| This fourth article, in the six-part series on the MIFC Report, focuses on the third logical construct on which the report rests, that is, the need for a fundamental change in financial regulation. India's approach to financial regulation is antediluvian and counterproductive. It needs to be transformed by shifting from prescriptive rules-based regulation (RBR) to open and broad principles-based regulation (PBR). |
| This change will be resisted by India's regulators because of the attitudinal adaptation it requires. They will argue that PBR requires such high standards of corporate governance that it will be a long time before India can think about applying it. Higher levels of skills and discretion need to be exercised by regulators and supervisors under PBR. Contrary to the RBR system of compliance box-ticking and using long laundry lists that monitor adherence to detailed regulations, PBR requires the independent exercise of discretion at the supervisor-financial firm interface on a much broader canvas of issues. It requires supervisors, and the managements of supervised institutions, to have an entirely different type of relationship that is mutually supportive and co-operative, rather than adversarial and confrontational. |
| That fundamental change involves a difficult transition from the comfortably precise specifications of RBR to broader, less precise specifications under PBR, leaving scope for judgement that may be criticised later. But it also requires regulators to relinquish their draconian punitive powers for petty infractions, in favour of broader, more powerful remedies (including the revocation of licences) in the event of infractions that involve not merely the letter, but also the spirit, intended behind the laws, rules and regulations that are framed. Eventually, despite resistance, PBR will come about as it becomes the global regulatory standard. |
| Apart from the approach to regulation, the MIFC Report also alludes to problems with our heritage of financial regulatory architecture and the division of regulatory responsibilities in different financial segments. Overall, the present approaches and arrangements in India no longer make sense in the financial world that is evolving domestically and globally. The trend worldwide is toward unified regulation of all financial institutions and services "" not the least because of the blinding speed at which new products and services are being innovated and applied, and the continued blurring of boundaries between what can be considered a pure banking product versus an insurance product or a market product. Bank loans can now easily be transformed into tradable security equivalents and listed on the exchanges. Derivatives are often just a form of insurance. But worldwide trends do not by themselves justify what might be appropriate in the Indian context, given its legacy and transitional challenges. |
| For that reason, the MIFC Report withholds (on grounds of pre-maturity) making a definitive recommendation on immediate unified regulation. Nevertheless, it has to be said that if India does wish to have a credible IFC operating in Mumbai, its regulatory architecture and arrangements must reflect the industry standards that apply in other leading IFCs. |
| For those reasons, the MIFC Report suggests that the RBI be divested of its multiple roles and the many conflicts of interests that such roles create. Global practice suggests that central banks perform best, and are most useful, when they focus on the single target of controlling inflation through monetary (interest rate) policy. This precludes central banks from regulating and supervising all banks. That function is seen as being better performed by a dedicated financial services regulatory authority. Some central banks (for example, the US) are mandated with controlling inflation, along with encouraging stable growth and high employment. But these other targets (growth and employment) are coming into question as goals that central banks should not be concerned with. Goals other than containing inflation are now seen as objectives for other arms of the government to achieve; not the central bank. |
| In India the central bank has straddled the Indian financial system like a Colossus. By and large, it has played a remarkably useful role; even if that role has been more variegated, more demanding, more 'developmental' and challenging than the role played by most central banks. Over time, the RBI has proven itself to be one of India's great public institutions. But the RBI has been made responsible for an incredible array of activities and goals. The impossibility of the RBI trying to hit multiple targets (such as low inflation, a stable nominal exchange rate, a high growth rate, a high flow of agricultural credit, and so on) is becoming more apparent by the day. For all these reasons, the MIFC Report suggests that responsibility for financial regulation be more clearly divided, defined and respected by domain. It suggests that the RBI be made responsible solely for containing inflation in India. The MIFC Report goes further. It suggests that a revamped RBI should be constitutionally independent. So should the financial regulatory authority that is separated from it. It should not be accountable to the government of the day through the ministry of finance (MoF). It should pursue a monetary policy that is good for India regardless of the political compunctions and priorities of any government. That is what international best practice now amounts to. And India would be ignoring such practice at its peril if it wanted to have its own IFC in Mumbai. |
| In my view, the current spread within which inflation in a rapidly growing, middle-income country like India should be targeted is 2-5 per cent. The floor of 2 per cent is set in order to avoid any risk of disinflation (which cannot be as finely tuned in India as in developed economies that are able to risk a 1 per cent floor). The ceiling of 5 per cent provides sufficient headroom for monetary expansion to support an 8-10 per cent growth target. That target should be achieved by the MoF and the Planning Commission, not the RBI. Of course, inflation has to be contained by the RBI in a way that engenders confidence in the global financial system about the strength and solidity of the rupee as an emerging reserve currency. That is what the rupee will become, as India becomes one the world's three largest economies by mid-century. |
| The MIFC Report also suggests that the RBI be divested of all functions other than the management of an inflation-targeting monetary policy. It recommends that the role of banking supervision be transferred to a separate and dedicated banking regulator. It also suggests that Sebi be made responsible for all regulation that concerns transactions in capital and derivatives markets (which includes all bond trading, including G-Secs, and all derivatives trading including futures/option contracts other than equity derivatives, that is for interest rates, currencies, credit default, political risk and commodities). For the time being, it accepts the necessity of having separate regulators for: (a) insurance; (b) pensions; and (c) commodities trading. But such regulation should be separate only for the consumer protection-related part of insurance and pensions. |
| The Report has been criticised by some (like Shankar Acharya) as going over the top in making these recommendations and, in particular, overloading Sebi "" which compared to the RBI is the new kid on the block "" and making it much too important in comparison with other financial regulators. Having looked at those arguments closely, I come to the conclusion that they warrant little merit and continue to argue for what the MIFC Report suggests. |
| The author was the chairman of the committee that wrote the MIFC report. This is the fourth in a six-part weekly series Also Read |
| Percy Mistry: The problems caused by state-owned banks Percy Mistry: The urgency of a new round of financial reforms Percy Mistry: Of discourse, garlands and brickbats |
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