The new question of financial stability

Financial Express, 20 October 2009

In India, it is being claimed that the role and function of RBI, as it presently stands, is the right way to address the goal of financial stability. It is argued that after the crisis, the world will now discover the merits of the RBI model. In recent days, Ben Bernanke has articulated the position of the US Fed, and the European Commission has adopted draft legislation, aiming at responding to current issues. Neither of them proposes a structure like RBI.

Financial stability is now in focus. The traditional tasks of regulation and supervision of financial markets and firms are termed "micro-prudential supervision". The key phrase that is now being emphasised is "macro-prudential regulation". This is different from the traditional functions of regulation and supervision of financial markets and firms.

Macro-prudential regulation is about looking at the entire financial system as a whole. It emphasises interconnections between firms. It is about symmetrically varying capital requirements across business cycle conditions. It is an emerging area where full clarity on the issues and policy instruments will only settle down in a few years.

As Charlie Bean (deputy governor of the Bank of England) emphasises, the instrument of monetary policy is fully used up in delivering low and stable inflation. Financial stability is a distinct goal which requires a corresponding distinct instrument (which has yet to be fully devised). The world is right now planning how this function will be executed.

On 1 October, Ben Bernanke summarised his position as five key elements. First, he said that all systemically important financial firms should have consolidated supervision. In other words, for a multi-firm organisation like ICICI or HDFC, there should be a unified financial regulator who is able to see all dimensions of the business. Through this, the biggest firms would face a UK-style unified regulator, even though the US (like India) has numerous financial regulators.

Second, he proposed an oversight council made up of all financial regulatory agencies, which should be charged with worrying about financial stability -- while each regulator uses the tools at its command to further this goal.

Third, he emphasised the importance of the legal mechanism through which troubled firms, like Lehman, can be closed down by the government. Fourth, he said that all systemically important payment, clearing and settlement arrangements should be subject to consistent oversight. Finally, he said that all consumers should be protected from unfair or deceptive practices.

In parallel, in Europe, on 23 September, the creation of a new European Systemic Risk Board (ESRB) to work on financial stability was proposed. In addition, a European System of Financial Supervisors (ESFS) is sought to be setup to bring greater coherence to micro-prudential supervision.

These developments are in striking contrast with recent speeches at RBI. RBI has claimed that now that financial stability is a concern, the old role and function of RBI should be defended. A convoluted argument is made, at the end of which it is argued that nothing is wrong with RBI, and that recent committee reports which have called for RBI reform should be rejected.

RBI is not alone in claiming that it does not require reforms. It is typical of a government agency to recommend reforms for everyone but itself. RBI's arguments would have greater credibility if they were less self serving. It would be quite a remarkable accident, for an Act drafted in colonial India to be optimal for the India of 2009. Looking outside the country, at the active field of financial stability, we see a very different picture as compared with that being put out by speechwriters at RBI.

The phrase `financial stability' is easy to bandy about. In India, it is generally taken to mean preventing financial crises through any means possible. That it not what the phrase means in the international discourse. It has a technical meaning: it is about examining the interconnected set of financial markets and firms as a whole, and not just the safety and soundness of financial markets or firms taken one at a time.

At present, RBI does the work of micro-prudential regulation of the currency and bond market. This is a unique arrangement, by world standards. Barring one exception, in all OECD countries and emerging markets, the regulation and supervision of all organised financial trading is housed in a single financial regulator. Central banks do monetary policy, and sometimes do banking regulation, but they do not do regulation and supervision of financial markets. The fresh focus on financial stability has not changed anything about this issue, which is one of micro-prudential regulation and not macro-prudential regulation.

In summary, an international consensus is developing around four propositions, which are consistent with the direction of policy reforms being mapped out in India over recent years: (a) Even if multiple financial regulators exist, the largest financial firms should face unified supervision; (b) Micro-prudential regulation of all organised financial markets should be unified into a single agency; (c) A committee of all financial regulators should look at financial stability; (d) Nowhere in the world is anyone moving towards the RBI model.

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