YV Reddy: Society, economic policies, and the financial sector
The Per Jacobsson Foundation Lecture 2012 by Dr YV Reddy, Emeritus Professor,
University of Hyderabad and former Governor of the Reserve Bank of India, Basel,
Switzerland, 24 June 2012.
Please see the remarks by José de Gregorio and Ignazio Visco related to this lecture.
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Chairman, esteemed panellists, and distinguished participants,
I am grateful to the Per Jacobsson Foundation, in particular Chairman Ortiz, for conferring on
me the honour of delivering the Per Jacobsson Foundation Lecture for 2012. I did not have
the good fortune to meet Per Jacobsson, so my familiarity with him is primarily through the
references made to him in the second volume of the history of the Reserve Bank of India. He
came across as a forceful personality, who had an excellent grasp of India's economic
policies and problems (Balachandran, 1988; p. 641). He was obviously a forthright person
with impressive foresight. I am wondering what Per Jacobsson would say if he were to
comment on recent developments in the financial sector.
The future of finance, and in particular saving it from a popular backlash against the global
financial crisis and related crisis-management policies, has rightly become a matter of great
concern. There is broad agreement that finance has, as in the past, the potential to do good,
which should be harnessed by all. However, it is essential to minimise its potential to do
harm. In the commendable search for good finance, central bankers have not merely a stake
but also have a legitimate role to play. From central banker's point of view, there are several
issues in this search for good finance for the future, but there are three inter-related issues
that I want to comment on today: (a) how to ensure that the financial sector serves the
society better; (b) how to integrate financial sector policies better with national economic
policies; and (c) how to ensure that the financial industry functions as a means and not as an
end in itself?
Major issues confronting the finance industry were articulated by Sir Andrew Crockett in this
forum last year (Crockett, 2011). The presentation today is in many ways a supplement to it.
Sir Andrew has made an enormous contribution to the global community of central bankers
and I would like to dedicate this address to Sir Andrew.
This presentation considers many issues raised on the future of finance (e.g., Ferguson,
2009, Sheng, 2009; Chittenden, 2010; Roubini & Mihm, 2010; Turner & others, 2010; Pringle
and Jones, 2011; CAFRAL-BIS, 2011; Blanchard & others, 2012; Shiller, 2012). My
reflections are moulded by not only a decade in central banking but also many years in
macroeconomic management in federal government and the Bretton Woods Twins, in
addition to a much longer period at provincial and local levels of government dealing directly
with the public. Keeping in view the composition of today's audience and the key role of
central banks in finance, I will be exploring select themes of operational significance to
central banks at the present juncture.
Society and finance
An assessment of the impact of the recent global financial crisis on the trust and confidence
of society in the financial sector is a useful starting point when considering ways of restoring
the trust. A major reason for the erosion of trust may be a sense that there has been a
comprehensive capture of regulation of the financial sector by the finance industry,
particularly in the leading advanced economies. A demonstrable commitment to provide
reasonable access to essential financial services to all segments of society would reinforce
the assertion that finance serves the larger community. This approach, which may broadly be
described as inclusive finance, goes beyond the current concerns with providing consumer
protection and ensuring systemic stability.
Restoring trust
It is true that the Occupy Wall Street movement directed at the financial sector has petered
out. This may signify a lack of popular support for the movement, or equally it may signify a
lack of hope that things will change or that better alternatives are on the horizon. A society's
trust and confidence in finance, like in any other sector, is derived partly from formal laws,
regulations and procedures, and partly on the manner in which they are implemented,
through both formal and informal channels. Trust is, therefore, difficult to measure, but on the
basis of surveys conducted and anecdotes reported in the media, there appears to be an
erosion of trust in the financial sector as a whole, and banking in particular, in advanced
economies. The perceptions of such an erosion of trust, however, differ.
What are the plausible reasons for the erosion of trust in some jurisdictions? We can only
speculate.
First, large sections of the population have been affected by the financial crisis, and they
consider themselves innocent victims of the crisis in financial sector. In particular, they feel
that those involved in the financial sector have enjoyed disproportionate gains and shifted the
pains of adjustment to the rest of the population.
