Friday, August 13, 2010

Is the CD Deshmukh Memorial Lecture a political event?

Going by Dr. Subbarao’s contribution this year, it certainly seems to be. This speech, if one were to take it at face value, exhibited a complete lack of awareness regarding monetary matters which drew a sharp & detailed rebuttal from Ila Patnaik.

However, I believe that the speech was made with a very specific intention. While a large chunk of the speech was dedicated to it directly, with the RBI Governor detailing the reasons why he believes that the RBI should be the coordinating regulator, the rest of the speech dealt with the proposed environment in which this should happen, albeit indirectly.

Discussions concerning the RBI’s role in the economy came to a head recently with the government replacing the ULIP Ordinance with The Securities and Insurance Laws (Amendment and Validation) Bill, 2010 [PDF]. This Act provides for the establishment of a joint body to reconcile and rationalize jurisdiction disputes between the 4 regulators (RBI, SEBI, IRDA &  PFRDA) by a joint committee which apart from representation from these regulators, will have the Union Finance Minister, The Finance Secretary & The Secretary (Financial Services) in the Ministry of Finance as members with the Union Finance Minister chairing it. In a concession to the RBI, The RBI Governor will not just be an “ex-officio member”, as stated in the ordinance, but the “ex-officio Vice-Chairperson” of the Joint Committee. The Committee will then follow any procedure it considers suitable and inform the Central Government of its decision within three months. The decision will be binding on all regulators.

The RBI has always believed that it is far more important than any of the other financial regulators, and with good reason. After all, RBI decisions touch far more lives, and exert greater influence over the economy, than those of other regulators. However, in expressing the underlying reason for this “seniority” the RBI often, intentionally, mixes its up. This was evident in Dr. Subbarao’s speech as well.

He takes the RBI’s current responsibilities and builds a case for such seniority being formalized by law at a time when the scope of the RBI’s responsibilities is being intensely contested. To say that the monetary authority should also be the prudential regulator for banks as they are the primary channel for transmission of monetary policy is denying current reality. Financial system risk is no longer restricted to banks and non-banks, including Mutual Funds, play an important role as well. The monetary authority, therefore, needs to have authority over all forms of financial risk in the system. The RBI tries to achieve this by making a case for increased power. I think it is better achieved by reducing it. Let me explain.

RBI’s role as a monetary authority would be enhanced if it were to delegate all prudential regulation, including that of banks, to other regulators, specializing in various types of financial risk. As a monetary authority, its role can then be strengthened by giving it the power to supervise the functioning of all regulators without undue favoritism. Currently, with bank & NBFC prudential regulation entrusted to the RBI, it has a tendency to favor these over other financial intermediaries, which in reality, works against efficient transmission of monetary policy as was evident in the events of late 2008. In this case, the RBI was very willing to look at the problems faced by banks, but agreed to assist the mutual fund industry only after intense discussion and convincing. The result was financial mayhem. The suspicion RBI harbors about the intentions & regulatory framework surrounding other financial intermediaries is an outcome of its regulatory ownership of banks & NBFCs. It believes other regulators to be deficient not because it knows them to be so, but because it believes that it does a far better job than them. If we take this competitive ego out of the picture, the monetary authority will be far better placed to manage systemic financial risk.

But for such a monetary authority to be empowered to this extent would need it to be accountable for its actions. After all, we cannot have an unaccountable body overseeing all prudential financial regulations and this is where the rest of the speech fits in. Dr. Subbarao, using archaic arguments, goes to great lengths to avoid any form of accountability for the RBI. He maligns the concept of inflation targeting as detrimental to the RBI’s other aims, namely development and financial stability, without defining a target for either. If the RBI wishes to support growth and control inflation in a financially stable environment, it can specify the target and relative priority for each and justify every action on this basis. If it believes that inflation in India comprises mostly of factors exogenous to monetary policy, as Dr. Subbarao states in the speech, let it define the inflation it is willing to target. Many central banks do the same by ignoring food & energy prices (both exogenous factors) and focusing on managing core inflation But it needs to come forth and say what it wants to manage, define a target and justify all actions on that basis. This would also lend greater discipline to RBI’s decision making and reduce the scope of personality driven monetary policy which is common under the present system.

By avoiding any form of quantification, the RBI wants to gain control over all financial regulations without any form of accountability. Without the increased power it strives for as well, it is evident that the RBI needs to be more accountable in its role of monetary authority. With increased power, it would be critical. As mentioned earlier, its a two step process. We need to create a Monetary Policy & Financial Stability Board in which the current RBI Governor and two relevant Deputy Governors assume the role of Chairperson and Members of the Board respectively. Chairpersons of other regulatory bodies like SEBI, IRDA & PFRDA should also be inducted on this board. The RBI, or what is left of it, should be headed by the senior-most remaining Dy. Governor. Similarly, other regulators can be led by the senior-most of their second line. However, this arrangement is only to ease transition, after which all members and the Chairperson of this board will be appointed by the Central Government. All regulatory bodies should then function under the supervision of the Board which takes ownership for monetary policy and financial stability with measurable targets and complete accountability.

The RBI’s current stance is working against the emergence of a cohesive regulatory framework for the financial market as a whole. To designate a particular regulator as senior increases the risk of financial market development being skewed towards the industry it regulates. It’s not a risk India can afford to take.

But the speech was disappointing at another level as well. The CD Deshmukh Memorial Lecture is an event many look forward to, anticipating words of genuine wisdom. Well, this year, we got a political statement guised as wisdom. Extremely convenient wisdom.

A version of this post appeared on my Business Standard Blog on August 13, 2010

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