to that, there is a very big piece of damage that comes because of our silo architecture which is that we lose the ability to understand the financial system as a whole. That is what financial stability work now needs to combat.

This is my rough categorisation of the sorts of things that have now come up in the last few years, which have illuminated our thinking on these questions. But you know, if I re-read the Percy Mistry and Raghuram Rajan reports today, I don’t find a whole lot of that which is overtaken by the events. The basic story stands. The reason is: India started out from such a horrible system that the basic direction of how to move away from that has not changed.

I also want to seek your view on a specific issue that gained prominence recently. There is a kind of lack of clarity about how the state governments can and should intervene in the financial markets. They have a clearly defined regulatory roles vis-à-vis the cooperative bank and institutions, we know that. But they also sometimes legislate their way to other spaces that are being regulated by an agency like, say, RBI. We witnessed this in the recent crisis in the microfinance sector of Andhra Pradesh. What do you think would be the way out of such situation? The risk of state government intervening is a risk that one has to consistently face especially when working with low income households.

These problems are ultimately rooted in the drafting of the constitution and the drafting of the laws. So in the short-term you cannot do much about it. I have been emphasizing that the heart and soul of the regulatory architecture is the law. We need to think about a new set of laws and some of these questions can indeed be addressed then.

As you know, there is a very very exciting development, which is the establishment by the government of the Financial Sector Legislative Reforms Commis (FSLRC) headed by Justice Srikrishna. It has given them a broad mandate to write a whole new set of laws to deal with an array of questions in Indian finance. In the last 5 years, we have finished quite a good bit of work on thinking about what we want to do in financial reforms in India. Now the time has come to put pen to paper and translate all this thinking into a new set of laws. I am hoping many of these problems should end up getting solved by the work of the FSLRC.

Dr. Shah, let’s at this stage take a step back from all these details about how things are right now and take a 10-year view of the financial system. I want to ask you, what is the vision of the regulatory architecture say, ten years from now? We know that there are a number of views out there – some people are calling for single regulator in the country, those views are getting silent now, but a majority are asking for some kind of consolidation away from this current structure of having half a dozen regulators with governments intervening all the various kinds of overlaps and arbitrage and gaps that we see. What is your vision?

There are a couple of things that are quite clear and there are others that are debatable. So the first is that, there is a lot of benefit by putting monetary policy in a central bank such as RBI, but it should be a narrow agency that does only one thing which is to choose the short term interest rate. There should be no other work in that agency, as we have seen elsewhere in the world with good central banks. So this is the first piece – that monetary economics is not finance and the two should be kept separate.

The second piece that I feel confident about is that all work on securities market should be unified into one agency. You may want to call it SEBI, you want to call it something else. But it really makes sense that all regulation and supervision of the securities markets should be unified into one single agency. These are two big things that we need to do.

From an Indian political perspective, I am a great believer in dispersion of power: that it is good to have multiple agencies rather than unification into a single agency. You could do it as banking, pensions, insurance separately or you could do it as an Australian model where one agency does the prudential regulation and one agency does the consumer protection. Both are reasonable approaches.

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.

But one day in the deep future, India will do a good job of appointments. At that point we can rethink some of this consolidation. But the time for that is not right now.

I think that there is a lot of economic sense in such consolidation. Perhaps the way to go about it is that in the future, again not right now, the logical place to start would be the treatment of large complex financial companies. So if you think of ICICI as one large conglomerate or HDFC, then it would help to have a unified supervision of these conglomerates. Maybe that is the place to start the unification in the future. But not anytime soon.

Central banking / monetary policy is the setting of the short term interest rate. So all of these finance functions, in my mind, are extraneous and a distraction or confusion and should not be in a central bank.

The other thing that you said is that all market based activities under one regulator – that makes sense. What are your views on how the rest of the financial system should be regulated? For instance, the IRDA is the insurance regulator, but the insurance companies do other things as well. How do we deal with issues like these?

I feel quite strongly that, the job of the banking regulator should not be to regulate all the activities of the bank. It is not an appropriate way to think about law. Even if I am a bank, the provisions of the Indian Penal Code apply to me and the banking regulator does not enforce the Indian Penal Code on me. All firms do many, many things and the right way to think about is that the relationship between a banking regulator and a bank is that the banking regulator regulates the banking business of the bank and not all the other activities of the bank. When the bank builds a structure, that structure has to obey the building code, and the banking regulator is not the one who enforces building codes.

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 the regulatory footprint should be by the activity and not by the organization. When an insurance company trades on a market, it should be subject to market supervision; it should obey the rules of the game of the market, and so on. It should not be the case that the insurance regulator is the god who controls everything about all activities of an insurance company. That’s a feudal notion. We should take a legalistic perspective: there are many laws and all the laws have to be enforced and a regulator is charged with enforcing one of those laws. That is his job.

What in your view are the key challenges to realizing the vision that you just stated?

The first challenge is the intellectual consensus. We have done a lot of work with the Percy Mistry and Raghuram Rajan reports and if most people will take interest and read those reports and think about them and ask about them, that would do a world of good. And we need to deepen our understanding of the issues, we need to gain confidence that we have figured it out. That is the first part of the story.

