The Financial Sector Legislative Reforms Commission (FSLRC) was set up in March 2011 with a two year term. To the credit of the Commission, it has hit the ground running and has covered extensive ground. On 1st October 2012, the Commission put out an extremely well drafted Approach Paper in the public domain, and as part of the consultative process has invited feedback. Apart from some limited discussion in the media, the Approach Paper has not received the attention it deserves.
The FSLRC Approach Paper sets out a magnificent panoramic view of what the Commission envisages as the new financial regulatory architecture. There is a fine line between policy and legislative reform and the reader is sometimes left with the feeling that the Commission has, on occasion, crossed that line. Legislative reforms in India are a tortuously slow process. Thus, it is unrealistic to expect that the new envisaged legislative framework can be put in place 12 to 24 months after the Commission submits it report in March 2013.
The Approach Paper draws a panoramic view of the new financial regulatory architecture, though the reader is left with the feeling that the Commission has, on occasion, crossed the fine line between policy and legislative reform
Financial regulation the world over is going through intense turmoil and in many areas the FSLRC enters unchartered waters. This paper attempts to evaluate only a few central recommendations of the Approach Paper. The evaluation is against the backdrop of the present state of the financial regulators–government relationship. In India, government hegemony over financial regulators is obvious and this is reinforced by the fact that a large number of regulatees are government owned. While the Commission makes the right genuflections to autonomy, independence and efficiency of functioning, it unwittingly becomes the handmaiden of regulatory capture, not by the regulatees but by government. The Approach Paper unintentionally veers to a dirigiste regime wherein the government’s supreme coercive powers will not only increase but get legitimised.
Unified Financial Agency
The Approach Paper proposes a new Unified Financial Agency (UFA) which will subsume the present regulatory functions of the Securities and Exchange Board of India (SEBI), the Forward Markets Commission (FMC), the Insurance Regulation and Development Authority (IRDA) and the Pensions Funds Regulatory Development Authority (PFRDA).
The UFA will deal with all the financial firms, other than banking and the payments system. Apart from absorbing the above-mentioned regulators, the UFA will also take over from the Reserve Bank of India (RBI) the work relating to organised trading of the bond-currency-derivatives nexus. In practice, what this means is that SEBI in its new avatar will take over all these regulatory functions. All the chairmen of SEBI so far have been exemplary, but it is no secret that many SEBI chairmen have paid the price of not toeing the government line. The theme of the FSLRC of autonomy and independence of regulators is more in form than in substance. Financial regulators in India have never enjoyed even a semblance of autonomy and independence.
The FSLRC claims that the proposed UFA will yield benefits in terms of economies of scope and scale in the financial system. It will establish the identification of the regulatory agency with one sector and reduce difficulties of finding appropriate talent.
While the Commission makes the right genuflections to autonomy, independence and efficiency of functioning, it unwittingly becomes the handmaiden of regulatory capture by the government
The Commission will be well advised to undertake an analysis of the staffing pattern of SEBI. From where does SEBI draw the bulk of its senior staff? How large and how effective is SEBI’s career cadre? SEBI has invariably drawn its top staff from the government and RBI. Saddling SEBI with additional extensive responsibilities would make its task more difficult. Merely lumping the present regulatory agencies under one head will not resolve the staffing problems of the UFA. What will happen is that government control will increase and specialists will make way for generalists.
The Financial Stability and Development Council (FSDC) has established a strong hegemony over financial regulators on the grounds that when regulators fight, the government has to intervene. The UFA would be more vulnerable to government dominance than the present multiple regulators.
Internationally, the jury is still out and unified regulators have not exactly covered themselves in glory. Given the turmoil in the international financial system, it would be best not to try and adopt models which are being discarded in the light of the recent international financial crisis. Transplanting a failed model into India would be risky. A safer approach would be to strengthen the present multiple regulators and let them build expertise in their own field. To the extent that there is need for coordination or turf issues, this can more than adequately be dealt with by the FSDC. It is not as if there have been no conflicts between regulators in the past. The big difference is that during the 1990s the differences were ironed out within the system rather than through indecorous public altercations.
There is no assurance that a single regulator will be able to function better than multiple regulators who have specialised expertise in their own areas. It is stultifying to believe that a single regulator will be the panacea for all the hurdles in building strong and efficient regulation. In fact, a single regulator may combine and accentuate the deficiencies of each of the merged regulatory agencies. A more cautious approach would be to accept the evolution of the Indian regulatory structure of multiple regulators and focus energy on strengthening the delivery capabilities of each regulator.
If India were to opt for the single regulator model, the logical solution would be to lodge it in the RBI, which is the ultimate provider of liquidity. But such an approach would be anathema to the FSLRC! It would be, therefore, best to continue with the present multiple regulator approach.
