India Studies in Business and Economics Dilip M Nachane Critique of the New Consensus Macroeconomics and Implications for India Foreword by Kaushik Basu India Studies in Business and Economics The Indian economy is considered to be one of the fastest growing economies of the world with India amongst the most important G-20 economies Ever since the Indian economy made its presence felt on the global platform, the research community is now even more interested in studying and analyzing what India has to offer This series aims to bring forth the latest studies and research about India from the areas of economics, business, and management science The titles featured in this series will present rigorous empirical research, often accompanied by policy recommendations, evoke and evaluate various aspects of the economy and the business and management landscape in India, with a special focus on India’s relationship with the world in terms of business and trade More information about this series at http://www.springer.com/series/11234 Dilip M Nachane Critique of the New Consensus Macroeconomics and Implications for India 123 Dilip M Nachane Indira Gandhi Institute of Development Research Mumbai, India ISSN 2198-0012 ISSN 2198-0020 (electronic) India Studies in Business and Economics ISBN 978-81-322-3918-5 ISBN 978-81-322-3920-8 (eBook) https://doi.org/10.1007/978-81-322-3920-8 Library of Congress Control Number: 2018950826 © Springer (India) Pvt Ltd., part of Springer Nature 2018 This work is subject to copyright All rights are reserved by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed The use of general descriptive names, registered names, trademarks, service marks, etc in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use The publisher, the authors, and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication Neither the publisher nor the authors or the editors give a warranty, express or implied, with respect to the material contained herein or for any errors or omissions that may have been made The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations This Springer imprint is published by the registered company Springer Nature India Private Limited The registered company address is: 7th Floor, Vijaya Building, 17 Barakhamba Road, New Delhi 110 001, India To the millions who lost their bread (in the global crisis) because of a handful who wanted more cake Foreword: Dilip M Nachane’s Macroeconomics Dilip M Nachane’s new book on macroeconomic theory and policy is the kind of book that I would have loved to have had on hand, when I was Chief Economic Adviser to the Government of India It is a remarkably comprehensive book that starts with a review of the main schools of macroeconomic thought, from Keynes’s General Theory to contemporary models of analysis, many of them inspired by actual policy challenges and crises, such as the global financial crisis of 2008 The book closes with two chapters devoted exclusively to India, with a special focus on the fiscal and monetary policy concerns that India faced over the last decade As such, the book should be valuable to students of economics and to policymakers in India, with an interest in macroeconomic policy, wanting a refresher course Macroeconomics as a discipline emerged with the groundbreaking work of John Maynard Keynes and his audacious effort to bring under one framework of analysis the world of money and finance, the world of goods and services, and the world of labor and jobs The emergence of Keynesian macroeconomics coincided with the last stages of the Great Depression, and subsequently became the go-to handbook for countering recessions and crises But the world economy is a complex organism that has continued to spring surprises in terms of new kinds of recessions that would not respond to standard policy packages That led to the modifications of old ideas and impetus to look for new macroeconomic paradigms There were powerful criticisms of the Keynesian model by the Chicago school and, in particular, by Milton Friedman that led to the doctrine of monetarism as an alternative model This book takes the reader through these various schools of thought, all the way to the New Consensus Macroeconomics, which is presented and dissected at some length, showing its strengths but also casting doubt on some of its features, including whether “consensus” is quite the right word for describing any kind of macroeconomics But this is not a book on theory for the sake of theory Having presented some of the main theoretical schools, the book ventures to discuss real-world problems We learn at length how the subprime mortgage crisis emerged in the USA, became a generalized financial crisis, and then infected other markets and economies vii viii Foreword: Dilip M Nachane’s Macroeconomics By 2009, the crisis had spread to emerging economies, including India Foreign investors nervous about the global economy, began withdrawing their money from “distant” economies By September 2008, the Bombay Stock Exchange Sensex Index was plummeting From a level of 19325.7 in January 2008, it fell to 8995.5 by March 2009 Merchandise exports to advanced economies were beginning to stall, and by the end of 2009, GDP growth in India had sharply declined Having been in the policy world at that time, I am acutely aware how the crisis was part and parcel of our lives What made the job harder was that there was no good paradigm to fall back on We had to use old-fashioned theory with a handsome dose of common sense and gut feeling, to design policy and respond to the crisis There will of course never be an exact textbook paradigm for most real-world problems; intuition and common sense will always play a role Nevertheless, Professor Nachane’s new book tries to