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Jaimini Bhagwati: Regulatory autonomy, not autarchy

Unaccountable regulators are failing everywhere. India should re-examine its priorities in financial sector regulation

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The stock of Hyman Minsky’s 1986 work, Stabilising an Unstable Economy, has been rising steadily after recurring financial sector breakdowns, particularly the meltdown of 2008. Most analysts now agree with Minsky’s contention that leveraged markets do not correct automatically, and that financial markets are not necessarily efficient.

Given the strongly correlated solvency vulnerabilities of European sovereigns and banks and the recent inconclusive Greek elections, market appetite for credit risk is likely to erode further. Consequently, the probability that in the next 12 months financial markets may face another “Minsky moment” has increased. The disorderly disruption of euro-zone credit markets could result in a preference for cash in money markets. The consequent panic would spread internationally, causing net capital outflows from developing countries, including India.

However, this article is not about such outflows potentially exacerbating our widening current account deficit woes or the consequences of a depreciating rupee. This article is about the need for a fundamental rethink about financial sector regulation, and the pitfalls of genuflection towards this sector.

Some events over the last one month reconfirmed, if any confirmation was needed at all, that financial sector management continues to seek extravagant compensation and take irresponsibly high risks. In mid-April 2012, shareholders voted against the CEO receiving a $15 million increase in his pay. Similarly, in the first week of May 2012, shareholders voted against the bonus package of the CEO of the UK insurance company and the executive pay proposals of the Swiss bank UBS. On May 10, 2012, it became public that the largest US bank, JP Morgan, lost $2 billion and was counting on its short positions on credit derivatives. The Securities and Exchange Commission, the US’ capital markets regulator, initiated an investigation into whether met the prescribed requirements of public disclosure.

Clearly, financial firms have the ability to devise trading strategies that can meet the most stringent of regulatory guidelines and yet take outright bets with shareholder equity or depositor/investor funds. The only way to reduce the probability that banks gamble away their equity capital is by stipulating that their leverage be drastically reduced. That is, the ratio of equity to risk-weighted assets should be cut from current levels of around 1:16 to, say, 1:6. Incidentally, at the height of the speculative bubble in 2006-07, this ratio had ballooned to around 1:50 for many major banks and insurance companies.

Given the widespread clout of financial firms, regulators and governments are tiptoeing around the issue of excessive leverage instead of confronting it. In the event of another Minsky moment, we can expect to see accusatory fingers pointed at each other. Another difficulty in addressing concerns about financial sector solvency is that regulation is essentially national while transactions can be international.

Turning to Europe, recovery could take up to two decades. This may sound pessimistic; but recall the experience of Japan since 1991. Consequently, India may face higher degrees of protection and inward-looking policies from the European Union. The implications of this are that India should not expect much of a boost from the US or Europe in the 12th Plan period (2012-2017) as it did in the 2002-07 period. Policy reforms are, therefore, that much more urgently necessary in India.

With these dark storm clouds gathering once again on India’s economic horizon – due to the euro zone’s difficulties and banks continuing to behave irresponsibly – we need to review the role of financial sector regulators. The objective of such a review should be to assess to what extent regulators and government should be held accountable for adhering to inflation targets, maintaining market stability, and promoting growth.

India has borrowed the template for its regulatory systems from developed countries and has set up separate regulators for banking, insurance, pensions and capital markets. Have we also adopted the mantra of regulatory autonomy somewhat uncritically? In certain quarters in India, the importance of the role played by the Reserve Bank of India is overstated by equating it with that of the Election Commission — and, by implication, free and fair elections. As we have witnessed repeatedly in the West and in India, regulatory autonomy has not prevented frequent financial market failures, since market and credit risk were allowed to build up to systemic proportions.

Of course, the norms of arm’s-length relationships between financial sector regulators and governments have been adopted fairly universally because elected officials are seen to be driven by short-term electoral considerations. On the other hand, the record of patchy, motivated or clueless oversight by regulators has been extremely expensive for the global economy in terms of foregone growth. On balance, is the rationale for regulatory autonomy, which implicitly seems to be to protect citizens from their own elected governments, sensible or realistic? It follows that it is time to ask whether central banks and other regulators should function autonomously to the point that they are autarchic. In other words, if central banks are empowered to tweak the price of money, by setting interest rates and managing exchange rates, impacting the valuations of all assets, why should they not be held partially accountable for financial stability and growth?

It stands to reason that, to be effective, the blunt monetary policy instruments available to central banks need to be accompanied and complemented by fiscal and other government-led measures. However, in most countries, the accountability for maintaining financial stability and promoting growth dangles ambiguously between governments and regulators. In the event of glaring failures, this lack of clarity gives both the cover of plausible deniability. It is not in the interest of the Indian electorate to allow such ambiguity to persist.

It is likely, though, that many in India would perceive any review of regulatory autonomy as the thin edge of the wedge. That is, there is a huge risk that the government may again take overweening primacy over all financial sector decision-making. And that the decision-making by qualified regulators cannot be understood by generalist elected officials, and hence should not be subject to government oversight.

To sum up, we should nevertheless reflect if our legislation needs to be amended to give a greater say to elected executives over technical decisions, which affect sustainable growth — including on inflation and monetary policy. If that is the case, we should set up management structures accordingly.


The author is India’s High Commissioner to the UK. 
These views are his own. 
j.bhagwati@gmail.com  

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