Despite US President Barack Obama's initiative on giving more regulatory powers to the Federal Reserve facing Congressional hurdles, the need to strengthen regulatory framework for the financial system remains valid. It is significant that a day after Obama announced his proposals, the European Union also agreed on a broad idea to establish a new regulatory structure. More nations are likely to follow suit in coming days.
Indian authorities too have begun to realise, more than before, the need to take a fresh look at the country’s regulatory paradigm. For Indian financial markets, there are more than one regulatory bodies with separate mandates. The degree of regulation is also different for different financial players, with some heavily regulated while others lightly. And there is distinct logic for these differences.
However, at the end of the day, money is fungible, and the problems that cross-flow of money can create have been brought home in the current global crisis.
In a recent speech, Shymala Gopinath, deputy governor, Reserve Bank of India, has brought out some interesting aspects of these issues. In her remarks at the Ninth Annual International Seminar on Policy Challenges for the Financial Sector in Washington in early June, she dealt with the “dynamic inter-connectedness between entities across regulated, unregulated and lightly regulated domains perpetuated through high leverage”.
There is an obvious need to push the regulatory perimeter, so that more players could be brought within the regulatory boundaries. The existence of multiple regulators could diffuse the concentration on important issues. The focus of a banking regulator could be different from that of a securities regulator, whose focus in turn may be different from that of an insurance regulator. The focus of all these entities could be at variance with the focus of a market regulator.
“If the entire financial system is looked as a single ecosystem, then in spite of the inherent differences between the various market players, it should be possible to identify the macro drivers of the whole system, the network flows. Using this perspective, it becomes evident that just focusing only on the perimeter would be missing an integral component that may need regulatory attention,” Gopinath said.
The need for strengthening and expanding regulatory regime also became clear once it was realised that maturity transformation undertaken by entities under light regulation, whereby they used short-term funds for long-term assets, paused a systemic risk.
While the prudential framework for banks in terms of asset-liability management prevented these heavily regulated entities from becoming a cause for concern on this point, entities under light and zero regulations ran huge ALM mismatches.
As Gopinath has pointed out, entities such as hedge funds were consciously left unregulated because they managed only private capital pools where the issue of investor protection was not relevant.
However, what was not appreciated was the systemic risks these entities were posing on account of the huge leverage positions they were carrying through either the formal banking channel or the funding markets, particularly repo markets.
“The seamless efficiency thought to be provided by close integration of the underlying asset markets and repo markets proved to be just a chimera,” she said.
Also, mutual funds are regulated from the investor protection angle by the securities regulator, but systemic implications of inert linkages became apparent in the post-Lehman period when RBI had to announce a special repo to enable banks to meet the liquidity requirements of mutual funds.
Thus, there seems to be every justification for a re-look at the regulatory framework for India’s financial markets. The form of the new regulatory dispensation—should one of the existing regulators get more powers over others, or should there be a super regulator over the existing ones—is merely a matter of details.