make some amends for the current lacuna, by blending our theoretical knowledge of macroeconomics with the actual experience in advanced and emerging economies Therein lies the strength of the book, and the reason why students of economics and practitioners of economic policy can benefit from it Ithaca, USA July 2018 Kaushik Basu Carl Marks Professor Cornell University Preface The New Consensus Macroeconomics (NCM) which established itself in the 1980s as the mainstream in macroeconomics essentially represents an “uneasy truce” between the then dominant new classical and real business cycle schools (associated with Lucas, Sargent, Wallace, Kydland, Prescott, etc.) on the one hand and on the other the nascent neo-Keynesian view (of Akerlof, Mankiw, Gordon, Phelps, Taylor, etc ) It combines features like Keynesian sticky prices and wages with the new classical assumptions of rational expectations and efficient markets It also incorporates features from classical monetarism such as the natural rate hypothesis and a vertical Phillips curve Its econometric medium continued to be the dynamic stochastic general equilibrium (DSGE) models of the real business cycle school NCM sets the tone for much of the macroeconomic (especially monetary) policy followed by the advanced economies in the period of the Great Moderation (1990– 2005) Among the major policy recommendations of NCM, special mention may be made of (i) inflation targeting, (ii) Taylor rule, (iii) non-intervention in asset markets (Jackson Hole consensus), (iv) light-touch regulation and (v) a strong belief in the ability of financial markets to regulate themselves (market discipline) So far as the emerging market economies (EMEs) are concerned, NCM (and especially its twin pillars—the rational expectations hypothesis (REH) and the efficient-market hypothesis (EMH)) supplied the intellectual basis for the successive waves of financial liberalization undertaken by governments in these countries beginning in the decade of the 1980s The recent global crisis has posed a very serious challenge to the NCM Firstly, empirical models based on NCM failed to anticipate the occurrence of the crisis and later its extent and severity Secondly, the solutions proposed within the NCM framework have met with limited success in the USA and actually compounded problems in the EU This has led to serious questioning of the NCM from four major alternative schools, viz the post-Keynesian, the Austrian, the Minskyan and the Marxist ix x Preface The above considerations constitute the underpinnings of the proposed book The book addresses six major questions, viz (i) To what extent were the macropolicies based on the NCM responsible for the developments leading up to the recent global crisis? (ii) Has the NCM theoretical framework outlived its utility and is in need of replacement by a suitable alternative? (iii) Do some of the other alternative theoretical frameworks provide more convincing explanations of the modern-day business cycles? (iv) Is the current focus of regulation centred on capital requirements and market discipline (Basel II to be succeeded by Basel III) appropriate? (v) For the less-developed and emerging market economies, is financial liberalization (financial deregulation plus financial innovation) an unmixed blessing or is there a benchmark beyond which such liberalization can prove detrimental? (vi) What are the political economy considerations underlying the current ongoing process of financialization in EMEs and is it in the long-term interest of these nations? The first four chapters of the book outline the evolution of macroeconomics from the publication of the General Theory of Keynes in 1936 to the establishment of a broad consensus (the New Consensus Macroeconomics (NCM)) around the mid-1980s Chapters and deal, respectively, with the origins of the global crisis in the USA and its transmission to the other major regions of the world Chapters to 10 analyse the four major alternative perspectives on the global crisis offered by the Austrians, the Minskyans, the post-Keynesians and the Marxists Chapter 11 attempts to provide a consolidated overview of the main theoretical post-crisis critique of the NCM, while Chapter 12 is devoted to a discussion of the critique of the policy mix followed in the period leading up to the global crisis Chapter 13 analyses in a Lakatosian framework, the process by which the mainstream NCM has countered this critique and largely stood its ground, making certain ad hoc changes while keeping the main edifice intact While the mainstream framework remains intact, the harsh lessons of the crisis have not been lost on the policymakers The comity of nations have been unanimous in advocating a coordinated approach to deal with global instability issues—the main partners in such a coordinated approach being national regulators and international bodies such as IMF, WTO, BIS Chapter 14 deals with the modalities of the amendments needed to the national and global financial architecture to facilitate the dialogue necessary to achieve a coordinated response to crises that have the potential of destabilizing the world trade and investment order The last two chapters deal with the Indian case in detail Chapter 15 outlines the main contours of the financial sector as it has evolved in India over the past three decades, and the special challenges posed for the financial regulators in a system that is being aggressively pushed towards deregulation and liberalization by a market-oriented domestic corporate structure together with the imperative of participation in the global financial community Our analysis Chapter 16 By Way of Conclusion: Selected Issues in Designing a New Architecture for the Indian Financial Sector Abstract