Prof. Jayanth R. Varma's Financial Markets Blog

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Indian Financial Stability and Development Council

I wrote a column in the Financial Express today about the proposal to create a Financial Stability and Development Council in India as a potential precursor to an apex regulatory body.

The announcement in the Budget speech this year about the setting up of a Financial Stability and Development Council (FSDC) has revived the long-standing debate about an apex regulatory body. Much of the debate on FSDC has focused on the politically important but economically trivial question of the chairmanship of the council. I care little about who heads FSDC—I care more about whether it has a permanent and independent secretariat. And I care far more about what the FSDC does.

The global financial crisis has highlighted weaknesses in the regulatory architecture around the world. Neither the unified regulator of the UK nor the highly fragmented regulators of the US came out with flying colours in dealing with the crisis. Everywhere, the crisis has brought to the fore the problems of regulatory overlap and underlap. In every country, there are areas where multiple regulators are fighting turf wars over one set of issues, while more pressing regulatory issues fall outside the mandate of any regulator. Regulation and supervision of systemically important financial conglomerates is an area seen as critical in the aftermath of the crisis. It is an area that has been highly problematic in India.

The most important failure (and bail-out) of a systemically important financial institution in India in recent times was the rescue of UTI, which did not completely fall under any regulator’s jurisdiction. The most systemically important financial institution in India today is probably the LIC, whose primary regulator has struggled to assert full regulatory jurisdiction over it. Even the remaining three or four systemically critical financial conglomerates in India are not subject to adequate consolidated financial supervision. The global crisis has shown that the concept of a lead regulator as a substitute for effective consolidated supervision is a cruel joke. The court examiner’s report in the Lehman bankruptcy released this month describes in detail how the ‘consolidated supervision’ by the US SEC of the non-broker-dealer activities of Lehman descended into a farce. Even before that we knew what happened when a thrift regulator supervised the derivative activities of AIG.

Consolidated supervision means a lot more than just taking a cursory look at the consolidated balance sheet of a financial conglomerate. An important lesson from the global crisis is that we must abandon the silly idea that effective supervision can be done without a good understanding of each of the key businesses of the conglomerate. High-level consolidated supervision of the top five or top ten financial conglomerates is, I think, the most important function that the FSDC should perform drawing on the resources of all the sectoral regulators as well as the staff of its own permanent secretariat.

Another important function is that of monitoring regulatory gaps and taking corrective action at an early stage. Unregulated or inadequately supervised segments of the financial sector are often the source of major problems. Globally, we have seen the important role played by under-regulated mortgage brokers in the sub-prime crisis.

In India, we have seen the same phenomenon in the case of cooperative banks, plantation companies and accounting/auditing deficiencies in the corporate sector. Cooperative banks were historically under-regulated because RBI believed that their primary regulator was the registrar of cooperative societies. The registrar, of course, did not bother about prudential regulation. Similarly, in the mid-1990s, plantation companies and other collective investment schemes were regulated neither as mutual funds nor as depository institutions. Only after thousands of investors had been defrauded was the regulatory jurisdiction clarified.

As far as accounting and auditing review is concerned, the regulatory vacuum has not been filled even after our experience with Satyam. Neither Sebi nor the registrar of companies undertakes the important task of reviewing published accounting statements for conformity with accounting standards. There is an urgent need for a body like FSDC that systematically identifies these regulatory gaps and develops legislative, administrative and technical solutions to these problems. By contrast, I believe that the role of ‘coordination’ between regulators emphasised in the current title of the high-level coordination committee is the least important role of an FSDC. Some degree of competition and even turf war between two regulators is a healthy regulatory dynamic.

At a crunch, I do not see anything wrong in a dispute between two regulators (or between one regulator and regulatees of another regulator) being resolved in the courts. After all, the Indian constitution gives the judiciary the power to resolve disputes even between two governments!

My favourite example from the US is the court battle between the SEC and the derivative exchanges (supported by their regulator, the CFTC) that led to the introduction of index futures in that country. A truly independent regulator should be able and willing to go to court against another arm of the government in order to perform its mission.

Posted at 10:19 am IST on Fri, 19 Mar 2010         permanent link