The Reserve Bank of India governor, D Subbarao, who is going to announce a slew of stimulus measures to revive growth, pointed out that while the regulatory regimes were tailored to address institutional failures, they were not equipped to address systemic failures. By far, the most contentious and most voluble debate triggered by the crisis is about the flaws in the regulatory architecture.
Speaking at the RBI-BIS seminar on “Mitigating Spillovers and Contagion – Lessons from the Global Financial Crisis” in Hyderabad on Thursday, he said that several issues came to the fore. Some of the most important issues are: how can complex derivative products, which transmitted risks across the system, be made more transparent? What are the financial stability implications of structured products like credit derivatives? Are exchange traded derivatives better than over the counter (OTC) derivatives? How do we eliminate the drawbacks of the ‘originate-to-distribute’ model? Is universal banking, the model that the United States has now turned to, appropriate? Can we apply the same regulatory regime for both wholesale and retail banks?
Under the very nose of the regulators grew a very extensive and complex network of a ‘shadow banking system’, comprising hedge funds, broker-dealers, private equity funds, structured investment vehicles and conduits and money market funds, he said. ?This shadow banking system was typically highly leveraged, and had an extensive nexus with the banking system. However, the shadow banking system suffered much lighter regulation. This ‘regulatory arbitrage’ encouraged loose practices, hunt for quick yields and non-transparent and risky financial products?, he said. When the systems began to unravel, it was realised that many of these institutions in the shadow banking system pose as much of a systemic risk as banks. The moral of the story is that if an institution is ‘too big to be allowed to fail’, it is also too big to be let off with loose regulations, said Subbarao.
“In doing so, I would urge that we remember two things. The first thing to remember is that no one size fits all. The second thing to remember is that some regulations arguably have been behind the curve. There is no denying that regulations have to keep pace with innovations. But in doing so, we must be mindful of the risks of over tightening regulations so much that they stifle innovation,” he said.