A flawed Approach

The Financial Sector Legislative Reforms Commission (FSLRC) completes its two-year tenure in March 2013. The Commission did well to release its Approach Paper on October 1, 2012, setting out its thinking on the new financial legislative architecture along with its tentative recommendations. The Commission has called for feedback, but curiously, this important paper has not attracted much media attention.

According to the Approach Paper, the present financial legislation needs to be scrapped, with the Commission proposing an entirely new financial legislative architecture featuring seven agencies:

A central bank that undertakes only monetary policy and enforces consumer protection law and micro-prudential laws in the fields of banking and payments;

A unified financial regulatory agency (UFRA) for all financial activity other than banking and payments;

A Resolution Agency;

A Financial Sector Appellate Tribunal (FSAT) which will hear appeals against all financial regulators including the central bank;

A Financial Redressal Agency;

The Financial Stability and Development Council (FSDC) and

An independent debt management office (Paragraph 123 of the Approach Paper).

Legislation and Policies

While the Commission is composed of the finest minds in law, finance, economics, central banking and government, it appears to have erred in not delineating legislation from policy. The legislative framework should provide an architecture under which the authorities could formulate alternative policies. Unwittingly, the Commission has trespassed into developing a legislative structure suited to a particular policy line.

The leitmotif of the Approach Paper is that all that needs to be done is to dismember the Reserve Bank of India (RBI), create a unified financial regulatory agency and concentrate even greater powers in an already all-powerful Ministry of Finance.

While doing so, the Commission appears to be oblivious of the fact that the macroeconomic management would be greatly attenuated by its passion to hive off activity from the RBI. The endeavour should be to see how the present financial legislation should be strengthened to improve the efficiency and effectiveness of policies and to be able to enforce the regulations in a more purposeful manner. In yielding to its great passion to overhaul the system, the Commission has deviated from its central objective.

The Commission has fallen to the strong temptation of deciding the particular policy framework it prefers rather than concentrating on the rather dreary nitty-gritty of improving the existing financial legislation.

The Commission appears to be enamoured by the UK Financial Supervisory Authority (FSA), despite it being universally acknowledged that the FSA experience was a failure of governance as it ignored the need for integrating macro policy considerations with supervision, which is vital for effective financial regulation. Dr C. Rangarajan, the doyen of the financial sector, has already cautioned against setting up of a UFRA and the Commission would do well to heed his advice.

Independence of RBI

The Commission envisages a diminished role for the RBI which would have no say in the non-bank financial sector, the government securities market and the foreign exchange market, which would logically imply that the RBI would have no say in the management of the exchange rate and, thereby, in the forex reserves.

Once this is done, the Commission envisages that the RBI would reach El Dorado of total independence. The Commission accepts the Impossible Trinity and with total monetary policy independence and no capital controls, the exchange rate would necessarily need to be left to market forces. This is not the policy of the RBI and the Government, but the Commission is determined to force its preferred policy model on the policymakers. On the issue of where the rule-making function on capital controls should be, the Commission is inclined to knocking off one more tooth in the RBI’s armoury and shifting this activity to the all powerful Ministry of Finance.

The Commission should know that independence of the central bank cannot be ensured merely by legislation, if the Government wants to get into the minutia of day-to-day monetary management. Under the architecture envisaged by the Commission, if the so-called independent RBI raises the repo rate — what it takes to control inflation, would the government be a passive bystander?

The answer is clear in the recent stand-off between the Government and the RBI with the Government publicly pushing the RBI to reduce interest rates. One is afraid that the Commission’s promise of independence for the RBI with accountability is a poisoned chalice.

Debt Management

As regards government debt management, the Commission opts for a separate Debt Management Office (DMO), totally separated from the RBI. This has been recommended by many earlier Groups/Committees but the basic precondition is that government reliance on borrowing would need to come down drastically, and this is nowhere in sight.

If the Approach Paper is a preview of the Commission’s Report, all that one can say is that the Commission’s fundamental approach is flawed as it is detached from reality.

Our distinguished Commissioners and the Secretariat would be well advised to peruse A. Vasudevan’s recent short book on Monetary Governance, 2012 (Academic Foundation) which deals with a number of issues with which the Commission is grappling.

Keywords: Financial Sector Legislative Reforms Commission’s Approach Paper, flawed approach

The Financial Sector Legislative Reforms Commission’s Approach Paper seems to favour a diminished role for the RBI, vesting more powers with the Finance Ministry.

(The author is an economist. blfeedback@thehindu.co.in )