The Financial Sector Legislative Reforms Commission submitted its report in March. The report is breathtaking in its expanse, sweeping in the changes it recommends and the promise it holds out is of taking India to an El Dorado. While admiring the superb drafting of the report, S S Tarapore feels it is necessary to undertake an in-depth examination of the implications of the Commission’s recommendations, and shares some of his anxieties
Processing of the sweeping legislative changes proposed by the Financial Sector Legislative Reforms Commission (FSLRC) will take numbers of years. There is often impatience at slow moving legislative reforms, especially in the financial sector, but it bears reiterating that in India, care is taken to assess and consolidate reforms to ensure against frequent rollbacks.
At this stage all that can be done is to have some broad discussions by way of providing feedback to the government. After the government takes decisions on the proposals, the actual legislative changes would need to be drafted (the Commission has, however, drafted a single Indian Financial Code, but it raises more issues than it answers).
Next would be the detailed scrutiny by Parliamentary committees and eventual adoption by Parliament of the final legislation. Legislative changes necessarily have to be cautious and our legislators will not be bamboozled into rapid and thoughtless changes. Fortunately, our Constitutional framework has sufficient safeguards to prevent reckless and rapid legislative changes.
A basic issue which needs to be addressed is whether the Commission has been captivated by the thrall of policymaking or whether they have stayed within their remit. The devil is in the detail and in this paper only a few issues are discussed. Each of these issues would warrant a full length paper and all that is attempted here is a broad-brush discussion of a few issues.
The FSLRC had put out an Approach Paper in October 2012 for obtaining feedback. The final report of the Commission submitted in March 2013 shows that it has paid scant respect to the feedback.
According to the Commission, the Unified Financial Authority (UFA) will regulate all entities in the financial sector other than banking and the payments system. The UFA is intended to be a super-regulator for all non-bank entities. It will subsume the role of the present Securities and Exchange Board of India (Sebi), the Insurance Regulatory Development Authority (IRDA), the Pension Funds Regulatory and Development Authority (PFRDA), the Forward Markets Commission (FMC) and any other possible non-bank regulatory agencies.
The curmudgeonly concession for the Reserve Bank of India (RBI) is that it will be the banking and payments system regulator for a temporary period of 5-10 years, after which even banking and payments system would be brought under the UFA.
‘Regulating the Regulators’ appears to be the new mantra, but what is not clear is how the single regulator will be empowered (INCLUSION, July-September 2012). The article continues to say that while the Commission stresses the need for greater accountability for the regulatory process, it is not clear how such autonomy will flow to the system.
The Commission recognises that the UFA’s need for qualified and experienced personnel will pose a formidable challenge. Winding up the existing regulators and setting up a grand UFA will not automatically result in a qualitative improvement in regulation and supervision.
While the Commission Chairman has anticipated that existing regulators will resist the loss of turf, there is no assurance that the UFA will perform better than the present multiple regulators. The track record of a UFA, where tried, has not come out in a blaze of glory and the government has to weigh the pros and cons before plunging ahead with the Commission’s adventurist recommendations.
It bears stressing that the central bank, as the ultimate provider of liquidity, is far better placed to handle regulation/supervision than any other agency. The central bank, however, cannot be expected to generate liquidity on the instructions of another regulator.
‘Regulating the Regulators’ appears to be the new mantra, but what is not clear is how the single regulator will be empowered Winding up the existing regulators and setting up a grand Unified Financial Authority will not automatically result in a qualitative improvement in regulation and supervision
The UFA may appear to be a brilliant idea but in practice it could turn out to be a very dicey proposition. The central issue should be how to improve regulation and supervision and how to develop skilled personnel. A mere abolition of existing regulators and setting up of a single large regulatory authority could well turn out to be counter-productive. As such, the central objective should be to strengthen existing regulators and not weaken or abolish existing regulators.
