Raghuram Rajan: Financial Sector Legislative Reforms Committee
Report (FSLRC) - what to do and when?
Talk by Dr Raghuram Rajan, Governor of the Reserve Bank of India, at the First State Bank
"Banking and Economic Conclave", Mumbai, 17 June 2014.
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The Financial Sector Legislative Reforms Committee (FSLRC) Report is one of the most
important, well researched, as well as well-publicized reports in Indian financial history. It not
only lays out the functions of the financial sector and how it should be structured, but also
how legislation and regulation governing it ought to look like. The authors of this report truly
have to be commended for their national service. The report's influence will be felt for many
years to come.
There is much to like and agree with in the report. In laying out the need for consumer
protection, raising the issue of whether products sold are suitable for the target customer,
and putting the onus on the financial institution to determine suitability, the report has forced
regulators to review their consumer protection frameworks. We at the RBI are indeed
engaged in such an exercise, informed by the valuable guidelines in the FSLRC report.
There is more of great value. The FSLRC's emphasis on the need for a clear monetary
framework culminated in the Dr. Urjit Patel Committee report, which will guide our thinking in
the years to come. Similarly, its focus on creating new institutions like the Financial
Resolution Authority, which will help us resolve distressed financial institutions at minimum
cost to the economy, is much needed.
I could go on. But I come here not to praise the FSLRC Report, but to debate some of it. I will
argue that there are two fundamental areas of tension. One is the oversight of regulators.
The FSLRC suggests laws that do not micromanage, giving regulators the freedom to fill in
the details in consonance with the changing needs of the economy. At the same time, the
FSLRC wants to check and balance the activities of regulators through judicial oversight. Too
much of checks and balances could completely vitiate the flexibility afforded by rewriting
laws. We need to find a proper balance, and the balance may vary with our level of
development. I worry we have not thought through this fully.
The second area of tension is the appropriate size and scope of regulators. The FSLRC's
recommendations seem somewhat schizophrenic here. On the one hand, it emphasizes
synergies in bringing together some regulators into one entity. But in the process it suggests
breaking up other regulators, with attendant loss of synergies. There is no discussion of the
empirical magnitude of the synergies gained or synergies lost, which makes the
recommendations seem faddish and impressionistic rather than based on deep analysis.
Indeed, across the world, we see a variety of organizational structures in existence,
suggesting that there is no one right structure. If so, there should be strong arguments for
departing from the status quo, which the FSLRC does not provide.
Let me elaborate on these two issues.
The logic for regulation
The logic for regulation according to the FSLRC is to deal with market failure or, more
colloquially, bad behaviour. The Commission talks about incomplete information or poor
incentives as a reason for bad behaviour, but one of the most important reasons for the bad
behaviour necessitating regulation is what economists call incomplete contracts; that is, the
behaviour of the regulated entity (vis a vis customers, the public at large, the taxpayer, or the
market) cannot be completely specified in contracts because it is too difficult to observe or
verify in real time, or it can only be gauged across many contracts.
This means that while courts can enforce specific contracts, the regulator can sometimes do
better. For instance, a bank may attract a lot of complaints from its credit card customers.
While no single customer may think the case worth taking to court, and while no customer
may be able to prove the bank was in the wrong, the large number of complaints will suggest
to the regulator that the bank needs to shape up. By comparing the nature of the complaints
it gets from this bank's customers with the complaints it gets from other banks, the regulator
can gauge whether something is wrong with the bank and act. Similarly, if a particular
product attracts a lot more complaints than other products, the regulator can ask the industry
to modify the product appropriately, or even ban it.
A regulator may also have to prevent certain forms of contracting - such as the CDO
squared and CDO cubed that emerged before the financial crisis. If the regulator thinks a
certain kind of security will impose undue risks on the system, it can ban the security, even
though it would have traded amongst consenting adults. While the regulator has no proof that
the security will behave as it thinks, the regulator cannot wait till the risks occur, for it may be
too late.