The second part of the story is the FSLRC which I think is the most exciting project in the entire history of Indian finance. Can you imagine ever in India’s past and god knows for how many more decades, that we get a comprehensive rewrite of all the laws of Indian finance? It’s a very, very big complex problem and it’s important that we should be executing this well. 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 is the bureaucratic politics that shapes this process. The individuals insides existing agencies are generally unwilling to make any changes to their role and function. Such defence, of course, is an absolutely instinctive response. So I have one working thumb rule that it is good to always completely disregard the views of SEBI on what the role and function of SEBI should be. It is good to disregard the views of IRDA on what the role and function of IRDA should be. It is good to disregard the views of Forwards Market Commission on how you should think about commodity futures. It’s good to disregard any statement, any speech by anybody connected with the RBI on questions of monetary policy arrangem etc. Because these are people who have self-interest, they are protecting turf. All of us in the public debate will be better off if we bring a basic skepticism to these kind of situations.

An interesting point you just made is regarding the need for creating an intellectual consensus around these issues. You said that a lot of work has already been done in India to develop ideas around improving the regulatory architecture and improving the financial system design in general. Now what can be done to bring about greater consensus around these ideas, especially among political leaders because, as you said, these issues are primarily related to laws and have to be legislated through. When I think about who can do something, the first names that come up are people like you, who are the forefront of thinking on these issues and are publicly communicating them. What more can be done to make sure that intellectual consensus around these issues is formed and sustained?

I have a two-part perspective on this. The first point is “Look, India is growing, India is changing dramatically, we are now a $1.6 trillion GDP economy, we are much more internationalized than we used to be and the game has changed”. There are a set of dysfunctional laws and agencies who were designed for an India which was a $50 Billion GDP, and today India is a $1.6 trillion GDP. So I think it’s pretty obvious that change is requierd. Every time I used to see these newspaper stories about the celebration of the 75th year of RBI, I used to get reminded ‘Wow, 75 years old, we really need to do something about RBI now’.

That is one part of the story. There is a change which is so manifestly visible, it’s blatantly obvious to anybody who has any connection to the financial system, that there is a gap between what these agencies are doing and what are the needs of modern India.

If we don’t make progress on solving our domestic problems of financial regulation then I believe that a large part and the growing part of Indian finance will actually end up happening offshore. This is already starting to happen. There are many, many parts of Indian finance that are increasingly being acted outside because we are being so slow and so ineffective in solving our own problems. The Indian economy is not going to wait for the Indian financial system. If the Indian financial system fails to deliver adequate capabilities in time then more work will simply switch offshore.

I am confident that these kind of pressures will constantly keep the pot on the boil and there will be a lot of impulses going to the politicians of the form ‘Hey, this thing is dysfunctional, you need to do something about it’.

And luckily this is not hot-button territory for voters. The only question in Indian finance where I am seeing many MPs have a strong view which is really inconsistent with the direction that we might like to go is the question of bank privatization. There is no support amongst existing MPs today for the privatization of existing PSBs. Barring this I have not seen a single hot-button issue where MPs or ministers have a visceral objection to reforming Indian finance. It is hard to reform PDS because there are voters who directly like PDS. But in contrast the number of employees of existing financial regulatory agencies is not very large.

So I am very optimistic that this is a process that will happen. The real problem is that these questions are complex and all of us need to work harder on understanding them. While we made a lot of progress in figuring it out, we need to do more in terms of doing research on questions of financial regulation, on understanding these things, on arriving at a better consensus about what went wrong, how it went wrong, and what can be done differently.

For example I am so disappointed at the media treatment about the Andhra Pradesh microfinance crisis. So many journalists are ready to jump into this conclusion that microfinance institutions are the glorified moneylenders and somehow there is this whole pejorative spin that goes along with it. So all of us have a lot of hard work to do in terms of both understanding the issues, in terms of communicating them, in terms of arguing about them, in terms of doing better research of having better understanding and a better quantitative sense about what is going on.

You said that there is knowledge that needs to be disseminated, understood and accepted widely. But taking a step back, are there still some important research questions under the theme of India’s regulatory architecture that are yet to be answered satisfactorily by research? What are those questions and which ones are at the top of the pile of priorities?

Wearing my academic hat, the way a research paper is done is one small question at a time. For example I mentioned the interest rate risk of banks. Many years ago I did some collaborative work on the measurement of interest rate risk of banks. It was careful, slow, quantitative work. We found that there were 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. Now that is a hard fact and something that one can do an academic paper on. On such a narrow question, one can really score victory and get a black and white answer.

That’s a valuable raw material for thinking policy. For example, when I was discussing conflicts of interest and I was explaining why it is important to keep a banking supervisor separate from a central bank, I was saying that there are these kinds of conflicts of interest.

There are close linkages in all this. Our ability to think about the grand policy questions is critically rooted on having a series of these building blocks. We need a series of top-quality academic papers in hand, that settle one question at a time. Each academic paper should be a small narrow question, where the author scores victory in terms of getting an answer that is really beyond dispute. And then we need a class of people who are able to learn that literature, put it together, and think about policy questions. Policy thinking is different from narrow quantitative academic economics, but we need both. And if we are doing only policy thinking in the absence of the narrow building blocks then I think that would be a serious mistake. In India we desperately need both.

Do you think we are doing well on either of the two?

We are certainly not doing well on the building blocks in terms of writing academic papers. There is only a handful of interesting policy-relevant quantitative academic papers coming out in India per year. So there is a shortage of people who take interest in these things. The incentives of the individual researcher are overwhelmingly in favour of shooting for journal publication and a research career outside the country. There is relatively little incentive and interest on the part of the researchers to do stuff that matters in India. That’s one of the problems that we have to overcome.

Dr Shah, thank you very much for taking time for this interview. It was a very insightful discussion and I really enjoyed it. Thank you.