UK?s new chancellor of the exchequer, George Osborne, announced a major overhaul of the financial regulatory apparatus last week. Significantly, the body responsible for regulation of the financial sector, Financial Services Authority (FSA), is to be abolished with most of its powers transferred to the Bank of England. Interestingly, like in the US, there will be a new agency to deal with consumer protection, presumably to curb predatory lending practices, which many believe form the core of the subprime crisis. More broadly, this overhaul in the UK reverses Gordon Brown?s celebrated separation of financial regulatory powers from the central bank in 1997. The UK model, where the central bank focused solely on monetary policy, while another independent agency was responsible for regulation, was a role model for many countries and was considered best practice in mainstream economics. Now the overhauled UK system will more closely resemble India?s, where RBI not only sets monetary policy but also regulates vast tracts of the financial system. Is this reason for RBI to feel completely vindicated about the role it has played in regulating the financial sector? The simple answer is no.
For one, it is not at all clear whether a central bank with greater powers will be in a better position to identify a potential crisis than an independent agency. Sure, the FSA failed to see many signs of crisis, but the US regulatory system, where the Fed has always had more regulatory powers, also failed to see the crisis coming. RBI, of course, does not even fit into this larger debate. The Indian financial system is safe because RBI doesn?t allow extensive financial liberalisation. And while this autarkic approach to finance may keep us safe, it also imposes a heavy cost?the Indian financial system is unable to deliver the kind of cheap finance that is necessary to power the real sector and the economy into double-digit growth. The real debate in India ought to be about how to take financial sector reform forward. In theory, this can happen even if regulation remains in the domain of RBI. But in practice, RBI has seemed reluctant to let competition even in plain vanilla banking flourish, leave aside the more complex domain of securitised assets and derivatives. The overhaul of regulatory structures in the US and the UK do, of course, provides valuable blueprints on how financial reform and regulation can be appropriately combined. But the same should not be used as an excuse to keep the Indian financial system closed for the foreseeable future.