Prof. Jayanth R. Varma's Financial Markets Blog

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Obama's Financial Reforms and Rajan Committee

I wrote an article in today’s Financial Express comparing Obama’s proposals for financial regulatory reform in the United States with the Rajan Committee proposals in India. Obama’s speech is available here and the full report is available here. The Rajan Committee report is available here.

On Wednesday, US President Obama unveiled an 89 page blueprint for reforming financial regulation in the US in response to the financial crisis. The proposals have several striking similarities with the recommendations of the Raghuram Rajan Committee in India a few months ago.

Obama outlined the need for overhauling the regulatory structure very succinctly. He said that where there were regulatory gaps, regulators lacked the authority to take action and where there were overlaps, regulators lacked accountability for their inaction. The US and India face this problem of regulatory gaps and overlaps far more acutely than many other countries (like the UK, Singapore or Germany) which have a more streamlined regulatory architecture.

While recognising this problem, both the Obama and Rajan proposals make only incremental changes to the existing architecture and eschew more ambitious proposals to scrap the system altogether and start all over again. The reality is that even these proposals might test the limits of what is politically feasible.

Obama called for the creation of a Financial Services Oversight Council (FSOC) which is very similar to Rajan’s Financial Sector Oversight Agencies (FSOA) in terms of its composition and structure. Both bodies consist of the heads of all regulatory agencies and have a permanent secretariat. One difference is that the FSOC is chaired by the Treasury Secretary.

The much bigger difference is that Rajan’s FSOA was also to be the macro-prudential regulator for systemically important financial conglomerates and organisations. Under Obama’s proposals, the macro-prudential regulator for such conglomerates (unimaginatively called Tier 1 Financial Holding Companies) is the Federal Reserve Board. Arguments can be made in favour of both models. In the Indian case, the critical concrete question would be whether the RBI should be the macro-prudential regulator for the LIC or whether this role should be performed by all sectoral regulators meeting together.

Obama calls for the creation of a Consumer Financial Protection Agency (CFPA) whose role is very similar to that of the Office of the Financial Ombudsman (OFO) proposed by the Rajan Committee. The key difference is that the CFPA is vested with vast statutory powers while the OFO was conceived of as having much of the characteristics of a self-regulatory organisation. I believe that while there is merit in starting out with less formal statutory powers, the OFO should also move in the direction of the CFPA whose bite is as formidable as its bark.

On the markets, the corner piece of the Rajan report was the merger of the commodities derivatives regulator (FMC) into the securities regulator (SEBI). In the US too there were high expectations about merging the CFTC into the SEC, but Obama has stopped short of this.

Given the perception of the SEC today as a failed regulator (Bear Stearns, Lehman and Madoff), it is perfectly understandable that the President is reluctant to reward it with greater powers. The one regulator whose failures were even more egregious than that of the SEC – the OTS which regulated AIG – is proposed to be disbanded. Another infamous regulator – the OFHEO which regulated Fannie and Freddie – has already been replaced by the FHFA. In this context, the SEC should count itself lucky that it has been left largely intact.

In the long run, however, a merger of the CFTC into the SEC is inevitable and if Mary Shapiro’s attempts to reform the SEC succeed, we might not have to wait for the next crisis for this to happen. In India, the arguments for folding the FMC into Sebi are very strong and there is no need to wait at all.

Obama’s proposal (like the Rajan report) calls for moving most Over The Counter (OTC) derivatives towards centralised clearing and bringing them under the purview of the market regulators. This is absolutely necessary. Obama’s blueprint also states that key settlement and clearing agencies should have access to central bank accounts and facilities to reduce their dependence on banks. This is an extremely important issue in India as well where the dependence of securities clearing agencies like NSCCL and CCIL on commercial banks has become an unacceptable source of systemic risk.

Obama’s reforms recognise the importance of preserving vibrant financial markets. Obama rightly states that the role of the government is not to stifle the market, but to strengthen its ability to unleash creativity and innovation. The goal is to restore markets in which we reward hard work and responsibility and innovation, not recklessness and greed. He also says that the purpose of regulation is to allow markets to promote innovation while discouraging abuse, and to allow markets to function freely and fairly, without the risk of financial collapse.

These are important principles to keep in mind. The current global crisis has discredited the existing regulatory regime for financial markets; they have not discredited financial markets themselves.

Posted at 9:42 pm IST on Fri, 19 Jun 2009         permanent link