The need for active public debt management was first articulated by the RBI Working Group chaired by D C Rao, as far back as 1981. This was followed by intensive work undertaken in the Ministry of Finance and the RBI on the need for cessation of automatic monetisation of the government budget deficit. C Rangarajan’s benchmark work in the late 1980s and early 1990s ultimately resulted in the two Supplementary Agreements between the government and the RBI in 1994 and 1997, leading up to the cessation of automatic monetisation of the budget deficit.
The Narasimham Advisory Group on Transparency in Monetary and Other Financial Policies (2000) was explicit on the need for separation of monetary policy and debt management. Then followed intensive work starting with the Y V Reddy-E A S Sarma Working Group on fiscal responsibility leading up to the Fiscal Responsibility and Budget Management Act, 2003.
The track record of a Unified Financial Authority, where tried, has not come out in a blaze of glory and the government has to weigh the pros and cons before plunging ahead with the Commission’s adventurist recommendations
The Commission fails to take note of the contextual nature of the recommendations of earlier groups/committees on an independent public debt management office and uses selective memory to support its own case.
Was it really necessary for the Commission to open its Chapter on an Independent Public Debt Management Agency (PDMA) by ridiculing the RBI’s emphasis on fiscal consolidation as a precondition for an independent PDMA?
One would have hoped that the Commission would have taken cognisance of the Committee on Financial Sector Assessment and, in particular, Rakesh Mohan’s observations on this issue. Had the Commission done this, it would have had a better appreciation of the preconditions necessary for separation of monetary policy and public debt management.
According to the Commission, the PDMA will be charged with the objective of “minimising the cost of raising and servicing public debt over the long-term with an acceptable level of risk at all times” (italics in the Report page 114). The Commission envisages that there will be an Advisory Council at a higher level and a Management Committee at the operational level.
The two bodies would have exclusive membership other than the Chairperson who would be common. Both the government and RBI would have nominees on the two bodies and the Commission stresses the need for “consensus decisions” and goes on to say that “enforcing a consensus requirement is also a way of ensuring that there is coordination between members of the Council. Ideally, the Chairperson of the Council must be obliged to seek consensus from all members.”
While there would be a record of all decisions, there would be the typical ‘winner take all’ recording of minutes and the RBI nominees would find it difficult to routinely resort to written dissent. The upshot of all this would be that by virtue of its membership of the PDMA, the RBI would become a vassal state of the PDMA. So much for the so-called autonomy of the RBI.
With the bulk of the banking system still in the public sector, the all powerful PDMA will have no compunction to twist a few arms to ensure that its objective of minimising the cost of government borrowing is achieved. The RBI, in turn, would have to create adequate liquidity to keep the cost of government borrowing down.
It bears mentioning that in the first half of the 1990s, the government accepted that its borrowing would be undertaken at market-related rates of interest. Over time, there has been a reversion to the government deciding at what rate it wants to borrow, with the fig leaf that the RBI would provide adequate liquidity to get the borrowing programme through.
The Commission’s recommendations, if implemented, would revert the system to the worst days of the dirigiste state. Here is a case of the Commission’s vision of a modern financial system coming up with a recommendation which would generate a centrally controlled diktat regime.
The treatment by the Commission of the RBI, a 78-year-old institution, is, to say the least, shocking. The RBI, as a central bank, is respected the world over, yet the Commission deems it fit to launch a vicious attack on it. The Commission uses a clever ploy that the RBI has too much on its plate which creates a conflict of interest and hence a number of areas of its functioning—public debt management, non-bank finance companies, financial markets and capital controls—should be taken away.
Eventually even banking regulation and supervision and the payments system should be taken away from the RBI to enable it to give exclusive attention to monetary policy. This provides the Commission with a rationale for delivering a lethal blow to the central nervous system of the RBI. The Commission’s Report is replete with proposals to cut the RBI down to size.
Under the Commission’s game plan, the RBI would have no say whatsoever with the functioning of the government securities market, the bond market and the foreign exchange market and yet the onus of malfunctioning of these markets would eventually fall on the RBI as all these problems would be put on to the RBI’s monetary policy.