Second, in the discharge of semi-fiduciary functions that are critical to the integrity of
financial markets, such as fixation of LIBOR and credit rating, the major global players in
financial markets discredited themselves by resorting to questionable practices.
Third, when several irregularities in the functioning of large financial intermediaries were
found, the regulators reacted to the wrong-doing by imposing penalties. The public at large
was often left in the dark about the details of the malfeasance and the losses they had
suffered.
Fourth, the shareholders in a few large financial conglomerates are actively questioning the
remuneration of senior management in some cases. This is unprecedented, reflecting the
loss of trust by shareholders in the management of financial firms.
Fifth, although public policies provided liquidity, extended bail-outs in some cases, and in a
few cases tax breaks, the much needed credit from the financial sector to the economies is
not forthcoming, even after accounting for the muted demand for credit.
Finally, there is resistance from finance industry leaders to suggestions for strengthening
regulations. In advanced economies, operational details of important reforms in the banking
sector, shadow banking activities and innovations in financial markets are yet to take a final
shape. There is, perhaps, what may be described as unionisation of global capital against
attempts by public policies to regulate the financial sector effectively.
It is also possible to argue that erosion of trust, if any, may be temporary, as seen in the past
when the financial sector faced crises. It is also possible that central bankers have no tools
for managing society's trust except by delivering their mandate through price stability and
financial stability consistent with maintaining employment and growth. But it is undeniable
that maintaining trust and confidence in finance is essential for the good of society at large.
My submission is that the mandate for maintaining financial stability, which often rests
primarily on central banks, has two related dimensions, namely the avoidance of disruptions
in the functioning of the financial system and (more positively) the promotion of trust and
confidence in the system. If there is any wing of public policy authority that has a stake in
building such trust, it is the central bank. Hence, the central bank should be watchful of
developments related to trust in their jurisdictions and take a conscious decision whether to
monitor and act, as necessary, to ensure continued trust and confidence in the financial
sector.
Comprehensive regulatory capture
As noted earlier, the decline of trust and confidence is partly the result of the perception that
there has been a comprehensive regulatory capture. While the popular explanations for
market failure relate to incentives, and possibly greed, the regulators' failures are generally
attributed to misplaced faith in the self correcting powers of markets, a lack of skills in
regulatory agencies and capture by vested interests. Such a capture can be described as
comprehensive, particularly in the countries that were most affected during the crisis, in the
sense that it was not restricted to the economic concept of regulatory capture, but extended
to the overall public policy relating to financial sector.
What could be the reasons for this?
First, the political leadership has a short-term horizon, and financial markets also have a
short-term horizon. This creates a natural tendency for their priorities to converge. Available
evidence shows that financial contributions to political activity from the financial sector in
many affected countries increased significantly in recent years. Moreover, large global
financial conglomerates seem to be in a position to influence not only political governance
but also corporate governance, to suit their own interests.
Second, regulators, as part of their public consultation process, often depend on the
regulated for consultation, which is a feature common in most industries. But the dominant
market shares of the few giants in the finance industry, combined with the characteristic
externalities of finance, make a difference to the process and outcomes. In the past, the
excessive deregulation of the financial sector was often designed to a significant extent
based on the advice of the interested market participants themselves.
Third, in cases where academics are advising on the design of reforms, they are often
finance experts, sometimes engaged with market participants in remunerated advisory or
consulting capacities. A large part of economic research on regulation is funded by the
financial sector. In fact, most of the analysis of macroeconomic trends available in the public
domain is from economists employed by large financial conglomerates. There may be, as a
result of several of these factors, a tilt in favour of the financial sector in media coverage too.
Fourth, in many countries, the finance industry offers prospects of highly paid jobs for those
employed in the regulatory agencies and Treasuries or Ministries of Finance.
Finally, finance and its regulatory framework are somewhat intangible and difficult for a
common person to fully understand. Hence interested groups can tilt the intended policy
changes in their favour by presenting their initiatives to shift equilibria between competing
considerations as mere technical issues.
