G Padmanabhan: India's regulatory approach to sophisticated financial
products
Comments by Mr G Padmanabhan, Executive Director of the Reserve Bank of India, at the
Award Ceremony of Dufrenoy Prize for Responsible Innovation in Finance, Paris, 18 June
2012.
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Assistance provided by Alpana Killawala and Ms Indira Nanu is gratefully acknowledged.
Ladies and gentlemen,
C' est en effet un honneur et un privilège d'être ici ce soir, dans une des plus belles villes du
monde, d'accepter au nom de l'une des Banques centrales les plus respectées du monde le
prix Dufrenoy de l'Innovation décerné pour l'année 2012, à la Reserve Bank of India (pour
nos calibrage politique dans le règlement des produits financiers). Je remercie tous ceux qui
ont contribué à nous choisir pour cet honneur. Maintenant avant que l'on me décerne le prix
pour l'innovation dans la langue française, je voudrais continuer mon discours en anglais. (It
is indeed and honour and a privilege to be here this evening, in one of the most beautiful
cities in the world and to accept, on behalf of one of the most respected Central Banks in the
world, the Dufrenoy Prize for innovation, awarded for the year 2012 to the Reserve Bank of
India, for our calibrated approach to the introduction and regulation of financial products. I
thank all those who have contributed to conferring this honour on us. And now, before I am
awarded the prize for innovations to the French language, let me continue my speech in
English.)
Let me begin by referring to the citation of the jury who decided on this prestigious Dufrenoy
Prize to the RBI. The observations of the honourable jury members about the Indian
regulatory approach being precautionary and gradual, with a culture of testing and paying
attention to potential negative effects of sophisticated financial products before facilitating
them, precisely encapsulates the culture and methodology of the Reserve Bank of India, as it
seeks to fulfill its mandate - by juggling the multifarious roles assigned to it - of maintaining
stability of both prices and the financial system and supporting economic growth. In all the
roles that we play, the common thread that underlies any policy is that it should promote
growth. Not just growth, but sustainable growth, which in turn can be brought about only with
inclusive growth, benefiting the society at large, but without undermining financial stability.
Now, a few words about what RBI does.
Apart from the quintessential central banking roles like formulation of monetary policy and
printing and distribution of currency, we also manage the external sector, regulate and
supervise banks, non-bank finance companies and segments of financial markets (money,
forex, government securities). We also regulate the payment and settlement systems. We
are banker to banks and to the Government - federal and state governments. We are also
the debt manager of the government, managing all their market borrowings, calibrating both
the amounts and the timing to ensure that this does not crowd out other players. Added to all
this, and perhaps unique to Central Banking anywhere in the world, we are mandated to pay
special attention to the agricultural and allied sectors and have created and hived off several
institutions for channelizing credit to agriculture, industry, small and medium enterprises,
housing, mutual funds, settlement of trades, etc., etc.
We also have a key role at very micro levels in the development process. We are currently in
the process of ensuring empowerment to a hitherto voiceless segment of society by
facilitating their entry into the mainstream of economic activity by trying to bring them into the
ambit of formal banking channel (financial inclusion) by customizing certain products and
services for them. We are following up this objective by also educating the people (financial
literacy) about the benefits of being part of the formal financial sector and the host of facilities
and benefits they can demand from it. We are also following up with the Government to
include financial literacy in the curriculum of educational institutions so as to equip the young
ones with the necessary skills before they enter the real world.
Having given you a bird's eye view of our myriad functions, let me walk you through our
policy formulation processes. Before introduction of any new concepts, regulations or
financial products, we generally elicit the opinions of various segments, i.e., stake holders,
academicians, financial institutions, researchers, and laymen. We do this by placing a
discussion paper on our website and the paper is converted into policy only after factoring in
the various inputs so received. This serves the dual purpose of (i) preparing the market for
the new product/dispensation and (ii) negating to a large extent the unexpected
consequences that a possibly one sided regulation could have brought about.