As the threat of the global crisis receded in India, issues of financial architecture have become dominant, with the inception of the FSDC and the announcement of the FSLRC We make out a case for a highly calibrated approach to the far-sweeping agenda marked out by the HPEC and CFSR (and largely but also more cautiously) endorsed by the FSLRC, especially as regards three issues: (i) the shift towards a principles-based system of R&S, (ii) instituting an integrated financial supervisory system and (iii) divesting the RBI of its banking supervision and public debt management responsibilities The future success of financial reforms in India will be crucially contingent upon how successfully the regulatory architecture adapts to the competing dictates of financial development and financial stability, and the extent to which the regulatory and supervisory system succeeds in maintaining its independence from the government as well as market participants Introduction1 Till the early 1990s, the Indian financial system was characterized, inter alia, by administered interest rates guided by social concerns, high intermediation costs, a low base of capital, directed credit programmes for the priority sectors, high degree of non-performing assets, low intensity of technologies, stringent entry barriers for new entrants, and strict regulations Since the early 1990s, financial sector reforms have been initiated with the explicit objective of developing a market-oriented, The author expresses his gratitude to Wiley Publishing co and Springer Publishers for their kind permission to use excerpts from the following two publications in this chapter: (i) the author’s paper “India’s Financial Sector: The Regulatory and Supervisory Landscape” published in the Wiley journal The World Economy, vol 35, No 1, p 32–43, Jan 2012 and (ii) the author’s article “Monetary Policy, Financial Stability and Macro-prudential Regulation: An Indian Perspective”, published by Springer in 2014 © Springer (India) Pvt Ltd., part of Springer Nature 2018 D M Nachane, Critique of the New Consensus Macroeconomics and Implications for India, India Studies in Business and Economics, https://doi.org/10.1007/978-81-322-3920-8_16 393 394 16 By Way of Conclusion: Selected Issues in Designing … competitive, well-diversified and transparent financial system Financial liberalization2 was viewed as an integral component of overall liberalization, in the twin beliefs that (i) liberalization in the real sector could not proceed satisfactorily in the absence of financial liberalization and (ii) financial liberalization was an “enabling condition” for faster economic growth, as it increases competition, transfer of know-how and transparency (Nachane and Islam 2011) As the Indian financial sector started evolving rapidly under the market-oriented liberalization initiated in the 1990s, the regulatory and supervisory framework (RSF for short) which had evolved under four decades of democratic socialist planning, began to increasingly come under stress With a view to identify and address deficiencies in this framework and suggest remedies, the Government of India appointed two committees in quick succession in the last decade, viz (i) The High-Powered Expert Committee on Making Mumbai an International Financial Centre (2007) (Chairman: Percy Mistry) which we refer to in short as HPEC and (ii) The Committee on Financial Sector Reforms (2009) (Chairman: Raghuram Rajan) or CFSR for short HPEC and CFSR Reports: A Critical Appraisal3 2.1 General Features While the two committees differed considerably in their scope, coverage and emphasis, their broad thrust was very similar The main deficiencies in the Indian financial system identified in the two reports may be briefly summarized as follows: (i) Low tolerance for innovation and excessive micro-management by regulators (ii) Regulatory gaps and overlaps.4 (iii) Multiplicity of regulators (iv) Inter-regulatory coordination (v) Paucity of effective risk management practices and (vi) Inadequate investor protection The process of financial liberalization is usually viewed as encompassing four dimensions: (i) financial deregulation, (ii) financial innovation, (iii) market making and (iv) financial supervision This section draws from the author’s previous publications—(a) author’s contribution “Monetary Policy, Financial Stability and Macro-prudential Regulation: An Indian Perspective” in Ratan Khasnabis, Indrani Chakraborty (eds.) Market, Regulations and Finance: Global Meltdown and the Indian Economy, published by Springer in 2014; and (b) author’s paper “India’s Financial Sector: The Regulatory and Supervisory Landscape”, published in 2012 in Vol 35, Issue of the journal The World Economy, by Blackwell Publishing Ltd (John Wiley & Sons, Inc.) Used here with permissions Several examples of regulatory gaps and overlaps are furnished in CFSR (Chap 6) 2 HPEC and CFSR Reports: A Critical Appraisal 395 To address these deficiencies, several fundamental amendments to the Indian RSF were suggested in the two reports Shift from a Rule-Based System to a Principles-Based System: Firstly, both the above committees make a strong pitch for a move from the current rule-based system to one based primarily on principles, wherein financial entities would be evaluated on the quality of their output, and their fulfilment of certain well-articulated principles, rather than on a strict adherence to the letter of the regulation [the contours of this controversy are laid out in many standard references such as Kaplow (1992), FSA (2009), Braun et al (2015), Dill (2017)] Consolidation of Regulation and Supervision of Financial Trading Activities under SEBI: The CFSR argued strongly in favour of unification of all regulatory and