It is possible to argue that capture of regulators is inevitable, and that a case can therefore
be made in favour of reducing formal regulation, and encouraging self regulation and
promoting principles-based regulation. On the contrary, there is a widespread feeling that
those were the very prescriptions that brought about the global financial crisis. The biggest
challenge for the future of finance lies, therefore, in designing governance practices that
avoid the dangers of comprehensive regulatory capture.
I would, however, hasten to add that public policy failures cannot at the same time be wished
away by placing undue blame on regulatory capture. It is evident that public authorities in
major financial centres genuinely believed that the financial system, even in its complex
evolution, was contributing to the public good. But this faith ex post proved to be misplaced.
Professor Levine observes that the absence of an informed, expertly staffed and
independent institution that evaluates financial regulation from the public perspective is a
critical defect in the governance of financial regulation (Levine, 2012). He suggests
establishing a body that would submit a periodic report to the legislative and executive
branches of government assessing the impact of financial regulation on the public. The body
would be politically independent, independent of financial markets and staffed with experts,
while having no official power over the central bank or other regulatory bodies. This may
sound utopian, but is worth trying in the present day turbulent market environment.
Consideration may also be given to the formulation of a "fair practice code" for finance
professionals, regulators and academia, extending the idea mooted by the American
Economic Association on a Code of Ethics. A similar approach has been suggested by
Professor Shiller in the context of financial innovation supporting the stewardship of society's
assets. He observes that "the best way to do this is to build good moral behaviour into the
culture of Wall Street through the creation and observance of best practices in its various
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professions CEOs, traders, accountants, investment bankers, lawyers, philanthropists"
(Shiller, 2012, p. xi). However, experience suggests that there are limits to the effectiveness
of such codes. In fact, ethical behaviour can be felt and understood, but it is difficult to
formulate it fully in a code intended for day-to-day organisational purposes. Moral behaviour,
in the final analysis, is a matter of individual choice. But what best practices can do is to
exemplify the inherent morality in the individual.
My submission is that serious consideration should be given to evolving trustworthy
institutional structures and adoption of best practices to re-assure the public that the scope
for comprehensive regulatory capture is being minimised. These assurances could be further
reinforced through improving the public image of central banks and, in particular, of the
Governors.
Inclusive finance
Inclusive finance implies that the objective of financial sector regulation should be as much
about protecting consumers as ensuring the availability of essential financial services to all
sections of society, keeping in mind the expectations and needs of the common person.
Emphasis on financial literacy by central banks has been advocated to enable consumers to
take advantage of competitive efficiency. However, the issue is not one of financial literacy
but of the behavioural patterns of common people dealing with finance. In this regard, it has
been rightly observed: "By properly deploying both incentives and nudges, we can improve
our ability to improve people's lives, and help solve many of society's major problems. And
we can do so while still insisting on everyone's freedom to choose" (Thaler and Sunstein,
2008, p. 8). It is useful to provide a default option of financial products for those large
sections of society that have neither the inclination nor the tools to make those choices. It
could be argued that a competitive financial system which is well-regulated, keeping in view
the needs for stability and consumer protection, would automatically ensure inclusive
finance. Experience so far does not support such a view. Public policy in relation to the
financial sector therefore needs to consider the expectations of large sections of the
community, typically those of a common person. They are bound to be different depending
on the society, but a few broad generalisations may be attempted.
First, common people need a place to keep financial savings in safe custody (e.g., wives
often need to keep them safe from wayward husbands in rural areas in developing
countries). They should be able to place and withdraw such savings with ease and at
minimal cost. While a range of instruments with a host of risk-reward profiles may be
provided by the financial sector, access to one safe and simple instrument is essential for a
common person. Often, this is a deposit in a recognised deposit taking institution,
traditionally a retail bank-branch in the neighbourhood. The edifice of trust in the financial
system, including leverage, is built primarily at this level.
Second, reasonable demand for credit for smoothing consumption between days/periods of
income and of expenditure has to be met by the financial system at a reasonable cost.
