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Mr Mukherjee's bad idea
March, 10th 2010

Now that we have said so many good things about Finance Minister Pranab Mukherjees Budget, it is time to say some nasty things too. We dont like the idea of the finance minister chairing a Financial Stability and Development Council. Mr Mukherjees Budget speech said the Council would monitor macro prudential supervision of the economy, including the functioning of large financial conglomerates, and address inter-regulatory coordination issues.

He seems to have taken a cue from the Raghuram Rajan Committee report on financial sector reforms that recommended a similar structure. On the face of it, it seems like a sensible idea, given the deep anxieties about financial stability that the global crisis has left in its wake. However, to make this work without diluting the status and authority of the Reserve Bank of India (RBI) could prove difficult in practice.

What could the problems be? For one, if the apex body emerges as a super-regulator that polices the functions of the existing set of financial regulators, it could end adding another tier of hierarchy in the regulatory process. The perception that the buck does not quite stop with them might just dilute the accountability of the existing regulators.

It will almost certainly cut down the speed of regulatory response to impending problems. That is hardly desirable in a domain like the financial system where rapid change is the only constant.

Second, it might be worth ones while to think through what financial stability really means. While it has become fashionable these days to talk of macro-prudential regulation and systemic risk, financial stability is ultimately about micro-entities within the financial system banks, NBFCs, mutual funds and so on.

The best judge of whether these entities are playing ball or whether their adventurism threatens the equilibrium of the financial system is a call best made by those that regulate them on a day-to-day basis.

It is also somewhat unfair to regulatory agencies like RBI to assume (as the creation of this uber-regulator implicitly would) that in focusing on micro-entities, they somehow lose sight of the bigger picture.

The track record of RBI, for instance, shows that its assessment of systemic vulnerability and stress has usually been extremely prescient. This does not mean that regulation is perfect. It is important to have better gauges of systemic risk and respond with instruments that focus on macro-stability (dynamic provisioning norms for banks comes to mind) rather than on short-term balance-sheet health.

The point, however, is that the existing regulators, particularly RBI, are perfectly capable of delivering this. Third, it is important to recognise that there are deeply-embedded advantages within our regulatory structure that allow for a more comprehensive regulatory agenda.

RBI is a full-service central bank entrusted with the regulation of banks, NBFCs and bond and money markets as well as the conduct of monetary policy. Thus the problem of coordinating the policies aimed at the macro objective of financial stability with that of micro-level regulation, typical of economies where the regulator and the monetary policy authority are distinct entities, should not arise in the Indian case.

There is, however, certainly a need for different regulators to talk to each other more frequently. They perhaps need a formal forum that enables this. But to set up yet another agency, that too with a full-time secretariat, would be overkill.

The prime minister and the finance minister must carefully take note of the fact that so far none of the former central bank governors have enthusiastically welcomed this proposal, while finance ministry mandarins seem to think it is a good idea. That, in itself says a lot!

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