Wednesday, August 18, 2010

Is the RBI just another regulator?

Following Dr. Subbarao’s speech which strove to position the RBI as the only choice for a coordinating regulator, comes this speech from Rakesh Mohan, a former Deputy Governor. Another memorial lecture was hijacked by a blatantly political agenda, and yet the case for RBI’s primacy amongst financial regulators was strengthened only marginally.

Most central bankers, past & present, would agree with the two speeches, not only because they believe it in the underlying cause, but because their approach has been blinkered by their past. They believe that banks are special but the financial crisis of 2008 proved them wrong. Shadow banks emerged as the lead protagonists in the financial crisis of 2008 and central banks couldn’t do anything about it till it was too late. Whether central banks chose to look the other way or were completely ignorant of emerging risks is irrelevant. All that matters is that non-banks could contribute to financial instability in equal measure as banks.

Lest you get me wrong, I agree that the monetary authority should be the coordinating regulator. But that the monetary authority should also be responsible for regulating a segment of the market is another matter altogether. In doing so, the monetary-regulatory body that emerges is powerful but with little responsibility and ownership of other market segments, prone to respond to demands of the segment they regulate even at the expense of other segments. Also, since this entity has very little control over other market segments, its prone to ignore developments that threaten market stability in these segments. Our current system looks more like the US system, with a central bank responsible for monetary policy and bank regulation and an independent regulator (in our case, multiple independent regulators) for the securities market. And this is the very system that failed. But is giving the RBI an exalted position a solution? Not if we are serious about reform.

Rakesh Mohan uses the UK as an example, saying that their move to fold the FSA back into the Bank of England argues for RBI supremacy. Well, it doesn’t. What it does argue for is unification of all agencies under the monetary authority where a homogeneous regulatory framework treats all market segments with equal respect and seriousness. It makes the case for treating banks as just another market segment, and not a market segment deserving special treatment. On the other hand, if the RBI becomes the coordinating regulator, as these gentlemen desire, it grants the bank regulator an exalted status when compared to other regulators. This will only result in more mayhem rather than less.

For a unified regulatory environment to work, it is essential that all regulations be accorded equal importance. Only then will it be possible for the regulator(s) to be in a position to recognize risks, no matter which segment of the financial sector they arise. And for that the RBI, in its current form, cannot survive. For the RBI Governor to be accepted as the head of a unified regulatory framework, this position needs to transform into one which carries direct responsibility only for the conduct of monetary policy. With bank regulation delegated to a Dy. Governor, it will be possible to merge other financial regulators with the RBI with the Chairperson/Head of these regulators as Dy. Governors. But this is just one way and experience indicates that it may not be the right one.

The RBI has always been an excellent regulator. But as I have mentioned earlier, its conduct of monetary policy has been disastrous. It has worked hard to hide its monetary policy failures behind its regulatory successes. And its done so very well. But if one were to look at normal parameters for measuring the efficacy of monetary policy, like inflation, growth & domestic stability, the RBI has failed at every step. This experience suggests that the RBI would be better positioned as a bank regulator, surrendering its monetary policy and financial stability roles to an organization formed expressly for this purpose. This entity will also oversee the functioning of all financial regulators, including RBI.

However, the Committee proposed by the The Securities and Insurance Laws (Amendment and Validation) Bill, 2010 [PDF] is not a complete solution. Its brief is to settle inter-regulatory disputes, some of which have held back critical developments in the Indian financial markets and that can only be good. But it cannot ensure financial stability. For that, more meaningful reform is needed.

Reform which does not insist on maintaining status quo at the RBI.

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