supervisory functions bearing on financing trading activities (including equities, corporate bonds, government securities, currencies, commodities) into a single agency, identifying SEBI as the most appropriate agency for the purpose Separation of Monetary Policy Responsibility from Banking Regulation and Supervision: The CFSR opined that, even though the prevailing system of the RBI being jointly responsible for monetary policy and banking supervision, seemed to be working fairly well, the system comprised inherent conflicts of interest It therefore recommended a separation of these two functions in the medium term Introduction of Mechanisms for Accountability of Regulators: Both the reports felt that accountability of regulators is important, and to this end, all financial regulators and supervisors should be accountable to a standing committee of the Parliament, and additionally an appellate tribunal was recommended to check regulatory overkill Coordination among Regulators: The need for coordination among regulators in India had been a long felt necessity A High-Level Coordination Committee on Capital Markets (HLCC) was accordingly set up in 1992, but it did not have any statutory backing nor a dedicated secretariat The CFSR recommended the setting up of a Financial Sector Oversight Agency (FSOA) entrusted with wide-ranging responsibilities,5 embodying a legal status and having a permanent secretariat While the above five constituted the main recommendations of the two committees, there are a number of supplementary recommendations including incentives for regulators, consolidated regulation of pension funds, streamlining of Tier regulations, etc The two committees laid out an ambitious agenda for financial liberalization in general and regulatory reform in particular So far as the last two recommendations listed above are considered, there seems to be a general consensus about their The list of responsibilities would be both macroprudential and supervisory and include periodic assessment of macroeconomic risks, the monitoring of large systemically important financial conglomerates and arbitration on inter-regulatory conflicts 396 16 By Way of Conclusion: Selected Issues in Designing … appropriateness.6 As a matter of fact, the last issue (of coordination among regulators) was settled on a permanent basis by the establishment of the Financial Stability and Development Council (FSDC) in 2010 (see Chap 15 for details) By contrast, the first three recommendations have attracted considerable controversy Accordingly, in this section we give a critical assessment of these three proposals (for various other points of view, please refer Mohan and Ray (2017), Shah and Patnaik (2011) etc.) 2.2 Principles-Based Versus Rules-Based Regulation Even though it is fashionable in the economics and accounting literature to speak of principles versus rules-based regulatory systems, legal theorists emphasise the futility of pursuing such a binary classification (see, e.g., Cunningham 2007) Several criteria have been advanced to classify given provisions as rules or principles, including most prominently temporal orientation,7 the levels of abstractness, specificity, universality (as opposed to particularity), vagueness and scope of discretion.8 Since most provisions would partake of these characteristics to varying degrees, actual legal systems are collections of hybrid provisions located along a continuum Bearing this in mind, the existing Indian financial legislative system may be classified as rules-heavy, while what the HPEC and CFSR advocated is a transition to a principles-loaded system Even if it is conceded that such a transition will not be immediate and would be accomplished in a phased manner, nevertheless, there are certain reasonable grounds for scepticism about a principles-loaded system for India as a long-term goal: A principles-based system vests considerable discretionary power with the regulator and does require a supra-regulatory mechanism for resolving conflicts of interpretation between regulators and compilers Such a supra-regulator is currently available for capital markets in the Securities Appellate Tribunal (SAT) and indications are that a Financial Services Appellate Tribunal (FSAT) for all the financial regulators might emerge in the near future But even with a supra-regulator in place, much of the litigation involving regulators are likely to be disruptive of efficiency, given the notoriously slow judicial system in India—a fact acknowledged by the CFSR itself (p 130) (see Debroy 2000; Armour and Lele 2008, etc.) Of course, conflicts of interpretation arise also within a rules-based framework, but are much less likely to be severe if rules are well-specified and exhaustive Rules are also appealing because of their relative predictability and certainty This certainty is especially important in modern financial markets dealing with Similar remarks apply to the supplementary recommendations Rules define boundaries ex ante, while principles define them ex-post (Kaplow 1992) Principles generally place more discretion at the hands of the regulator as compared to rules (Nelson 2005) HPEC and CFSR Reports: A Critical Appraisal 397 complex structured products, where risk-assessment tools are of the essence and one key risk dimension is regulatory and enforcement risk (BIS 2009) An important argument in favour of a rules-based system is the judicial ascendancy of interpretive textualism.9 While not solely focused on the literal definition of a statute, judges display reluctance to deal with fuzzy principles, preferring not to deviate too far from the conventional meaning embodied in the statute (see Nelson 2005) As noted by Wallison (2007), there is the safe haven effect of a rules-based