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Current General Studies Magazine: "New Financial Code: a Faulty Road Map" August 2015

Current General Studies Magazine (August 2015)

General Studies - II "Debate Based Article" (New Financial Code: a Faulty Road Map)

While countries in the West are giving their central banks more authority and regulatory powers, India is proposing a system to reduce the RBI to a shadow of itself.

Amid all the talk about a New Financial Code (NFC) and the hullabaloo about the government’s apparent attempt to curtail the powers of the Reserve Bank of India (RBI), some deeper questions seem to have been missed: what is the exact aim of the proposed Indian Financial Code (IFC)? What is it trying to fix? Is a need for a fix at all?

Much of the discussion has revolved around the proposed creation of a Monetary Policy Committee (MPC), which is to be responsible for all matters relating to monetary policy. The argument in favour of an MPC is that: it is standard practice worldwide to have a committee in charge of monetary policy. So far, India has given that responsibility to the RBI and, in particular, to its Board of Directors.

And, though there is no specific provision for this in the RBI Act, the Board has, by and large, entrusted the RBI Governor with that responsibility. So, to the media and to the lay public, the fact that the RBI has cut or raised interest rates is synonymous with the Governor himself doing it.

Conflict of interest

The proposed MPC, composed of seven members, the majority of whom are to be nominated by the government, will take over from the RBI all aspects of monetary policy, including the setting of interest rates. This has riled up a large section of economists, bankers and central bankers. The government, they say, should not be in charge of monetary policy.

The potential for conflict of interest is vast. So far, the government has been interested in securing high growth rates, not only as an electoral plank but also as a means to finance various expenditure schemes proposed in each Budget. The RBI, on the other hand, is tasked with controlling inflation, which often accompanies high growth rates. Raising interest rates is the best tool to achieve this, but it also puts a dampener on growth.

Instituting a committee stacked with government nominees, thus, creates a conflict of interest. Should the committee try to achieve growth regardless of rising inflation, or should inflation be targeted despite slowing growth?
Much has been written on this even though it is just one of many issues. To realise the other implications, it is important to understand what exactly the RBI does. Hint: it’s not just about interest rates of which the policy rate is just one.

The RBI’s primary responsibility includes monetary policy. However, it is also responsible for maintaining financial stability; regulation and supervision of banks as well as of the Non-Banking Financial Companies (NBFCs). It also accumulates and maintains India’s foreign exchange reserves and works in the forex, government securities and derivatives markets. And, last but not least, it has the responsibility of handling India’s public debt and currency rates, as well as heading the Deposit Insurance and Credit Guarantee Corporation (DICGC), which basically insures all bank deposits. In addition, the RBI is the highest authority when it comes to payment and settlement systems in the country.

Now, let’s see what the Indian Financial Code (IFC) proposes. According to the Code, the RBI will continue to be in charge of monetary policy (via the MPC); the supervision and regulation of scheduled banks; currency management; and payments and settlements systems. There is no clarity yet on its role regarding foreign exchange reserves, but lacking any mention in the Code, the assumption is that it will retain control over them.

The Code goes on to say that the regulation and supervision of NBFCs, and activities in the forex, derivatives and government securities markets will be under a proposed ‘financial authority’. This authority is to “regulate all financial services other than banking and payment systems”, and will have a mix of nominated members from both the government and the RBI.

Regulation of NBFCs

Incidentally, there is already some ground for conflict between the RBI and this financial authority — namely, the regulation of Non-Banking Financial Companies (NBFCs). The IFC defines a bank as a “financial services provider” in the business of accepting deposits from the public. Under this definition, all deposit-taking NBFCs would then become banks. Who, then, would regulate them: the RBI or the financial authority?

The IFC also envisages the creation of a Financial Stability and Development Council (FSDC), “a statutory agency for fostering the stability and resilience of the financial system”. Other bodies being created include a Public Debt Management Agency and a Resolution Corporation, which will take over the role of the DICGC.

The Indian financial sector is governed by a host of different laws that were enacted as and when needed to form various regulatory bodies like the RBI; the Securities and Exchange Board of India (SEBI) and the Insurance Regulatory and Development Authority (IRDA). Each of these bodies has taken a while to settle down and start working efficiently. SEBI, for example, has taken about 20-25 years to be effective.

The IFC is looking to amalgamate all these agencies into the proposed financial authority that will deem the RBI — so far a kind of first among equals — as just one of the many financial agencies, with the Governor and Deputy-Governors being designated as Chairman and members.

So, while developed countries in the West are busy giving their central banks more authority and regulatory powers following the financial crisis in the late 2000s, India is proposing a system whereby the RBI is rendered a shadow of its former self. In the U.K., the Financial Services Authority (FSA) has been brought back under the Bank of England. Banking supervision in the European Union (EU) is coming under the European Central Bank (ECB), and similar moves are being made in the U.S. with regard to the Federal Reserve.

Separating banking regulation from that of other, non-bank credit institutions will create many possibilities of regulatory arbitrage, and could lead to financial instability.

Overall, the key question to be asked is: what is broken that the IFC is trying to fix? The latest Financial System Stability Assessment Update by the IMF, released back in 2013, found that “the regulatory and supervisory regime for banks, insurance, and securities markets [in India] is well developed and largely in compliance with international standards.”

Why then this need to destabilise a well-functioning system — in the process sidelining an institution that has held its own over 80 years — by repealing 19 laws and creating five new institutions?

Given the wide-ranging and cascading effect of such a policy decision, a far fuller discussion of all the issues and not just those relating to monetary policy, is needed — it cannot be driven by the hobby horses of a few.