After a long slumber, the government seems to have woken up to the urgent need for ambitious financial sector reform. The proposed Financial Sector Legislative Reforms Commission (FSLRC), announced in the Budget, has no less a mandate than to rewrite all the different (and often ancient) legislations on the financial sector (significantly including the RBI Act 1934) to align them with a much changed global reality.
The post-financial crisis scenario is an opportune time (in terms of political economy) to carry out financial sector reform, an opportunity that may not return in a hurry once the global economy is back to normal. It is crucial, therefore, not to get things wrong.
Unfortunately, the government seems to have stumbled at the start by using the Budget speech to announce the setting up of a Financial Stability and Development Council (FSDC), a statutory body (or super regulator) that will coordinate and effectively preside over sectoral regulators (like RBI, Sebi, Irda and PFRDA). The announcement seems hasty not because coordination is not important?it is?but because the details haven?t been thought through.
For one, there is already a body that performs a coordination role?the high level coordination committee on financial and capital markets (HLCC), chaired by the RBI governor and comprising the heads of all the financial sector regulators and finance ministry officials. Of course, unlike the proposed FSDC, the HLCC is an informal group with no statutory powers. And it is chaired by RBI, which is also a sectoral regulator (banking) and, therefore, hardly in a position to resolve conflicts between regulators.
But any new body that will have statutory powers needs a lot of careful thought and planning. Already there is confusion about whether the FSDC?s powers will be advisory or binding orders. There are reports that the finance minister will chair the FSDC?a bad idea given that strong independent regulation must be separate from the political executive. The government also seems unclear whether the HLCC will be wound up?for now the suggestion is that both bodies will exist together, precisely the kind of scenario that will lead to turf wars of the exact type that are meant to be overcome by super regulatory coordination.
Ideally, therefore, the announcement of setting up such a body should have followed rather than preceded the work of the FSLRC, because the FSLRC will potentially have the power to rewrite the remit (and role) of existing regulators.
And if the FSLRC has to make a real impact, it must spend considerable time and effort rewriting the RBI Act. The biggest policy conflicts in the financial system, as has often been argued on these pages by a number of columnists, arise from RBI?s over-extended role. Ideally, the central bank should just have the one remit of setting monetary policy. There can, of course, be debate about what the target of monetary policy should be?inflation, output, exchange rate or some combination of the three. But there should be no debate, for example, on the need to separate the government?s debt management functions from the central bank?there remains a fundamental conflict between setting interest rates for the whole economy and managing the government?s debt.
Similarly, there should be only limited debate on separating the function of regulating banks from RBI. This role can either be handed over to a restructured Sebi or to another independent regulator. Banking needs to be freed from RBI?s draconian, and often conflicted (in terms of interest), control.
Needless to say, RBI and its powerful bureaucracy will resist any proposal that cuts down their sphere of influence. RBI has already stonewalled the DMO on a number of occasions. So what could make RBI change its mind?
Here is where the FSLRC and the government can dangle the carrot of the super regulator to RBI. If the RBI abdicates its specific regulatory remit over banks, it can be asked to head the proposed FSDC, just like the Bank of England now plays the role of the super regulator in the UK. There is much merit in a trimmed-down RBI playing the role of super regulator. For one, it is independent of the political executive and will lend the FSDC a professional, not political, touch. Second, it can mediate and coordinate between different regulators without any conflict of interest once it?s shorn of its banking regulator role (unlike its role in HLCC at present). Third, as the lender of last resort that will actually have to hand out money in a potential crisis scenario, it will be in RBI?s interest to see that a crisis doesn?t happen. And last but not least, as the most clued-in observer of the macroeconomy (within the government system), RBI will be best placed to identify and warn of signs of trouble.
A grand bargain with RBI can, therefore, potentially solve the biggest existing conflicts of interest in the financial system while giving an appropriate structure to a new super regulator.
dhiraj.nayyar@expressindia.com