The FSLRC’s Approach to the RBI
A prestigious Commission like the FSLRC should be totally free from any institutional bias, but its hostility towards the RBI is glaring in the Approach Paper. The Prime Minister, Dr Manmohan Singh, often says that in India strong financial institutions are difficult to come by, and hence nothing should be done to weaken the RBI.
The leitmotif of the FSLRC is clearly to dismember the RBI. This will be a monumental blunder and the FSLRC should seriously reconsider this approach. There are a number of issues which raise anxieties.
The FSLRC envisages that the RBI be restricted to three functions, viz., monetary policy, regulation and supervision of banks, and supervision of the payments system. This will be a major dismemberment of the RBI. The approach of the FSLRC to first dismember the RBI and then pay lip service to RBI’s autonomy and independence is not reflective of intellectual honesty. The RBI has a historical pre-eminence in the firmament of the Indian financial system and taking away vital functions from the RBI will significantly weaken the overall financial system.
Government Securities Market
The RBI plays a crucial role in the government securities market, particularly as the government is dependent on the RBI for its burgeoning borrowing programme. The government, as early as 1992, made earnest attempts to reduce its reliance on institutional support to cover its large deficit. Following the 1994 and 1997 accord between the RBI and the government and the subsequent Fiscal Responsibility and Budget Management Act, 2003, the government formally committed to reducing fiscal deficit, but such aspirations have been totally belied. The government is heavily dependent on statutory prescriptions on institutions to get its borrowing programme through. The dilemma is that the government wants to borrow more at low rates of interest. This attenuates monetary control. If the RBI is distanced from the government securities market, then it will no longer be RBI’s task to ensure orderly conditions in the government securities market. If the FSLRC wishes to advocate distancing the RBI from the government securities market, for consistency the FSLRC should also categorically state that in its grand design RBI’s Open Market Operations (OMO) are to be strictly used as part of its monetary policy, the RBI would have unfettered rights to drive up government securities yields when it wishes to undertake monetary tightening and that the RBI be allowed to conduct its monetary policy without let or hindrance.
The Commission raises the issue of whether the rule making function (subordinate legislation) on capital controls should rest with the Ministry of Finance or the RBI. The tilt of the FSLRC is clearly to move this function away from the RBI. The FSLRC Approach Paper does not seem to recognise that there is, for all practice purposes, de facto Capital Account Convertibility (CAC) for individuals; for all others there has been, for many years, a very large degree of capital convertibility. The work in India on CAC is applauded the world over but the FSLRC Approach Paper, for reasons of its own, chooses to ignore the work of the RBI.
Bringing legislative changes into force is complex. The FSLRC would have creditably completed its task by setting out its recommendations. Any further work should be the responsibility of government
In the FSLRC scheme of things, the RBI would have nothing to do with the forex market. The implications of this for management of the exchange rate need to be taken into cognisance by the FSLRC. Furthermore, what are the implications of the FSLRC recommendations for management of RBI forex reserves? Consistent with the stance of the FSLRC would be that forex reserves be outside the purview of the RBI. The FSLRC should examine the entire issue of capital controls, the forex market, the exchange rate and forex reserves in a consistent framework. While examining these issues, the FSLRC should examine the track record of the RBI in this area. Let there be no mistake – but for the RBI during the 1991 balance of payments crisis, India would have gone under. There are, admittedly, problems in managing the forex sector, but the FSLRC’s tilt towards separating this function from the RBI and placing it in the Ministry of Finance would merely sanctify the erstwhile centralised control regime. This is surely not the intent of the Commission but its enthusiasm to cut the RBI down to size leads to an extremely centralised system. The analytical issue of the Impossible Trinity is well known: It is not possible to have an independent monetary policy, totally free capital flows and a managed exchange rate. The Indian approach is to use the second best solution of managing the three corners of the tripod. Stripping the RBI of its important role in the forex sector could be fraught with serious hazards and such risks are avoidable.
Deposit Taking Activities
The FSLRC envisages that the RBI will only regulate and supervise banks. The problem in India is that non-bank financial companies (NBFCs) as well as non-bank non-financial companies have been raising deposits. The experience of the past fifty years has been that NBFCs have been obstreperous and there has been prolonged litigation. Over the years the RBI has brought about a semblance of order. The FSLRC recommendation is that the NBFC sector be outside the purview of the RBI. Ideally, deposit taking should exclusively be a banking function and any deposit taking entity should be subject to RBI regulation/supervision.
Debt Management Office
The idea of a separate Debt Management Office (DMO) was mooted by the Narasimham Advisory Group on Transparency of Monetary Policy (2000). This recommendation was premised on the government being able to moderate its fiscal deficit. Unfortunately, the fiscal position has worsened and there are no signs of improvement in the fiscal deficit to the point where a DMO can be put in place. The FSLRC does not envisage a DMO being contingent on vastly improved fiscal deficit. Setting up a DMO, independent of the RBI, well before a fiscal correction would be disruptive. Moreover, premature setting up of a DMO would imply a strong pre-emption of public sector bank resources by the government, as a predominant part of the banking system is government owned. The government needs to get out of its swaddling clothes of virtually automatically borrowing from banks and other financial institutions. The FSLRC would be well advised to defer the setting up of the DMO till the fiscal deficit is moderated.