system Rules, which are well specified and unambiguous, reduce the scope for discretionary interpretation by regulators Compliance with such transparent rules, gives the regulated entities a sense of absolution, which is never fully present in a principles-based system, where the threat of interpretative issues arising ex-post is ever looming Finally, in many emerging market economies, such as India, there is a concerted move to involve regulated entities in the promulgation of financial legislation In this new atmosphere of collaborative governance, there is a demand from regulated entities that the articulation of provisions be free of vagueness, explicitly stating exceptions, riders and qualifications Such perceptions would favour a rules-based system of regulation and supervision over a principlesbased one Thus, while the distinction between principles and rules-based systems is not as sharp in reality as made out in the HPEC and CFSR, on a balance of considerations, the case for a switchover of the Indian regulatory system to a principles-based one in the foreseeable future is far from clear 2.3 Integration of Financial Trading Regulation and Supervision Both the HPEC and the CFSR make out a strong case for integrated regulation and supervision of the financial sector (in which a single agency is responsible for regulating and supervising banking, securities and insurance business), and additionally recommended that this agency be distinct from the RBI The latter, of course, is tantamount to saying that the RBI be divested of its supervisory responsibility towards the banking sector Hence, the third recommendation above is actually nested within the second Hence, we consider the two recommendations together The case for integrated regulation and supervision, derives from the rapid pace of modern financial innovations, in which hybrid products (such as ULIPs in According to Ghoshray (2006), “Anchored in the text, structure and history of the statute, textualism seeks the most literal meaning, free from the perceptive idealism of broader social purpose” 398 16 By Way of Conclusion: Selected Issues in Designing … India)10 often create inter-regulatory conflicts of turf, in a multiple regulatory system The rise of financial conglomerates also poses special regulatory and supervisory challenges in the traditional multiple regulatory model Increasingly, therefore, a number of developed countries have opted for integrated financial regulation and supervision under a financial services supervisory agency (see, e.g., Grunbichler and Darlap 2003) A priori, there is no reason why such an integrated agency should be located outside the central bank (see Masciandaro 2006) However, pragmatic considerations argue against a central bank also taking over the regulation and supervision responsibility of the entire financial sector.11 The rationale that the HPEC and CFSR put forth for divesting the RBI of its banking regulation and supervision mandate, is the apparent conflict of interest between the monetary policy objective and the objective of maintaining a healthy banking sector (see p 138 of the CFSR Report) This oft-repeated argument in the regulatory literature can be countered by two other equally persuasive arguments Firstly, the lender of the last resort function requires for its judicious execution, access to detailed bank-specific information on the part of the central bank In principle, there is no difficulty in envisaging an arrangement under which the proposed unified financial supervisory agency is required to share sensitive information with the central bank However, such communication can often fail, as tellingly illustrated in the Northern Rock collapse in the UK in September 2007 Secondly, it is often contended that the availability of banking supervisory information on an online basis, enhances the efficiency of monetary policy.12 These arguments apply with much greater force in the Indian context, where (i) banks are major players in the forex, government securities and equity markets and are the key link in the transmission of monetary policy, (ii) their size and inter-connectivity lend them a special significance for financial stability and (iii) the market for government bonds is largely an inter-bank market with a majority of the bonds arising out of the government’s fiscal operations, the oil subsidies and the sterilization operations of the RBI Thus, in the opinion of many analysts (see Acharya 2008; Ram Mohan 2009; Nachane 2012, etc.), if the RBI is to discharge its monetary and financial stability objectives satisfactorily, then it is advisable that it 10 Unit Linked Insurance Plans (ULIPs) are similar to mutual funds with an added insurance component In August 2009, a turf war erupted between the SEBI and IRDA over an order issued by SEBI banning 14 insurance companies from issuing ULIPs, with the IRDA countermanding this order The matter was ultimately decided in favour of the IRDA through government intervention in June 2010 11 Firstly, such an arrangement would overload the central bank with too many diffuse responsibilities Secondly, since responsibility for the different market segments would most likely be vested in distinct departments of the central bank, old inter-regulatory rivalries and differing mindsets are likely to be now internalized interfering with the primary responsibilities of monetary and financial stability 12 Empirical evidence on this is however, mixed While Peek et al (1999) in their empirical analysis of the Federal Reserve case, uncover complementarity between the R&S and monetary stability functions, Cihak and Podpiera (2008) find no such evidence in the diverse sample of countries they consider HPEC and CFSR Reports: A Critical Appraisal 