Since we have been awarded the prize for the gradual introduction of new financial products
into the markets, let me illustrate with an example on the guided, gradual, sequenced and
calibrated development and integration of markets in India, one of which, namely, the forex
market, Mrs. Gopinath and I have been privileged to witness almost since the very
beginnings. Forex markets started in India with the banks being required to maintain square
or near square open exchange position and the central bank announcing the buying and
selling rates. Today the country can boast of a market with a daily turnover of USD 60 Billion,
with most of the products and their variants being traded and a Central Counter Party (CCP)
arrangement for settling inter-bank forex transactions. Even today, corporates are allowed to
access the market only to hedge an underlying exposure and not to take any punts on the
currency. They are still not allowed to write options and thereby take on open ended risks. In
recent times, the same thumb rule has been followed even while enabling Credit Default
Swaps (CDS) contracts. In other words, little skeptical of the globally accepted, almost
axiomatic belief in the self correcting mechanism of markets, but also conscious that too
much regulation could throttle, we have put in place certain safeguards, which while allowing
normal free play would guard against the ability of individual market makers to move markets
in directions beneficial to them but detrimental to the stability of the system. We, therefore,
prescribed limits on positions and leveraging keeping in view the interconnectedness of
institutions in the financial system. The recent global meltdown occasioned precisely on
account of these factors of excessive leverage coupled with lack of regulation have
vindicated our stand that no systems that undermine the real economy should be allowed
unbridled freedom as any ravages to the real economy take years to repair.
At the same time, recognizing that well developed, efficient markets are a prerequisite for
price discovery and critical from a Central Bank perspective for the efficient transmission of
monetary policy impulses, the RBI has been playing a proactive role in developing the
financial markets in a manner so as to ensure that they are in sync with the real economy.
Simultaneously, efforts are being made to develop infrastructure, technology and capabilities
of market participants, while evaluating their ability to absorb shocks, and insisting on their
putting in place robust risk management systems, since we are conscious that our
overarching objective is the maintenance of financial stability.
But should all this mean a total change in approach to financial innovation? At the
International Research Conference hosted by us, Mr John Lipsky of the IMF while focussing
on the importance of finance for rapid and sustainable growth, observed, and I quote, "While
some might consider this topic odd in light of the current crisis, I will seek to draw out some
key lessons of recent events for the appropriate policy stance toward financial innovation.
Many critics...have concluded that such innovation is to be actively discouraged. But I would
claim that this is precisely the wrong lesson to draw. Despite the unsettling and even
dramatic recent global experience with "cutting edge" finance, I believe that without a
renewed effort to foster financial innovation in the global economy, all countries - including
emerging market economies - will underperform their potential. The principal challenge for
policymakers, then, is to strike an appropriate balance between financial openness that
supports growth - enhancing innovation while at the same time implementing regulations
and effective supervision that limit the potential risk of financial instability..." The recently
published report by the World Economic Forum titled "Rethinking Financial Innovation"
(2012) concludes, "Successful innovation in financial services can improve capital
productivity with beneficial effects that permeate through the wider economy. Unsuccessful
innovation can have the opposite effect. It is important, therefore, to face up to the challenge
effectively..." The report advocates that effective risk management systems need to be put in
place and goes on to argue that "aside from explicit risk-management frameworks,
governance mechanisms (should) also include new product development and approval
processes employing various safeguards against unwise innovation...and an extensive
regulatory infrastructure". This is a daunting challenge and has indeed been challenged, but
the Indian regulatory approach to financial innovation has always endeavoured to be on
these lines.
In concluding, I would once again like to convey gratitude of the Reserve Bank of India to
Ecole des Mines de Paris for recognizing and appreciating us for the very reason we were
criticized not so long ago. It is indeed an honor and we are here to accept the award with all
humility and are deeply conscious of the fact that we have miles to go yet. I would also like to
thank all those who are present here today to witness this award ceremony.
Merci beaucoup and a bientôt.