Smoothing of consumption may also be longer-term, including over lifetimes.
Third, remittances or payments may have to be made within families over different locations
or for various other purposes, and such services should be available and accessible at
affordable cost. These services are often a monopoly of the officially recognised or regulated
banking or payment system, and hence regulators need to accept some responsibility for
delivery of such services.
Finally, from a common person's point of view, public policy should ensure the easy
availability of simple-to-understand instruments in credit, capital and insurance markets.
Consumer protection is important in the financial sector, but ensuring the supply of
simple-to-understand products should be an obligation of regulators; it is an essential step to
gain the trust of the common person.
In some advanced economies, regulators are already paying attention to excessive charges
on retail financial services, in particular credit cards. Experience in some developing
countries indicates that the involvement of public policy in expanding coverage of finance
among the general public has had a beneficial impact. It is true that public policy experience
with subsidised credit in some developing economies, and with housing credit in some
advanced economies, has not been good. But inclusive finance emphasises affordable
access to simple products, and not excessive leverage or at the cost of prudence. Inclusive
finance is not a substitute for the primacy of fiscal policy with regard to social welfare.
My submission is that we are in a world of expanded mandates for central banks, and
inclusive finance should not be excluded from such mandates. Perhaps central banks could
satisfy themselves and the society at large that, between the markets and regulations,
finance is serving the minimum needs of most common people while maintaining efficiency
and stability. That would be the cornerstone for restoring trust and confidence in the financial
sector. Central banks could explore avenues for using technology and financial innovations
that meet the needs of common people.
Economic policies and the financial sector
Experience with the crisis has brought into focus three inter-connected complexities that
have to be continuously addressed by the financial sector. These are: the balance between
state and market as appropriate to the financial sector; the balance between real and
financial sectors, where the latter should enable the real sector to perform; and finally,
balancing the conduct of macroeconomic policy at the national level with the dynamics of the
global macroeconomic environment. Public policy is conducted at the national level, but at
the same time, globalisation of economies, often driven by technology, is a reality, and the
global macroeconomic environment is an outcome of national policies in a framework of
nebulous global governance arrangements. The challenge for national central banks is to
find space for the conduct of their own policies in an increasingly inter-dependent global
economy.
Macroeconomic policies and the financial sector
It is tempting to debate the pros and cons of developments in the financial sector without full
recognition of the macroeconomic environment and of the functioning of product and factor
markets. The right balance between free markets and appropriate financial sector regulation
is ideally explored in the light of the significant role of macroeconomic policies in maximising
benefits and minimising costs of the financial sector to development and welfare. During the
"Great Moderation", low and stable inflation was attributed to the success of monetary policy,
ignoring the impact of the globalisation of trade and, to some extent, immigration in some
economies. There was admittedly a spillover effect of monetary policies on stability in the
financial sector. There is a realisation that, ideally, countercyclical monetary and fiscal
policies should supplement countercyclical policies in the regulation of the financial sector in
a variety of ways to ensure financial stability. For instance, consideration is being given to
taxation of the financial sector, on institutions and on transactions, as a supplement to
regulation of the financial sector in the interest of stability, and possibly growth and equity.
Further, policies relating to management of public debt have a bearing on the functioning of
the financial sector. For example, financial sector entities, particularly banks, either as part of
portfolio management or through statutory pre-emption, hold significant government debt as
assets. There is a recognition that large swings in capital flows could have an adverse impact
on the financial sector. There is also awareness of the potential use of prudential regulation
to manage capital accounts. Persistent and unsustainable current account deficits or
surpluses may have the potential for destabilising the financial sector.
The macro policy framework at the national level, which is admittedly critical for good
finance, is determined by the sovereign with legitimacy and accountability to its citizens. But
macro policies at the national level have to take account of the deep and growing linkages
between national economies and the global economy. An important issue, therefore, is the
scope and limits for international coordination of national economic policies.