The treatment by the Commission of the RBI is shocking. It uses a clever ploy that the RBI has too much on its plate which creates a conflict of interest and hence a number of areas of its functioning —public debt management, non-bank finance companies, financial markets and capital controls — should be taken away
The Commission comes up with a strange recommendation wherein the Ministry of Finance will have virtually exclusive control over all capital inflows while the onus of managing all outflows would be on the RBI. This is patently unworkable. Capital inflows, particularly portfolio inflows have a major impact on the overall monetary situation and the arrangement proposed by the Commission would greatly attenuate the efficacy of monetary policy.
The peremptory dismissal of the written dissent by three members, with rich experience in the financial sector, reflects the kind of beat the Commission has been marching to. Acceptance of the Commission’s recommendations on capital controls would compromise the efficient handling of stresses and strains in the external sector.
With the present balance of payments current account deficit (CAD) of 5 per cent of GDP, experimenting with scatter-brained ideas on capital controls would be a sure way of generating a major foreign exchange crisis, which would, in retrospect, make the 1990-91 crisis to be a pleasant tea party.
The Commission, for some unaccountable reason, has an organisational structure which it imposes on all institutions be it the RBI, the UFA or the Resolution Corporation. They will all have a Chairperson and a ‘member law and administration’. As per the proposed Indian Financial Code, there will be no provision for a ‘Governor’ or ‘Deputy Governors’. Cui bono? (To what purpose?).
Instead of providing safeguard to the Governor, akin to the Chief Election Commissioner and the Comptroller and Auditor General, the Commission is gravitating to dispense with the post of Governor of the RBI. The whole ploy is to downgrade the RBI to the level of any other financial institution. The Commission’s insidious proposal is not without purpose.
To argue that the US Federal Reserve Bank has a Chairman of the Board is misleading. The US Fed members of the Board are all called Governors and the head of these Governors is a Chairperson. The Commission owes the nation an explanation for the disrespect it shows to the central bank of the country.
The Commission surely knows that central banks, the world over, are recognised as being unique and very different from other regulators by virtue of the power to create money. In its attempt to downgrade the RBI the Commission has downgraded India in the community of nations and made itself a laughing stock before the world. Such insensate recommendations by the Commission should be summarily dismissed.
The Commission pays homage to the independence of the central bank with accountability and then resorts to cloak-and-dagger circumlocution to ensnare the RBI with its fine print. The Commission argues that the RBI should be given a quantifiable monitorable objective as its monetary policy objective. While the Commission refers to the broad international consensus on price stability as the focus of the central bank, it refrains from making such a recommendation.
The objectives would be set every two years by the government after consultation with the RBI. There would be a predominant objective and secondary objectives which would be prioritised and subject to the predominant objective being delivered. The statement would also specify what would constitute a substantial failure. In such an arrangement, the RBI could be assigned an impossible objective — and it merely be a whipping boy for the government’s failure.
Any credible setting of objectives should follow the assignment rule of a policy — to attain the objective it is best suited to deliver — and with it, the predominant objective would obviously be price stability. Furthermore, it should be recognised that one of the basic principles of effective policies is that one instrument of policy should have one objective.
The Commission talks about the predominant objective of monetary policy being changed, for instance to nominal GDP or the exchange rate. Illustratively, in the kind of milieu prevailing today, a particular real rate of growth could be made as the predominant objective and this could be a virtually impossible task for monetary policy to attain.
If the government is unwilling to make price stability the predominant objective, a second best solution would be to allow the RBI to set out its objectives and the statement jointly with the government. If the government wants to use the override, the objective set out by the government and the RBI should both be put in the public domain.
As is the practice in a number of countries, the Commission recommends the setting up of an executive decision making Montetary Policy Committee (MPC) with each member having a vote and the Chairperson having a right of veto. To have a voting MPC and then to provide a veto is meaningless. There is something structurally flawed in the Commission’s recommendation relating to the MPC.
Under the Commission’s scheme of things, there would be a seven member MPC consisting of only two members from the RBI and five External members appointed by the government. Besides the Ministry of Finance nominee would be a non-voting member but with a right to articulate the government viewpoint. It is pertinent to mention that with Big Brother watching, brave would be the external member who would deviate from the government line.
