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Friday, September 17, 2010

Regulation of Financial System

Is It Prudent to Dilute the Autonomy of RBI?


 


The regulatory mechanism put in place by the government recently to address the disputes arising between the regulators has obviously raised concerns among the financial regulators. The angst felt, particularly by the RBI, at the government’s promulgation of Securities and Insurance Laws (Amendment and Validation) Ordinance, is quite understandable for, the ordinance takes away from the RBI its perceived position of ‘first-among-equals’. Indeed, it may even snatch away the very autonomy of RBI by virtue of replacing the existing mechanism of resolving the disputes between regulators by the High Level Coordination Committee on financial markets chaired by the Governor of RBI with a Joint Committee chaired by the Finance Minister.

So, there emerges an apprehension among many including the RBI that the ordinance is essentially meant for letting the Finance Ministry have the final say on the Central Bank. There is, of course, an understandable reason behind it: Quite often, it is noticed that the RBI has refused to tow the government’s line of thinking in catering to its short-term political interest, though it fell in line with the government subsequently, having essentially no formal independence.

Intriguingly, D Subba Rao, Governor of the RBI, made known the discomfort of the RBI at the government’s ordinance in no uncertain terms when he said: “The jury is out on the issue of fiscal dominance of monetary policy. But it will be less than honest not to acknowledge that the autonomy of monetary policy from fiscal compulsions is once again under threat, and resolving that threat requires credible efforts by both governments and central banks.” The former governor of RBI, C Rangarajan too aired similar opinion when he said, “Any freedom or autonomy of regulators should not be diluted.”

To better acknowledge the ongoing chasm between the RBI and the government over the question of autonomy, we must first appreciate the fact that the financial sector has historically proved to be the source of economic crises all over the globe—including the latest global economic crisis. Its aftermath has only increased the global awareness about the pivotal role of central banks in ensuring financial stability. As a result, there are discussions going on all over the world as to what changes are needed in the regulatory mechanism so as to minimize the probability of financial crisis recurrence. There appears to be a consensus to put in place a mechanism of macro prudential regulation to ensure financial stability. It is ironical that as countries such as the US and UK are contemplating to further strengthen the role of the US Fed and the Bank of England, we are resorting to retrograde ordinances!

That aside, what is more important to remember here is: banks borrow short and lend long, of course, to cater to the interests of the entire economy, but in the process place themselves in a risky position—risk emanating from the mismatch in the maturity of their assets and liabilities. This can result in their inability to honor the demand for money from their depositors. And this loss of confidence can lead to a run on the bank, and a loss of confidence in one bank can become contagious across the system resulting in systemic risk, which will ultimately affect the whole economy by curbing credit flow to businesses, as it did happen in many countries in 2008. And most importantly, in the hour of crisis, healthy banks too in the anxiety to protect themselves are known to behave in a strange way—such as selling assets when price-risk increases, leading to collapse in asset prices—that collectively undermines the very system. In such situations, what is needed is restoration of confidence in the market players and who else can do it better than the Central Bank of a country that is accountable for the implementation of better monetary policies. It is these complexities associated with banking coupled with what has been witnessed in the latest global crisis that have made the world realize that the central banks are better qualified and equipped to maintain financial stability. Incidentally, the UK is on the verge of abandoning its existing policy of separation of financial regulation from its Central Bank.

That being the world view about the role of central banks in ensuring financial stability, we cannot think of diluting the powers of the RBI to oversee the financial system of the country and its accountability to ensure its stability. Of course, difference between the Central Bank and government are inevitable but it doesn’t mean that the autonomy of central bank needs to be clipped. A sensible government, would on the other hand, prefer to entertain a healthy dialog to sort out differences and leverage on the strength of the technical expertise of the Central Bank to pursue a fiscal policy that best serves the objectives of its political economy. At the same time, it is essential for the Central Bank to appreciate that there is nothing like absolute autonomy in a democracy where everyone has to submit to the dictates of the system as a whole.

In any case, no sensible government would ever try to gag the dissent—though ironically, the very RBI which is today craving for autonomy, has itself resorted in the recent past to silence one of its deputy governors, who expressed a contrary view to its stated policy—but would rather prefer to work for consensus-driven decisions in managing the macroeconomy that is increasingly becoming complex in today’s shrinking world of eroding national sovereignty. But the question is: How sensible are we?


– GRK Murty 

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