It is instructive therefore to briefly analyse the evolution and efficacy of the most recent
efforts at global coordination of the macroeconomic environment through the mechanisms of
Summits of the G20. The initial stage of coordination through the G20 Summits was to avoid
collapse in the financial system and to moderate the slide in the global economy through
macroeconomic responses, in both monetary and fiscal areas. There were simultaneous
actions. The uneven recovery that followed led to differences in short-run policy actions
among countries, but this was recognised as inevitable under the circumstances. However,
there was an effort to identify long-term structural issues and attempt to address them. There
was some agreement in very broad terms, but differences persist on the sources of global
imbalances and the appropriate correctives at the national level.
More recently, country specific commitments to correct some imbalances have been
attempted, but differences on the measurement of needed correctives and the timeliness of
actions are stark. A possible reason for these differences is that short-term motivations at the
national level seem to run counter to the longer-term interests of the global economy. There
are unmistakable signs of diminishing returns from the G20, despite initial achievements and
the promise of greater coherence in future.
One positive development has been that the democratic deficit at the level of global financial
architecture has been somewhat narrowed. But there is, as yet, no coherent global
macroeconomic policy. The global macroeconomic environment is the result of the
interaction between macro policies at the national level and national markets that are at
different stages of development and that have differing degrees of integration into global
markets.
It is true that successful arrangements for global coordination while retaining space for
national public policies are working well in certain sectors, such as aviation, telecoms and the
internet. But they seem to get into difficulties in regard to macroeconomic policies and
finance. Clearly, there is a need to explore why global agreements work reasonably well in
some sectors, leading to acceptable and assured outcomes, while when it comes to macro
policies and finance such agreements appear difficult to arrive at - and what we can learn
from them.
Global finance and global governance
The basic assumption underlying the benefits of globalised finance is the existence of
competitive efficiency in global financial markets. The assumption can be, and has been,
questioned on several well-known grounds, namely: the lack of a sound international reserve
currency system; the absence of credible lender of last resort facilities at the global level; and
the dominance of a handful of rating agencies and accounting firms without adequate
evidence of market discipline or effective rules for their functioning. The leading rating
agencies and accounting firms, along with few leading business news agencies, have
continuous dealings with each other, which tends to reinforce the exercise of their
oligopolistic power over markets. Further, operations of international banks/conglomerates
specialising in cross-border flows, combining traditional banking and risky investment
banking operations, have close business and operational links with rating agencies,
accounting firms, etc. The concentration of global financial power in a few entities with close
mutual connections has considerable potential to undermine competitive forces.
In assessing the competitive efficiency of global financial markets, it may be useful to make a
distinction between the role of multinational banks which have subsidiaries or branches in
different countries but predominantly operate in domestic markets, and that of international
banks which specialise in cross-border financial activities, especially flows on capital
accounts, both short-term and long-term. Experience has shown that multinational structures
that relied less on wholesale funding and forex swap markets have been less vulnerable to
crises. International banks are able to operate across different financial markets and
countries with significant divergence in fiscal regimes as well as regulatory regimes. They
have often been found to deal in financial flows of suspect legality in one country, though not
always in both countries involved. International banks have the opportunity and incentive to
conduct operations involving tax avoidance. Because of these operations, international
banks enjoy significant influence over the political economy in several countries. In the
prevailing environment of global financial markets, some large global financial conglomerates
are larger and, perhaps, more powerful than some of the central banks.
It is clear from the experience of the euro area that, in effect, the sovereign becomes the
source of extraordinary intervention as the ultimate risk bearer in times of crisis. The problem
arises when the sovereign's capacity for such intervention is constrained by globalisation:
this may be beneficial in many respects, but it could undermine the capacity of the sovereign
to tackle the financial sector problems that arise. The conduct of fiscal policy itself is
dominated by consideration of the view of global financial markets on the sovereign's
solvency and its capacity to support the financial sector under distress. Extraordinary
intervention by the sovereign and related fiscal measures are thus subject to the credit rating
agencies' appraisal of their solvency (Sen, 2012). These considerations may have a bearing
on the conduct of both financial sector regulation and macro policies at the national level.