It is pertinent to mention that the Bank of England has a nine member MPC consisting of five members from the Bank of England and four External members, but with no provision for a veto. The Commission has done a disservice to the development of monetary policy.
The RBI is better off with the handicaps of the present vague and undefined monetary policy process rather than the Commission’s proposal which is a poisoned chalice.
The Commission envisages that the present Securities Appellate Tribunal (SAT) should be expanded into a Financial Sector Appellate Tribunal (FSAT) to also review decisions of the RBI. This is an insensate recommendation.
The Commission’s recommendation lacks any appreciation for the central bank—this apathy runs throughout the Commission’s Report. The Commission’s recommendation on setting up the FSAT should be rejected outright.
The Commission claims that under the present framework corrective action is unduly delayed in the case of banks/finance companies and therefore, the Commission recommends the setting up of a Resolution Corporation.
Thought needs to be given as to why timely Prompt Corrective Action (PCA) does not get implemented in India. The real problem is that political economy considerations hold sway which prevents effective PCA.
The present system of deposit insurance in India is essentially that of a pay-out agency with no powers for enforcing remedial action. The inertia of revamping the operations is partly due to inter-departmental turf war within the RBI.
It is not as if the malady and the solution are not known. The Jagdish Kapoor Working Group on Deposit Insurance (2000) had made many path-breaking recommendations, including the introduction of differential insurance premium and an active role for the Deposit Insurance Agency in implementing corrective measures.
It is pertinent to note that the Commission prefers not to acknowledge its lineage to the seminal work of the Jagdish Kapoor Working Group.
The bane of the problem in India is the erroneous belief that a regime of differential premium would result in banks with higher premium facing a run on their deposits. In the area of urban cooperative banks there was for long a system of grading and this did not cause a run on banks.
At best, what would happens is that banks with low premium would gain deposits at a faster pace than the poorer functioning banks and the overall effect would be salutary in that the system would be stronger. The Jagdish Kapoor Working Group’s recommendations were modelled on the US Federal Deposit Insurance Corporation (FDIC), which is a globally accepted ideal model of deposit insurance.
The FDIC has effective regulatory/supervisory powers in relation to deposits. The problem in India is the philosophical leaning of the Indian psyche which encourages banks/institutions to lend, to lose and to live as our ethos rejects the death of banks/institutions.
With the present balance of payments current account deficit of 5 per cent, experimenting with the Commission’s scatter-brained ideas on capital controls would be a sure way of generating a major foreign exchange crisis, which would, in retrospect, make the 1990-91 crisis to be a pleasant tea party
The Commission recommends the setting up of a Resolution Corporation, essentially on the lines of the US Resolution Trust which was successful in the US as the assets it took over were real assets in terms of housing and when the cycle turned, the Resolution Trust was able to successfully recover its investments.
The Commission’s proposed Resolution Corporation is to cover banks as also finance companies. In the case of finance companies—the assets taken over by the Resolution Corporation would be an empty shell. Thus profits would be private and losses would be public.
The Commission proposes to lodge the deposit insurance activity within the Resolution Corporation. There are already strong pressures to provide insurance cover for the finance companies. Several Committees/Working Groups have examined this issue and unanimously recommended that the authorities should not provide insurance cover for the finance companies.
Once deposit insurance is placed within the Resolution Corporation, and the Resolution Corporation covers finance companies, the pressure to provide cover to the finance companies will be very difficult to resist. Hence, to the extent a Resolution Corporation is set up, deposit insurance should be kept totally out of the Resolution Corporation.
The ideal solution would be to have a separate Deposit Insurance Agency, owned by the RBI which should be empowered with strong regulatory/supervisory powers in the area of deposit activity of banks.
The reason for RBI ownership is that in case of a financial crisis there could be a large drain on the deposit insurance agency. In short, the Commission’s proposal to combine deposit insurance with the Resolution Corporation should be rejected.
In recent years—in India and in many other countries—attention has been focussed on reaching out to those outside the formal financial system. Financial inclusion cannot be undertaken in isolation, and a basic precondition for successful inclusion is putting synergy in real sector activities.
