Srikrishna emasculates RBI, shifts power to finmin

The Reserve Bank of India’s (RBI) wings are being clipped in the new financial sector regulatory architecture being proposed by the Justice BN Srikrishna Financial Sector Legislative Reforms Commission (FSLRC).

On the face of it, it seems as if only the other regulators (Sebi, Irda, PFRDA and FMC) are being merged into a new super-regulator, the Unified Financial Agency (UFA) - to regulate the stock markets, insurance, pension funds and commodity markets respectively.

The RBI remains the regulator for the banking sector. But look closer, and the central bank’s centrality in financial regulation is gone: it will run monetary policy, regulate the banking sector and enforce consumer protection. Nothing more.

What has gone out of its jurisdiction are the following:

#1: Non-bank financial companies and housing finance companies are now outside the ambit of RBI regulation.

#2: The RBI will no longer be the government’s debt manager. A new public debt management agency will take over this job of raising loans for the government.

#3: Capital controls on inward flows-not only foreign direct investment, but other flows as well-are now under the government’s direct reach, not the RBI’s. The RBI will merely frame regulations for outward flows “in consultation with the government”. This means the RBI will have little control over the shape of inward flows-hot money, cold money, funny money-that could destabilise the economy.

#4: Most important, the Commission seeks to establish a statutory Financial Stability and Development Council (FSDC) which will be headed not by the RBI, but the finance minister himself. While this is already the case, the Commission’s stamp on approval for this whittling down of the RBI’s role in ensuring systemic stability means that the latter’s independence will be further compromised.

Not surprisingly, the Commission’s final report, submitted earlier this week to the government, has as many as four notes of dissent, most of it relating to capital controls, the RBI’s role, and the new regulatory architecture.

The dissenters are JR Varma, a professor at IIM, Ahmedabad, KJ Udeshi, former deputy RBI governor, PJ Nayak, former chairman of Axis Bank, and YH Malegam, a chartered accountant.

Varma warns against “regulatory overreach” since the commission has suggested authorisation requirements for anyone providing a “financial service”, and these could include a whole gamut of services, including those of accountants, lawyers, actuaries, and other professionals - which is wholly unnecessary. He says financial services requiring regulatory authorisation should constitute a narrow list of activities.

Udeshi’s dissent relates to the fact that inward capital control regulations will be outside RBI’s purview. She says that the RBI should have the power to frame all rules relating to both inward and outward capital flows, barring only FDI policy, which is rightly the role of government.

She says: “In India, the forex reserves accretion is invariably on account of a capital account surplus and not due to a current account surplus and hence the composition of the inward flows assumes importance….There is widespread concern among several central banks in emerging market economies about the added pressures on monetary management due to the prevailing extraordinarily strong and volatile cross-border capital flows. If the RBI has no say in initiating policy relating to these volatile flows, the RBI would be constrained to take monetary policy measures, both direct and indirect and administrative actions, to deal with the consequences of such flows; such measures may not be what the government or industry and the business community seek, leading to overall dissatisfaction.”

According to Udeshi, “if the RBI is to be accountable for the performance on its balance-sheet, it has to be enabled to decide on the timing, quantity and quality of inward capital flows so that it can calibrate its forex interventions and sterilisation measures.”

PJ Nayak is worried that the Commission’s report reverses a trend towards greater regulator autonomy by shifting powers back to the government, especially the FSDC.

Pointing out that “the last 25 years of the evolution of financial sector regulation in India has seen a continual empowerment of regulatory agencies”, he regrets that “the Commission now arrests and partly reverses this directional movement, and it is with apprehension that one must view the very substantial statutory powers recommended to be moved from the regulators (primarily RBI) to the Finance Ministry and to a statutory FSDC, the latter being chaired by the Finance Minister”.

He adds: “This transfer of powers collectively constitutes a profound shift in the exercise of regulatory powers away from (primarily) RBI to the finance ministry. The finance ministry thereby becomes a new dominant regulator. To rearrange the regulatory architecture in this manner, requiring new institution-building while emasculating the existing tradition of regulators working independently of the government, appears unwise. There is no convincing evidence which confirms that regulatory agencies have underperformed on account of their very distance from the government; indeed, many would argue that this distance is desirable and has helped to bring skills (and a fluctuating level of independence) into financial regulation.”

As for Malegam, he has problems with the fact that suddenly non-bank financial companies (NBFCs) and housing finance companies (HFCs) will not come under the RBI.

He says: “I believe that it is essential that NBFCs and HFCs should be regulated by the same regulator as regulates the banks, i.e. RBI.” His reasons are simple: they are often borrowing from banks, and they are of a size that can threaten the banking system if not supervised adequately.

The recent global financial crisis emerged in part because non-banks were doing shadow banking activities, but went under the radar of the banking regulators.

Says Malegam: “NBFCs and HFCs are engaged in activities which can be termed shadow banking. They are of a size, individually and collectively, which can pose a serious challenge to the efficient regulation of banks. All the considerations mentioned in the (Commission’s) report to support the need for a single unified regulation support a single unified regulation of banks, NBFCs and HFCs. Consequently, it is imperative that NBFCs and HFCs be regulated and supervised by RBI.”

Malagam points out that the “total assets of NBFCs aggregate to Rs 1,038,000 crore, which represents roughly 12.7 percent of the total assets of all scheduled commercial banks”.

It’s not surprising that the finance ministry wants to control this kind of money.

Whatever the other merits of the Srikrishna FSLRC, its recommendation to cut the RBI’s powers down to size may be questionable. This is not to suggest that the RBI has been doing a wonderful job of regulation and monetary management. But it could also mean that the bosses in the finance ministry have influenced the Commission a bit too much.