Monetary policy is easy; Financial regulation is hard

Financial Express, 29 Jul 2010

Monetary policy requires a handful of good people. There is little political economy in play. A few announcements a year from a monetary policy committee (MPC) sum up the action. And once proper accountability structures are setup, there is little discretion. Financial regulation is much unlike this. It is transaction intensive: regulators interact with financial firms hundreds of times every day. A financial regulator may try to make rules, but there is no escape from judging compliance with principles in a discretionary fashion. There is a corrosive political economy where vast profits can be obtained by subverting regulation. Monetary policy is easy. Financial regulation is hard.

Lant Pritchett of Harvard has a deeply insightful classification scheme about the complexity of government, done jointly with Michael Woolcock. For all government functions, they ask two questions: Is it transaction intensive? and Do government employees have discretion? From a public administration viewpoint, it is easy to organise government when there are few transactions and government employees have little discretion. The hardest problems are those with a large number of transactions and where government employees have discretion.

Monetary policy is held up by Pritchett and Woolcock as an example of an easy problem. Once a central bank is setup properly, it has a calendar of MPC meetings which make a few decisions per year. Once a central bank is setup properly, there is a strong accountability mechanism -- inflation targeting. The MPC then has relatively little space to exercise discretion.

To setup monetary policy in a country requires roughly five people for the MPC and roughly 20 people to support them with research. There is little political economy in these decisions: it is an exercise of technical skills. Good countries have started recruiting globally into these functions, reflecting the fact that this is technical expertise without complex politics. If the MPC were replaced by computer programs which made decisions, remarkably little would be lost. Doing monetary policy is roughly as easy as being an air traffic controller who schedules a few flights a year. All it needs is a small team or a computer program where the requisite arcane technical skill is combined with the right mandate.

In contrast, from the viewpoint of public administration, financial regulation is hard. Financial regulation and supervision involves hundreds of interactions every day between employees of financial firms and employees of financial regulators. It is hard to setup these processes properly.

We might try to do financial regulation with a well specified set of rules. But financial firms will always come up with clever dodges where the spirit of a rule is violated but the letter is not. The only way out is `principles based regulation', where employees of financial regulators have discretion in judging whether principles are upheld or not.

RBI has a long tradition of financial regulation, but there are two essential hurdles. First, RBI deals with mostly public sector firms, where profit maximisation is absent. Second, RBI runs a central planning system, where firms are given little flexibility. For India to make progress, both these elements have to be shed. India cannot get to $4000 per person of GDP without a domination of private financial firms, and a removal of central planning. It is SEBI that faces the brunt of complexity in financial regulation.

Once a regulator faces private firms, and once a regulator steps away from central planning, financial regulation is the hardest of problems in the Pritchett/Woolcock classification: with many transactions and where government employees have discretion. Complex judgments have to be made, such as determining when a management team is `fit and proper' to run an exchange. Regulators will be deeply concerned about their choices in these matters, for there will be only 2-3 exchanges in the country, and mistakes (e.g. the problems of the Bombay and Calcutta exchanges in 2001) have nationwide ramifications. Similarly, regulatory staff have to judge who is fit and proper to run a bank (though failures such as Global Trust Bank have smaller ramifications). Facing these challenges is a daunting prospect.

It is very hard to evolve a resolute, competent and uncorrupt workforce in financial regulators. Financial firms will attempt unpleasant tactics in trying to make more money. They can lobby politicians and regulators to bend the rules, cheat customers, buy press coverage, and steal in various ways. All over the world, the real difficulty of financial regulation lies not in the technical questions, but in the real world interplay with political economy.

The project of institution building which is presently underway at SEBI is thus of crucial importance for India's future. If we follow through fully, we will learn how to do financial regulation with the highest ethical and technical qualities, where sound decisions come about despite lobbying. If we fail on this project of institution building, finance will remain stunted. We will either fall back into central planning, or collapse into the crises of crony capitalism.

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