In brief, my submission is that the prospects for credible and acceptable global governance
arrangements to ensure a workable global economic policy and environment within which
global finance could contribute to growth and stability, do not appear very bright. I am not
addressing a more fundamental issue: whether global economic governance, ensuring
common economic policies for all nations, would eliminate the benefits of diversity. Too much
global policy coordination might lead to the universalisation of risks of policy mistakes. The
main contention is that good finance is essentially a function of good economic policies, and
such good policies are primarily national, though significantly impacted by the global
macroeconomic environment - which, as already mentioned, is not a product of design.
Approaches to regulation of the financial sector will, therefore, continue to be national, in a
global environment that is not necessarily favourable.
Regulation of the financial sector
There is a recognition that policies relating to regulation of the financial sector must optimise
the benefits of the financial sector while minimising the costs or risks associated with it.
There are several dimensions to striking this balance, which this august audience is well
aware of and involved with. I selected three themes for consideration today: the optimal level
of financialisation, appropriate innovation in the financial sector, and the effectiveness of
financial sector regulation.
Optimal Financialisation
Not long ago, many countries recognised the costs of excessive regulation of finance and of
financial repression. More recent events seem to indicate that excess financialisation of an
economy may also contribute to the crises. It may be that finance is good for economic
development over a certain period, but only if practised in moderation. The idea of optimal
financialisation seems to have been accepted implicitly by the financial sector reform
measures being contemplated in many advanced economies. At the same time, several
developing and emerging economies are considering measures to develop the financial
sector, in particular financial markets. In their quest for optimal financialisation, the countries
that are attempting further deregulation and development of financial markets would benefit
from an understanding of how excess financialisation manifests itself. However, the
manifestation of excessive financialisation may not be confined to finance, and may extend
to commodity markets, corporates and households.
The financialisation of commodity markets happens both by virtue of deregulation of trade in
commodity market exchanges and by virtue of the excessive liquidity that happens to be
readily available. The correctives in public policy with regard to excessive financialisation of
commodity markets may be at times beyond the scope of financial sector regulation.
During recent years, there has been a significant financialisation of household budgets,
particularly in advanced economies. The changes in demand for certain goods are often
dependent on credit conditions. Future cash flows are often determined by the market value
of pension funds and other sources of social security over a lifetime. It is not clear whether
limiting the leverage of financial intermediaries would by itself constrain the excess leverage
in household budgets.
There has also been financialisation of corporates. Corporates are not only exposed to the
financial markets in relation to their underlying operations in terms of what they produce or
sell, but also in terms of treasury operations.
This excessive financialisation occurred in many advanced economies for other reasons.
Incentives were created to multiply the transactions in the financial sector in the form of
income from commissions related to transactions. Further, complexity was introduced with
regard to some of these innovations, often to undermine the regulatory prescriptions
regarding transparency or capital adequacy, or to mislead the counterparty. Shadow banking
enabled undermining of regulatory prescriptions. Most recent initiatives with regard to
reforms in regulation address these issues.
For many developing and emerging economies, who are progressing on the path towards
optimal financialisation, it is necessary to avoid excessive financialisation, and more
importantly to explore the impact of finance on growth, ideally on the basis of empirical
evidence. Research has associated higher growth with the development of the financial
sector, but more recent evidence on trade-offs between growth in the real sector and the
financial sector is equivocal. The experience of Asian emerging economies so far indicates
that the beneficial effects of deregulated finance relative to free trade may be overstated.
Further, institutional rigidities and the state of factor and product markets vary between
countries, and they do interact with level of financialisation.
This subject is explored in a recent paper titled "Reassessing the impact of finance on
growth" (Cecchetti & Kharroubi, 2012). The paper investigates how financial development
affects growth at both the country and the industry level. The paper shows, based on a
sample of developed and emerging economies, that the level of financial development is
good only up to a point, after which it becomes a drag on growth. It also shows that a fast
growing financial sector can be detrimental to aggregate productivity growth. This is a line of
enquiry which should be further explored to arrive