The Approach Paper’s treatment of financial inclusion is perfunctory. Although the FSLRC recognises that financial inclusion is important, it laconically asserts that the agenda relates to the “development of missing markets, such as the bond market, and achieving scale and reach with nascent markets…” (Paragraph 93). It is surprising that the Approach Paper does not discuss the crucial issue of financial literacy. “The Commission will…make recommendations emphasising enumerated objectives, enumerated powers, a rule making process and the rule of law” (Paragraph 97). The Commission would do well to revisit this issue.
A Resolution Corporation
At present, there is a deposit insurance corporation which provides insurance for bank depositors up to a specified amount. The present system is admittedly flawed on three counts. First, the corporation is a mere payout agency. Second, the premia are uniform and as such better functioning banks subsidise poorer performers. Thirdly, the corporation has no regulatory/supervisory powers relating to bank deposits. It is not as if these facts are not known to the RBI. The Jagdish Capoor Working Group had brought out these issues. It is unfortunate that the hegemony of the Department of Banking Operations and Development over the poor-cousin deposit insurance corporation has thwarted reform. The top management of the RBI should use this as a wake-up call and take immediate action. First, there should be two schemes: one for scheduled commercial banks and a second for cooperative banks. One scheme should not subsidise the other. Second, both schemes should have separate schedules of differential premia based on the performance of each bank. There is an exaggerated notion that if there are banks with high premia there would be runs on banks. In the urban cooperative banks segment, there was a system of grades. This did not result in runs on banks (there were runs but for reasons other than the grade). Thirdly, the RBI should quickly empower the deposit insurance corporation to undertake regulation and supervision relating to depositors’ safety of funds and enable the corporation to issue instructions to banks. It should be possible to implement these changes within the present law provided the RBI top management reins in inter-departmental turf problems.
The FSLRC recommendation of a Resolution Corporation is fraught with difficulties. According to the Approach Paper, the Resolution Corporation will cover banks as well as non-banks and it will be difficult to resist pressures to provide deposit insurance to NBFCs. Given the Resolution Corporation’s remit, profits of financial firms will be private but losses will be public. Separating the Resolution Corporation from the RBI implies that the government will be saddled with financing losses. It is uncertain whether the Resolution Corporation would be able to undertake prompt corrective action in the case of NBFCs.
A Resolution Corporation is a dangerous idea in the Indian context. Unlike in the US where the Resolution Trust was able to absorb real assets (essentially by way of housing), in the Indian context the Resolution Corporation would merely be a vehicle for picking up losses (as invariably there would be non-existent assets). The Commission’s recommendation could well imply that the government will end up with a huge open-ended problem of covering losses of NBFCs. Given the precarious state of the fisc, the government would do well not to take the huge risk of bringing in the non-bank finance sector under a Resolution Corporation. In a number of countries, a Resolution Corporation type of model has saddled governments with a burden as large as 10 to 15 per cent of GDP. Experimenting with the FSLRC’s ideas of a Resolution Corporation could put the fisc totally out of control.
Drafting of Bills
Once the Commission submits its report by the end of March 2013, the government will examine the recommendations. Drafting of the relevant bills should then be taken up by the government in light of its decisions and in consultation with concerned agencies.
The Approach Paper is replete with references to the Commission itself undertaking drafting of the bills. The fault lies not so much with the Commission per se but with the terms of reference which refers to “rewrite the legislations” (Paragraph 4 of the Approach Paper). Given that there are over 60 Acts and multiple rules and regulations that govern the financial sector, this is clearly a faulty term of reference.
The FSLRC seems to accept this impossible task. The Approach Paper says: “This document expresses the approach that FSLRC will take in drafting laws” (Paragraph 106) and, “FSLRC will work on drafting law in each of these areas” (Paragraph 107). “The Commission would consider the need for setting up a dedicated unit in the MoF to process the recommendations and initiate action for implementation of the Report…change the legislative structure over the next 12 to 24 months” (Paragraph 136). The Approach Paper signs off with the statement that “the laws drafted by the FSLRC will induce improved working of the supervisory process” (Paragraph 139) and that “The aspirations of the Commission is to draft a body of law that will stand the test of time” (Paragraph 141).
If the intention of the Commission is to merely outline the recommendations for legislative reforms, then the Commission should refrain from repeatedly emphasising that it will undertake the drafting of the bills. After the Commission submits its report, the government should process the report in consultation with other concerned agencies and only then consider the specific drafting of bills. Bringing legislative changes into force is complex. The FSLRC would have creditably completed its task by setting out its recommendations. Any further work should be the responsibility of government.