399 be not relieved of the banking supervisory mandate This view should be given due weightage before any drastic changes to the current regulatory architecture are contemplated Interestingly, Bimal Jalan and C Rangarajan (both former Governors of the RBI) have expressed views disfavouring the introduction of a financial sector supra-regulator (see Jalan 2012; Rangarajan 2012) Financial Sector Legislative Reforms Commission (FSLRC) The Government of India signalled its serious intent of overhauling the financial regulatory and supervisory architecture, by following up the HPEC and CFSR committees with the setting up of the Financial Sector Legislative Reforms Commission (FSLRC), under the Chairmanship of Justice B N Srikrishna in March 2011 In its report submitted to the government two years later (March 2013), the FSLRC suggested a broad sweep of reforms spanning several aspects of the financial system The general approach of the FSLRC is best described as a nonsectoral principles-based approach (as opposed to the current sectoral rules-based one) It reiterated and elaborated on several of the recommendations made by its predecessors (HPEC and CFSR), most importantly the gradual migration to a principles-based system and an integrated financial supervisory regime But the FSLRC also introduced and emphasized several other aspects of which the most important are the following: (i) Consumer Protection for safeguarding the interests of consumers in their interactions with financial firms For this, it has proposed a new unified agency to be termed the Financial Redressal Agency (FRA) This recommendation of the FSLRC was accepted in the 2015–16 Budget, and a task force to operationalize the concept was established (under the Chairmanship of Dhirendra Swarup), which submitted its report in June 2016 (see Government of India 2016) However, the establishment of the FRA along the lines suggested by the task force is awaited (ii) Micro-Prudential Regulation The FSLRC identified five areas of micro-prudential regulation which needed strengthening, viz regulation of entry, regulation of risk-taking, regulation of loss absorption, governance rules and regulatory and supervisory independence (iii) Resolution Corporation A new Resolution Corporation was recommended to look after the unwinding proceedings of firms in financial distress This recommendation of the FSLRC was taken up in the Financial Resolution and Deposit Insurance Bill, 2017 which was introduced in Lok Sabha during the Monsoon Session 2017 The Bill is currently being examined by a Joint Committee of the two Houses of Parliament It seeks to establish a Resolution Corporation which will (i) monitor the risk faced by financial firms such as banks, insurance companies and stock exchanges, (ii) pre-empt 400 (iv) (v) (vi) (vii) 16 By Way of Conclusion: Selected Issues in Designing … identified risks to their financial positions and (iii) resolve these financial institutions in case of failure (i.e when they fail to honour their obligations such as repaying depositors) To ensure continuity of a failing firm, it may be resolved by merging it with another firm, transferring its assets and liabilities or reducing its debt If resolution is found to be unviable, the firm may be liquidated, and its assets sold to repay its creditors Systemic Financial Stability The FSLRC proposed to statutorily empower the FSDC to deal with its mandate of systemic financial stability The arrangement that actually emerged is one in which the financial stability mandate is primarily allocated to the RBI, but the other regulatory agencies (such as the SEBI, IRDAI and PFRDA) also share the responsibility, with the overarching responsibility of coordination among the different regulators being the domain of the FSDC (see SEBI 2010, Subbarao 2011; IMF 2017) Monetary Policy The FSLRC seems to have implicitly endorsed an inflation-targeting strategy Its recommendation is for the Ministry of Finance to set up this target, with the RBI entrusted with the task of monitoring and implementing this target, with a Monetary Policy Committee (MPC) aiding the task The composition of the MPC, its role vis-à-vis the RBI (whether advisory or executive), and the terms of its appointment have been left quite vague This recommendation seems to have been accepted in principle, except that the choice of the inflation target has been retained with the RBI (see RBI 2010) Public Debt Management The establishment of a new agency, the Public Debt Management Agency (PDMA), has been proposed by the FSLRC as it was felt that under the present system (where the RBI handles all government debt issues), the RBI faces a potential conflict between its monetary policy objectives and debt management objectives This proposal was dropped from the Finance Bill 2015 by the Finance Minister on 30 April 2015, though it may be revived again later While the potential conflict between monetary policymaking and public debt management cannot be ruled out a priori, there is considerable evidence that the RBI has acquitted itself creditably in the role of banker and debt manager to the government, without letting this impede its primary monetary policy mandate As a matter of fact, the RBI’s continued efforts have resulted in the development of an orderly government securities market, which has streamlined its open market operations for monetary policy Several other arguments for a more nuanced and graduated approach to the establishment of a separate Public Debt Management Agency (PDMA) have been recorded in an incisive article in the Indian Express (see Patnaik 2015) Unified Financial Agency The existing sectoral regulatory architecture was strongly disfavoured by the FSLRC, which proposed a move to a new system In