The broader point is that a lot of regulatory action stems from the regulator exercising sound
judgment based on years of experience. In doing so, it fills in the gaps in laws, contracts, and
even regulations. Not everything the regulator does can be proven in a court of law. Courts
do not interfere in the specific decisions of a corporate board - using the business judgment
rule, they do not second guess business decisions, and only pull up boards when there is a
violation of the legal process of arriving at a decision. In the same way, there are a range of
regulatory decisions where regulatory judgment should not be second guessed.
The danger of excessive legal oversight
Yet one reading of the FSLRC is that almost everything the regulator does, not just the
framing of regulation or the process by which decisions are reached but also the exercise of
regulatory judgment as well as policy decisions, is to be subject to legal appeal. For that, it
wants to create a Financial Sector Appellate Tribunal. The intent is to place more checks and
balances on regulatory actions. Note that the process by which the regulator reached a
decision, as well as the conformity of the decision with basic principles such as natural
justice, can already be challenged through a writ petition in High Court. Even now, some
regulatory decisions can be appealed to the central government. But how much checking
and balancing is enough? Do we want even policy decisions to be appealable? Can legal
oversight become excessive?
There are three dangers we have to guard against. The first is to ask tribunals to make
judgments that they simply do not have the capability, experience, or information to make,
and where precise evidence may be lacking. If we attempt to do this, we will undermine the
very purpose of a regulator. Of course, one could trust the good sense of the tribunal to
follow a "regulatory judgment" rule and not intervene in a broad array of matters, but does
this not imply a double standard - we trust the tribunal's judgment but not that of the
regulator. More likely, though, past experience suggests that entities like to justify their
existence, and if set up, a tribunal will intervene more than necessary.
The second danger is that easing the appellate process will invite appeal. In a developed
country with well-established regulations, a case history of judgments, and speedy delivery of
justice, this would not be a problem. In India, where the financial system is developing and
many new regulations have to be framed (more so if we move to a principle based approach
for legislation), and where the tribunals will have a significant amount of learning to do, the
encouragement to appeal could paralyze the system and create distortions, as needed
regulations are held up and participants exploit loopholes.
Finally, in every country, a healthy respect for the regulator serves to keep participants on
the straight and narrow. In a developing country, where private behaviour is less constrained
by norms or institutions, this is especially important. But to the extent that private parties with
their high priced lawyers can check the regulator, that healthy respect dissipates. So the final
danger is that the regulator could become a paper tiger, and lose its power of influencing
good behaviour, even in areas that are not subject to judicial review.
Am I arguing that no checks and balances are needed? Certainly not! But there are already
checks and balances in place, including review by constitutional courts like high courts
through writ petitions. Senior officers of the regulator are appointed, and can be removed, by
the government. The FSLRC recommends an annual report to parliament, as well as regular
discussions with parliamentarians. These are good suggestions, which would add to
oversight.
Some could argue that SEBI is already under the Securities Appellate Tribunal, so why not
bring other regulators under a tribunal? So long as the Tribunal only questions administrative
decisions such as the size and proportionality of penalties, I do not see a problem. But if it
goes beyond, and starts entertaining questions about policy, the functioning of a regulator
like the RBI, which has to constantly make judgments intended to minimize systemic risk, will
be greatly impaired. Indeed, because of the tendency of any new organization to overreach
to justify its existence, one should be careful about tying the financial regulator with further
judicial oversight. Better to revisit these issues a few years from now when both regulation
and oversight mechanisms are better developed.
Finally, we do understand that if the regulator wants to be trusted, it has to display the
greatest competence and integrity. The RBI, despite the general deterioration in the probity
of public institutions, has maintained a reputation for integrity. We cannot be complacent
about this and have to work on maintaining a culture, as well as service conditions, that
encourage integrity. We also have to work continuously on upgrading our capabilities so we
match the fast pace of change in the financial sector.
Regulatory architecture
Another area where there are tensions in the FSLRC's reasoning is on regulatory
architecture. Let us take the suggestion to merge all regulation of trading under a new
Unified Financial Agency. So the Forward Markets Commission, as well as the bond
regulation activities currently undertaken by the RBI, would move under a new roof, as would
SEBI. But this assumes that the central synergy is the fact that the instrument is traded. But
could other synergies exist? And how important are they?