Given the galaxy of experts on the Commission one would have expected the Commission to provide some thought leadership on how to traverse to successful financial inclusion. It is unfortunate that the Commission has given perfunctory treatment to this vital subject. The Commission’s central concern is that financial inclusion comprises interventions which impose certain costs.
According to the Commission—the opening of bank branches in rural areas imposes costs on banks. The Commission is of the view that the Central Government should reimburse the service providers with cash or cash equivalent or tax benefits. A basic issue here is between financial legislation and financial policy—and again, the Commission has crossed here the line between legislation and policy.
It is well known that the first contact of a customer with a bank happens as a depositor and invariably the depositors in rural areas open savings bank accounts which earn a low rate of interest of 4 per cent per annum.
As pointed out at many SKOCH Summits—it is not as if financial inclusion is a burden on banks—in fact it is a profitable activity. Advocacy by the Commission to compensate banks for opening branches in rural areas does not appear to be within its terms of reference.
With iconoclastic fervour, the Commission storms the source of money. Predictably, in the internecine battle with the RBI’s Praetorian Guards, rivers of blood will flow. It must be remembered that countries which destroy their central bank destroy themselves. Is the Nation prepared to face such scenario?
It is disconcerting that the Commission is all too eager to compensate banks for providing financial services to the deprived segments of society but is not concerned about the costs of providing cheap credit to large industry. This smacks of an elitist approach.
Here the Commission shows little sensitivity to the basic principles of distributive justice. The government has been picking up the tab for providing the socioeconomic infrastructure in the underdeveloped regions of the country. To sum up, the Commission’s recommendations on financial inclusion are totally alien to the existing realities.
As a high-powered body—the Commission was expected to recommend required changes in India’s financial legislative framework which would result in a significant and enduring improvement in the working of the system.
Unfortunately, there is an underlying nihilistic leitmotiv which leads the FSLRC to consider destruction of existing financial institutions and to recommend an adventurist financial architecture which has had a chequered history in other countries.
While the Commission makes the right genuflections on financial liberalisation—its recommendations effectively result in a reversion to the dirigiste state with centralisation of power.
In its enthusiasm, the Commission frequently trespasses the fine line between financial legislation and financial policy. The Commission’s approach is clearly partisan—something which is just not expected of a prestigious national body.
The cavalier treatment of Financial Inclusion is a major failure of the Commission. The Commission has completely missed out on the extensive work undertaken in recent years by the government, the RBI, banks and other organisations (including the rich output of SKOCH).
Rather than suggesting the strengthening of the legislative framework to facilitate financial inclusion, the Commission gets into the inanity of subsidising banks which is a transgression into policy.
Central to the Commission’s game plan is the elimination or shrinking of the role of certain institutions. The proposed setting up of a Unified Financial Authority and abolition of individual sectoral regulators would not guarantee an improvement in the quality of regulation/supervision. All that would happen is th
You may recall the movie called ‘Roti, Kapda aur Makaan’ in the early 1970s, which was a reflection of what was going on at that time – extreme inflation, extreme...
It is felt that the IBC or the Insolvency Bankruptcy Code has been a game-changer in economic legislation. Five years into its introduction, the IBC is a well-oiled apparatus, with...
The biggest regret expressed by Ram Sewak Sharma in the book ‘The Making of Aadhaar’ is the limitation on the usage of Aadhaar. Peculiarly, I share this regret. Consent-based widespread...
Five simple policy actions can be of enormous help to MSMEs to tide over the COVID crisis. These can be implemented even during the lockdown.
State Rankings Highlights Andhra Pradesh retains number one..
It was the morning of 16th February 2021,..
West Bengal has come to be synonymous with..
Step 1: Call for Project Submission Call for..
Inclusion is the first magazine dedicated to exploring issues at the intersection of development agendas and digital, financial and social inclusion. The magazine makes complex policy analyses accessible for a diverse audience of policymakers, administrators, civil society and academicians. Grassroots-focused, outcome-oriented analysis is the cornerstone of the work done at Inclusion.