Monday, March 8, 2010

The RBI should be the super-regulator

The Union Budget contains a proposal to set up a Financial Stability and Development Council (FSDC) to "monitor macro prudential supervision of the economy". This new super-regulator is proposed to monitor the functioning of large financial conglomerates, co-ordinate among the RBI, IRDA, PFRDA and the SEBI, and promote financial literacy and financial inclusion.

Presently, the RBI Governor heads an informal High Level Coordination Committee (HLCC) on financial and capital markets, which consists of all the regulators and finance ministry officials. But the RBI's role as the banking regulator, and the resultant inevitable conflict of interest, often detracts from the effectiveness of the HLCC. In any case, the HLCC is not vested with any statutory powers to pass binding directions to its members or enforce discipline among members.

There have been calls to divest the RBI off its banking regulatory powers and then make it the super-regulator. Already there is widespread opinion that the RBI's role as debt manager for the Union Government conflicts with the effective conduct of monetary policy. The need for the setting up of a separate Debt Management Office (DBO) has however been repeatedly rejected by the RBI.

I am inclined to argue that if a super-regulator to co-ordinate among all financial sector regulators is created, the RBI should assume that role. Further, in light of the sub-prime crisis and the systemic ramifications of widespread bank failures, it may also be appropriate to retain the banking regulatory role with the RBI. Here are atleast four reasons in support of the RBI as the super-regulator

1. As Ben Bernanke recently pointed out, the central banks' bank regulatory powers significantly enhances its ability to carry out its conventional central banking functions - its ability to effectively address actual and potential financial crises depends critically on the information, expertise, and powers that it gains by virtue of being both a bank supervisor and a central bank

2. The twin functions of consolidated supervision of individual banks and assessing macroprudential systemic risks require expertise that only the RBI possesses. Any effort to replicate the same in another agency will not only be near impossible, but also very costly. Further, only the RBI has the requisite market credibility to exercise this role.

3. The RBI needs to manage both the monetary policy and the external sector, a challenge that requires effectively addressing the Impossible Trinity (middle solutions of open but managed capital account and flexible exchange rate but with management of volatility). The RBI's relative recent success with this ( in contrast with the failures elsewhere) can be attributed to its ability (and willingness!) to judiciously deploy the full spectrum of banking and financial market regulatory instruments. Rakesh Mohan and Muneesh Kapur attrinute this to "the fact that both monetary policy and regulation of banks and other financial institutions and key financial markets are under the jurisdiction of the Reserve Bank, which permitted smooth use of various policy instruments".

4. As Paul Volcker points out, recent events have conclusively proved that "monetary policy and the structure and condition of the banking and financial system are irretrievably intertwined". Separating the two activities will hamper both functions and render the respective regulators ineffectual.

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