For instance, in forward trading where a real commodity is delivered, regulatory oversight
over the real markets for the commodity where price is discovered, as well as over
warehouses where the commodity is delivered, may be important sources of regulatory
synergy. Should the FMC be subsumed under the Unified Financial Agency or would it be
better off having stronger links to the ministries overseeing the real commodities? I think the
answer needs more investigation.
Similarly, is the regulation of bond trading more synergistic with the regulation of other debt
products such as bank loans and with the operation of monetary policy (which requires bond
trading) than with other forms of trading? Once again, I am not sure we have a compelling
answer in the FSLRC report. My personal view is that moving the regulation of bond trading
at this time would severely hamper the development of the government bond market,
including the process of making bonds more liquid across the spectrum, a process which the
RBI is engaged in.
The FSLRC also seems to be inconsistent in its emphasis on synergies and regulatory
uniformity. It proposes all regulation of trading should move under one roof, all regulation of
consumer protection should move under another roof, but the regulation of credit should be
balkanized - banks should continue to be regulated by the RBI but the regulation of the
quasi-bank NBFCs should move to the Unified Financial Agency, a regulatory behemoth that
would combine supervision of trading as well as credit. This balkanization would hamper
regulatory uniformity, the supervision of credit growth, and the conduct of monetary policy.
More broadly, the FSLRC seems to have a somewhat idealistic view of the benefits of
reorganization. It seems to believe that once activities are combined in an organization,
synergies can be fully exploited while if they exist in separate organizations, synergies will
not be exploited. I too shared such a view, but I now believe it is too extreme. Silos within a
large bureaucratic regulator may prevent synergies from being exploited, while frequent
interregulatory meetings can allow regulators to capture many of available synergies between
their activities. Indeed, one particularly useful proposal by the FSLRC is to put the Financial
Sector Development Council on a firmer footing. It is a good venue for inter-regulatory
cooperation, and its benefits are further augmented by personal interactions. For instance,
Chairman SEBI and I try to get together once every month to note and resolve issues.
At the same time, while negotiations and cooperation between regulators can overcome
organizational barriers, it is not wise to give a regulator a responsibility and leave the tools for
exercising that responsibility in other hands. The RBI has responsibility for managing the
internal and external value of the rupee, and more broadly, for macroeconomic stability. As a
number of multilateral agencies and academics have recognized, the ability to shape capital
inflows is now a recognized part of the macro-prudential tool kit. But by taking away control
over internal capital inflows from the RBI, isn't the FSLRC taking away an important tool from
the RBI?
If it ain't broke...
Lest all this sound like an unthinking defence of regulatory turf, let me add that there are
places where the RBI could give up powers. For instance, if the government wants to
manage its own debt, there is no reason for the RBI to stand in the way. I don't believe the
government suffers any less from conflicts of interest in debt management (unlike the views
of the FSLRC), but the RBI could well carry out the government's instructions without any
loss in welfare. I imagine, however, that the government will depend on deputations from the
RBI for a while for advice.
Instead, think of my remarks as an attempt to draw out the important and undoubted benefits
of the FSLRC report, while eschewing grand schemes with dubious chances of success.
Undoubtedly our laws need reform, but that is no reason to try entirely new approaches to
legislation, overlaid on entirely new regulatory structures, complemented by entirely new
oversight over regulation. Undoubtedly, we have had, and will have, periods when regulators
have not gotten along with each other. But is that a reason to merge some organizations and
break up others, perhaps ensuring dysfunctionality along many other dimensions? After all,
there is no single regulatory architecture that has emerged with distinction from the crisis.
Instead, different regulatory architectures have succeeded or failed based on the
circumstances of the country and the quality of the regulator.
Undoubtedly, we have also had occasions when regulators have exceeded their remit or
been high-handed. But is that a reason to subject their every action to judicial
secondguessing? Is there a reason we need more checks and balances, or are we trying to solve a
problem that does not exist.
As the Chinese would say, let us recognize the value of crossing the river by feeling each
stone before we put our weight on it. Let us not take a blind jump hoping that a stone will be
there to support us when we land. Or in American, if it ain't broke, don't fix it!