Column : Making a case for the FSDC

Written by Anuradha Guru | Anuradha Guru | Updated: Apr 20 2010, 01:35am hrs
The Budget 2010-11 recognised the importance of financial stability in light of the fact that the financial crisis of 2008-09 has fundamentally changed the structure of banking and financial markets the world over. The finance minister, in his Budget speech, announced the setting up of an apex-level Financial Stability and Development Council (FSDC) to strengthen and institutionalise the mechanism for maintaining financial stability. The council will, without prejudice to the autonomy of regulators, monitor macro-prudential supervision of the economy, including the functioning of large financial conglomerates and address inter-regulatory coordination issues. It will also focus on financial literacy and financial inclusion.

Why this emphasis on financial stability Why now and not earlier These are some questions that come to mind following this Budget announcement. Given the indubitable importance of maintaining stability in the financial system, what are the arguments for the intervention of public authorities in restoring or promoting financial stability

The crisis that engulfed the world financial order in 2008 can, in retrospect, be said to have been caused by the contagion effect of one institutions failure spreading to the others, as a result of a general breakdown of the trust of investors in the ability of financial institutions to meet their liabilities, which is the cornerstone of a stable financial system. Further, it is quite obvious that these institutions responsible for the contagion effect were institutions of systemic importance to the financial system as a whole. Like any other major reform measure in the financial markets, the FSDC, too, is in response to a crisis situation that served as a trigger for this announcement. Though Indias financial systems escaped the effects of the global financial crisis, the movement towards the FSDC is a step in the right direction, aiming to ensure that the mishappenings in western countries do not happen here.

The foremost task of the FSDC would be to objectively define financial stability in the Indian context, as there is no internationally accepted definition. One definition is that a financially stable system can be said to be one that is robust to macroeconomic disturbances and thus able to withstand unforeseen shocks, relying on its stable key institutions, so that there is a high degree of confidence that they would continue to meet their contractual obligations on their own. Financial stability means not only an absence of actual crisis, but also the ability of the system to limit and manage imbalances before they assume a magnitude that threatens itself or the economic processes.

However, this definition is incomplete, as it does not define the key institutions or SIFIs, which are fundamental for the maintenance of financial stability of the system. There is a huge debate on which institutions, in a financial system, are most important for ensuring stability and the criteria of choosing one over the other. When the US government went all out to bail out AIG but not Lehman Brothers, many questions on this line were asked. What kind of financial institutions are too big to fail or are SIFIs for the financial system Most importantly, to what extent and in what manner should public authorities intervene to maintain stability of the system and how to deal with moral hazard issues arising out of this intervention

The next assignment of the FSDC would perhaps be to identify SIFIs in the Indian economy. Issues that would need to be debated are: should banks be treated as being in the same league as non-banks. in the context of financial stability and possible bailouts; is failure of a big bank the same as that of a small bank; and should the central bank be concerned about volatility in asset prices that may lead to instability among financial institutions Then it would be essential to draw out a supervision framework for SIFIs, recognising that they ought to be such as to remove the advantages derived from becoming systemically important and to create time-consistent incentives for them. Also, there may be certain financial markets of more importance than others in ensuring stability of the system as a whole. Which are these and how to differently regulate them

It would also be important to assess the ways in which financial instability interacts with the real economy to either amplify or moderate the effects of initial shocks. Thus, it is important that regulators responsible for oversight of different financial institutions interact and cooperate closely among themselves and with those responsible for stability of prices and the real economy. The FSDC could be the forum for such interactions.

The author is a civil servant. Views are personal