Column:Clear the turf for super regulator

Mar 03 2010, 20:53 IST
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SummaryThe FM in his Budget speech announced the setting up of the Financial Stability and Development Council.

The FM in his Budget speech announced the setting up of the Financial Stability and Development Council. This apex council is being set up to strengthen and institutionalise the mechanism for maintaining financial stability. Given the emergence of financial conglomerates, this column has argued about the benefits from having a super regulator. Nevertheless, thoughtful implementation is key to the eventual success of this measure. First, the objectives of the council vis-à-vis those of the sectoral regulators need to be clearly detailed to avoid turf wars and an eventual stalemate in the process of financial regulation. Second, an integrated supervisor may extend moral hazard problems across the entire financial sector. Clear communication is required to minimise this problem.

The range of regulatory activities of the new council could be narrow or wide depending upon how clearly the objectives of the council are laid out vis-à-vis those of sectoral regulators. The Budget speech mentions that the council would monitor macro-prudential supervision of the economy, including the functioning of large financial conglomerates and address inter-regulatory coordination issues. However, these objectives can be interpreted very broadly by the members of the council, which may lead them to step in the toes of the existing regulators. This could lead to turf wars as well as jostling for regulating space among the sectoral regulators, on the one hand, and between the council and each of the sectoral regulators, on the other. Clear specification of the objective would help in minimising such inefficiencies.

Specifically, the creation of the council raises the important issue about the degree to which RBI should be involved in prudential macro-supervision. There are clearly some synergies between banking supervision and monetary policy. For instance, the central bank needs to be aware of the financial position of banks when formulating and implementing its monetary policy. There is a clear synergy between the information needed for banking supervision and the information about banks needed for monetary policy purposes. RBI also needs to have information about the creditworthiness of the participants in the payment system. This task involves an assessment of the solvency and risk management of individual banks. Furthermore, information about the liquidity and solvency of banks is required for RBI’s lender-of-last-resort responsibilities.

There are also operational arguments for RBI being in charge of banking supervision. The economies of scale and commonalities between banking supervision and other functions of the central bank may be substantial and indeed stronger than those between banking and other parts of the financial sector.

However, there is a fundamental difference between the monetary policy decision and decisions taken with respect to macro-prudential regulation and supervision. The monetary policy decision is basically the same decision taken repeatedly, simply defined (not simple!), and taken relatively transparently based on information that is largely publicly available. The effects of the decision are widespread, and there is no opportunity of appeal by those affected. In contrast, supervisory decisions are not taken at a predefined time; they are based on private and often confidential information. There are many types of decisions that need to be made—for example, concerned parties may be significantly affected, and have the opportunity to appeal the decision in court. Furthermore, expertise spanning all the financial sectors is necessary, particularly when the supervision and regulation concerns financial conglomerates. Given these fundamental distinctions, I would favour macro-prudential regulation and supervision to be entrusted to the apex council with the monetary policy decisions remaining the sole preserve of RBI.

The second concern with respect to the creation of the apex council as a super regulator concerns moral hazard. Financial market participants may believe that all creditors of all institutions supervised by an integrated supervisor will receive the same protection. For instance, the creditors of other financial institutions may expect—and demand through a political process in case of financial problem—that they be given the same protection as the depositors in banks. The creditors to a bank, that is, the depositors are provided the benefit of deposit insurance to avoid the possibility of runs on the assets of a bank. However, since other financial service providers such as insurance companies or pension funds do not face this problem of a run on their assets, it is inappropriate to extend such a feature to their creditors. Without clear communication to all such affected parties, it is possible that the safety net provided by deposit insurance implicitly gets extended to other parts of the financial sector. While clear communication by the apex council would alleviate such a problem partly, it is unlikely to be fully resolved unless and until the supervisor acts exactly in line with the pre-announced rules in specific cases of financial failures.

The author is assistant professor of finance at Emory University, Atlanta, and a visiting scholar at ISB, Hyderabad

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