Financial architecture blues

Business Standard has an edit on legislative trouble brewing in Indian finance.

`Financial architecture' is a subject of hot discussion in India. (There is a small treatment about this in the paper on Indian finance by Raghuram Rajan and myself in Priya Basu's book). As I see it, one big piece on which there is a clear international consensus is that there should be a lean monetary authority, which only sets the short rate. As Anand Chandavarkar and others have emphasised, it is important to remove fiscal and financial functions from the central bank, so as to free up the central bank to just do good monetary economics, without fear or favour.

This takes you to the second question: To FSA or not? To merge all financial regulation into a single agency, or not? There are arguments for this both ways. Centralisation in an FSA reduces turf conflicts. But in an Indian setting, I can see the dangers of centralisation of too much power into one agency. (I had a piece on this in BS back in 1997, at a gloomy time when SEBI was blocking all kinds of progress in securities).

For a long time, I used to find the FSA solution very attractive. But on balance, I think India will be better off with 4 regulators in finance, to do banking, securities, pensions and insurance. (I had a piece on keeping IRDA and PFRDA distinct, in BS, in 2000). Each of these is a big enough task to merit a meaty organisation of 200-1000 people. It's good to have one CEO of each of these 4 organisations, who lives and dies by the fate of each industry. Yes, there are some messy problems on the interfaces between these, particularly owing to conglomerates like HDFC or ICICI. But having four distinct regulators will also give greater experimentation and innovation. At any one time, one of the four will be a laggard in terms of stifling innovation, but one will be a well-run ship with smart people and doing good things, which will later generate pressure through both precedents and competition upon the other three. If we have just one FSA, it will concentrate too much power into one hand, and the damage that one bad choice of a leader can do is tremendous. Given how badly the appointments process works, it's best to be cautious about this kind of damage.

In this framework, all securities activities would collapse into SEBI, just as is the case with roughly every advanced-country securities regulator. In a typical advanced country, when you go to the futures exchanges, you get to trade - on a single screen - any underlying, ranging from equity to currency to interest rates to commodities to new stuff like weather or catastrophes.

But as the BS edit emphasises, this doesn't seem to be in the pipeline. Instead, we seem to be headed for a bizarre situation with three distinct `ponds' : an equity pond, a RBI pond and a commodity futures pond. The exchange infrastructure in each pond will be forced to non-compete with each other. The exchange industry is oligopolistic in the best of times. It's a struggle to get competition into it. Lawmaking like that described in the BS edit will make it much worse.

As the BS edit emphasises, the world is moving towards single-screens that trade everything. But in India, we're forcing the economic agent to make three companies, obtain three or more exchange memberships, have three or more trading screens, and all sorts of compliance overheads. It's inefficient.