What is the recipe for building financial supervisors?

Financial Express, 4 May 2010

One of the most important challenges that India faces today is that of building effective State agencies. All of us have watched PFRDA, SEBI, IRDA, FMC and RBI. What is the recipe for building high quailty agencies in economic governance?


What can we learn from SEBI's story?

Clarity of purpose
SEBI is a relatively young agency, created after the reforms of 1991. It was the first agency in India which saw itself as regulating a market while having no view about what the market outcome should be. SEBI is a pure regulator - it does not own or operate market infrastructure.
For a comparison, RBI owns a bond exchange and depository - which gives RBI a DOT-style attitude towards competition. More importantly, RBI is a player on these markets. It is hard for an agency which is manipulating the market to have an ethos of enforcing against market manipulation. Similarly, the Ministry of Agriculture has controlled the Forward Markets Commission, and it wants to have a say in the price of cotton or sugar. Modern economic thinking, of having a well functioning market that discovers the price, and then respecting that price, makes the Ministry of Agriculture very uncomfortable.
Post-socialist staffing
The second good ingredient at SEBI was that it was a brand-new agency which carried no historical baggage. It did not have an entrenched socialist organisational culture which had to be unlearned, unlike RBI or FMC which have struggled to catch up with the new India, a market economy. It was able to do new things on the key issues of human resource policies, which has helped create high staff quality.
Rule of law
The third ingredient which has worked out right at SEBI is the emphasis on the rule of law. SEBI was lucky to deal with a primarily private industry, where clubby methods of addressing problems within the government were not used. So SEBI has to act against private financial firms in writing, through orders which are posted on the website. At its best, SEBI orders are reasoned orders, arguing from scratch what is the wrongdoing and how the law gives SEBI the power to impose a certain penalty.
The firms at the receiving end repeatedly choose to appeal at the SAT. SAT has emerged as a high quality specialised court for finance. SAT has delivered results on the three critical dimensions of speed, knowledge of finance and willingness to disagree with SEBI. SEBI does not sulk when a financial firm appeals at SAT. This is now seen as an everyday process.
When an agency is enveloped in rule of law, these vigorous checks and balances have prevented the arbitrary exercise of power. It has helped foster an internal meritocracy within the organisation where mistakes by SEBI staff are likely to generate a painful result at SAT.


What can we learn from RBI's experiences?

Low corruption
The first is the remarkable accomplishment of building a largely corruption-free organisation. This has been assisted by the fact that most of the financial system that RBI deals with involves PSUs, who are unlikely to offer bribes. Even then, given the extent of discretionary power (i.e. lack of rule of law) in the hands of junior RBI staff, the fact that significant corruption has not arisen is remarkable.
Intellectual leadership
The second thing which has worked out right at RBI is outstanding leadership. With governors like Rangarajan and Jalan, RBI brought an intellectual capability which was an order of magnitude ahead of mainstream India, and led the way on building a market economy. These governors created a positive public image for RBI, and helped push the agency towards sensible decisions on many questions, carrying RBI into reforms even though the old guard of the agency had socialist leanings.


Why has IRDA worked out badly in many respects? One key ingredient which went wrong is the location in Hyderabad. Once that decision was taken, the talent pool that IRDA could access dropped sharply. In contrast, SEBI, RBI, FMC and PFRDA are able to recruit from all across India as prospective employees are generally willing to move to Bombay or Delhi.

A location in Bombay is particularly useful because of the marvellous finance-related web of human capital in Bombay. Each employee of SEBI is surrounded by friends and family who work in the financial system. This helps bring a great deal of awareness and knowledge by osmosis into the organisation. This process was blocked off for IRDA in Hyderabad, where there is no financial industry.


So what lessons can we draw from these? Financial regulation and supervision agencies should be:

Placed in BombayAs in RBI, SEBI, FMC.
Free of conflicts of interestAs in SEBI
HR process for a high quality post-socialist teamAs in SEBI
Lead the way on building a market economyAs in Rangarajan and Jalan
Enveloped in rule of lawAs in SEBI
Achieve low corruptionAs in RBI

Back up to Ajay Shah's 2010 media page
Back up to Ajay Shah's home page