the proposed new system, the RBI would be essentially entrusted with three functions, viz (i) monetary policy, (ii) regulation and supervision of banking in enforcing the proposed consumer protection and micro-prudential measures and (iii) regulation and supervision of payment Financial Sector Legislative Reforms Commission (FSLRC) 401 systems in enforcing these two laws The FSLRC recommended the establishment of a Unified Financial Agency to implement the consumer protection law and micro-prudential law for all financial firms other than banking and payments This agency was envisaged to take over the work of organised financial trading from the RBI in the areas related to the Bond-Currency-Derivatives Nexus, and from FMC for commodity futures, leading to unification of all organised financial trading including equities, government bonds, currencies, commodity futures and corporate bonds The government is actively planning to experiment shortly, with the idea of a unified regulatory agency on a pilot basis for the GIFT city (Gujarat International Finance Tec-City) Regulatory and Supervisory Independence: A Neglected Issue We now turn to a discussion of, what we believe, is an extremely important issue for an EME like India, viz regulatory and supervisory independence This has most surprisingly received only scant attention in the CFSR (and fails even to get a mention in the HPEC), though it has been discussed (somewhat inadequately) in the FSLRC Regulatory and supervisory independence (RSI)13 refers to the independence of the regulatory and supervisory structure from not only the government, but also from the industry and financial markets (regulatory capture) Unfortunately, the academic literature in this area has been almost exclusively focused on central bank independence (CBI),14 to the virtual neglect of RSI.15 The neglect of RSI assumes importance when one considers the fact that almost all episodes of financial distress have been associated with a weak RSI.16 While independence of the regulatory (and/or supervisory) agency is now recognized as the sine qua non of successful regulation in all spheres, the need for such independence is paramount for financial sector regulator(s), since financial stability 13 RSI is often confused with central bank independence (CBI), though as stressed in the literature (see Lastra 1996; Taylor and Fleming 1999; Quintyn and Taylor 2002), the two are conceptually distinct and need not necessarily coexist even when the regulation and supervision functions and the monetary policy functions are vested in the same authority 14 There is a prolific literature on CBI We only mention three recent publications, viz Masciandaro and Volpicella (2016), Masciandaro and Romelli (2015) and Fels (2016) 15 A few important references on Regulatory capture/RSI are Baxter (2011), Etzioni (2009), Potter et al (2014), etc., apart from the classic papers of Stigler (1971) and Becker (1985) 16 See De Krivoy (2000) for the Venezuelan experience of the mid-1990s, Lindgren et al (1999) for the East Asian experience, Hartcher (1998) for Japan etc 402 16 By Way of Conclusion: Selected Issues in Designing … partakes of the nature of a public good (Goodhart 2004) The received literature views RSI as spanning four areas (see Quintyn and Taylor 2002), viz (i) Regulatory Independence: This refers to the autonomy enjoyed by the agency in formulating regulations (which involve both prudential regulations as well as disclosure requirements) within the overall legal framework of the country (ii) Supervisory Independence: The supervisory functions of an agency involve several areas including on-site inspection, off-site monitoring, sanctions and their enforcement, granting and revoking of licences Independence from government and market entities is particularly crucial in the discharge of this function for effective financial stability (see, e.g., BIS 2009) (iii) Institutional Independence: This refers to the status of the agency being independent of the executive and legislative branches of the government and is reflected in the manner and terms of appointment of senior executives, governance structure and transparency of decision-making (iv) Budgetary Independence: This refers to the funding sources of the regulatory agency, viz whether it is self-financing, or supported through the general government budget, as well as the degree of control exercised by the agency over the disbursal of its funds Each of the above aspects of independence can be compromised to varying extents by interference from the government as well as market participants The overall legal framework is particularly relevant in determining the operational independence enjoyed by each regulatory agency A commonly employed distinction in legal theory is that between common law and civil law systems (see Debroy 2000) The former refers to a system where law is interpreted and thus “written” by judges, their judgments in specific cases serving as precedents for future similar cases The civil or codified law system is one where laws are written into statutes and are strictly interpreted by judges of that country While the two systems are of course overlapping, for taxonomic purposes it is the practice to classify systems according to which of the two forms predominates By this criterion, the Indian system is usually classified as a common law system (see, e.g., Galanter and Krishna 2003) In the field of financial legislation in India, the process of judicial adjudication for legal reform has been largely inactive Some significant changes in the laws relating to financial practice have been accomplished through parliamentary amendments or enactments such as the Foreign Exchange Management Act (1999), Competition Act (2002), Securitisation Act (2002) However, the most successful mechanism for enacting new laws in India has been the delegation of quasi-legislative powers to regulators such as the RBI and SEBI Of the four apex regulatory bodies in India, three have been established as statutory bodies via parliamentary enactments, viz the RBI (via the RBI Act 1934), SEBI (via the SEBI Act 1992) and IRDA (via the IRDA Act 1999), while the PFRDA is under the Ministry of Finance Thus, the first three might be said to enjoy a fair degree of regulatory and supervisory autonomy (in terms of the four Regulatory and Supervisory Independence: A Neglected Issue 403 dimensions of autonomy set out above) from the government However, this realization has to be tempered by three facts—(i) firstly, an element of indirect control of the government does exist by virtue of the fact that almost all senior executive positions in these three organizations are appointed by the executive (usually the Cabinet), (ii) government nominees also figure importantly on the boards of these agencies and (iii) if the mandate of the newly established FSDC is broadened to include financial sector development (in addition to the originally proposed mandates of financial stability and inter-regulatory coordination), then the regulatory agencies might face considerable emasculation of their power to exercise a degree of control over the introduction of new financial sector products and processes Budgetary sources are also an important dimension of autonomy The RBI is self-financed and as such does not depend either on the government or the market for budgetary support On the other hand, SEBI and IRDA are mainly financed through fees and charges collected from the market entities under their jurisdiction Thus, all three agencies may be said to enjoy a fair degree of budgetary autonomy from the government But the other major dimension of regulatory and supervisory autonomy, viz autonomy from the influence of financial markets is equally important, but rarely addressed systematically (especially in India where it almost seems shrouded in a conspiracy of silence).17 Independence from markets is more difficult to ensure than independence from the government, since the forces operative here are extremely subtle The influence of markets on regulators and supervisors can be exerted through several channels, all of which have been operative in varying degrees in the Indian context (i) Firstly, there could be an overrepresentation of financial sector and corporate representatives in high-level official committees and bodies, concerned with the designing of regulatory and supervisory frameworks This usually takes place at the instance of a government strongly committed to market-oriented reforms (whether out of a genuine belief in the efficacy of free markets or as an outcome of domestic and international lobbying pressures is not always clear) and is usually done with the ostensible purpose of taking on board the “financial industry” point of view.18 (ii) Secondly in post-liberalization India, most media outlets are under corporate ownership, with editorial/broadcasting functions not sufficiently independent of proprietary control As a result, large sections of the media are strongly aligned with corporate interests and are usually successful in setting up a grading system in which supervisors and regulators are routinely rated publicly on how friendly they are to markets As a result, “the needs of In the words of a very famous US central banker “it is just as important for a central bank to be independent of markets as it is to be independent of politics” (see Blinder 1997) 18 As a matter of fact, if this were the sole purpose, it could be easily accommodated by calling in such representatives as observers or witnesses and recording their testimonies 17 404 16 By Way of Conclusion: Selected Issues in Designing … businesses, as opposed to investors and employees, appear to have been heard most loudly by those responsible for reform” (Armour and Lele 2008, p 31) (iii) Thirdly, the fact that SEBI and IRDA are funded through charges on their regulated constituents undermines their autonomy from markets at least to some extent, though as these charges are jointly determined by the regulators and the government, blatant moral hazards seem to have been avoided (iv) Finally, and perhaps most importantly, financial market institutions, industry bodies and corporate think tanks have in the last decade become involved in regulatory agenda-setting by organizing seminars, roundtables and workshops involving regulators, civil servants, academics and market participants with a view to achieve a market-centric consensus on various issues of governance and regulation This has resulted in both the private sector and regulators internalizing an ideology favouring “light-touch” regulation (see Lall 2009) Inherent in such an arrangement is the danger of ultimately having a regulatory authority overtly sensitive to financial market demands, to the relative neglect of prudential considerations of financial stability and general social welfare Conclusions Wide-ranging reforms in the Indian financial sector were unleashed in the early 1990s, and their momentum has continued unabated right up to the present, though at a somewhat moderated pace post-crisis In line with the evolution of the financial sector, a need was felt for a corresponding reorientation of the regulatory and supervisory system To identify the emerging lacunae and inefficiencies in the latter, the government appointed two high-level official committees (HPEC and CFSR) which came up with several proposals of a far-reaching nature While the two committees differ 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