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Tuesday, October 20, 2009

New thinking on financial stability

I have an article in Financial Express today, where I discuss RBI's take on financial stability, which sums up to the rejection of all recent thinking in India on monetary and financial reform, in the light of recent thinking on this subject at the US Fed and the ECB.


  1. I do not think that it is intellectually compelling to criticize the RBI no matter what it does, Mr. Shah. (Nor do I find it politically compelling in the sense that you will simply be streotyped as the person who is reliably anti-RBI, ie an ideologue, but that is a separate matter).

    The fact remains that appealing to consensus is not an intellectually robust argument: look what happened to the Washington Consensus around financial deregulation. However you slice it, the RBI went against the prevailing winds and prevented a great deal of contagion spilling into its jurisdiction. The consensus has failed on deregulation, why should it be any stronger on regulation?

    This is not to say that there are no worthwhile ideas in this new regulatory consensus you point to, quite the contrary. It is simply to say that an appeal to consensus per se, positing the RBI as an outlier, has little intellectual merit, to my mind.

    Now, has the RBI's conservatism come at zero cost? Of course not; no one could reasonably state that there is nothing to criticize in their policies. But to do so credibly, one has to take a somewhat nuanced view.

    Stability is always going to be bought at some macroeconomic cost, by definition. One of the key features of macroprudential regulations, as you note, is countercyclical capital requirements. And you ought to know that, leading up to the crisis, the RBI undertook such measures in a fine-grained, sectoral manner, again, much against the prevailing consensus. The cost from this has to be weighed against the benefits of stability. Perhaps we have that trade-off wrong. But the West hardly had it right. The truth is somewhere in the middle, waiting to be found by thinking independently. Whatever the RBI's faults, and it has many, one cannot accuse it of not doing that.

    Finally, I should note that the RBI's microprudential approach is not necessarily orthogonal to macroprudential regulation. As a recent paper by the BIS notes, "Prudential tools that target financial stability need to be calibrated at the level of the financial system but implemented at the level of each regulated institution."

  2. 1.Is Indian capital market at such a sophisticated stage to call for a unified regulator?
    2.With existing regulators failing to deliver on basic minimum discharge of duty expected of them,can we even begin to think of complexities that a unified regulators entail:
    a.SEBI--has failed to ensure even minimum disclosures?
    b.IRDA-has failed to rein in obscene commissions and misseling of products resulting in poor penetration.
    c.RBI-Has ensured and blessed Fat NIMs,discrimnation against existing borrowers vs new borrowers,non development of critical financial products, abysymal branch penetration
    d.PFRDA-What does it actually do?
    If these agencies are failing individually, what a colossal failure would the unified regulator be? Or can they make up for each other's failure?

    Conservatism and Stability(interest rates et al) might be debatable, but the bare minimum one can expect from the regulators is to not allow foul play from market participants and not be a hindrance in the development of financial market(if it cannot be a facilitator)

  3. The rules of the game of this blog are: no personal attacks, no personal innuendo.

    So I have deleted a group of comments.

    I will write a pointwise response to the ideas mentioned therein, since I really hate to waste the time and effort that you guys have put in. I really hate to do this, but there is absolutely no compromise on the issue of personal attacks: once that gets going, it's downhill all the way. It is either only-ideas-in-comments or I will have to switch off comments on this blog.

    Focus on ideas, not individuals.

  4. Incremental change is more valued in India even when radical change is required. Hence the sort of comments you get.

  5. Deleting comments is one thing, and quite fair. Editing them down is quite another. There was absolutely nothing personal in suggesting that you would have to find an example of a deep and liquid currency market in a non-key currency for your argument to hold. Why then was this portion of the first comment deleted?

  6. The switch that I get is all or nothing - either I delete a comment or I don't.

    I don't like censorship at all, and I will not delete comments as long as they stick to ideas and stay away from ad hominem attacks. Criticise ideas all you like, don't get into people.

  7. It's personal only if take it personally !

  8. I don't agree. There are places on the net where civilised conversation takes place. There are places where it doesn't. A regular feature of the latter is where tempers get raised, bellicose statements get bandied about, etc. It's best to not go down that route. Even if person X can handle rough language, person Y cannot, and by dropping down to that level, we exclude Y from the conversation.

    Focus on the ideas, not on the people.

  9. Ajay, just to be clear here, and fair to your readers, I have to say that, as the author of the first and fifth comments (but not the seventh one), I am 100 percent certain that the comment was edited. It first appeared in full, then in an edited form. So either there has been a malfunction or your "all or nothing" comment is not exactly correct.

    To be clear, I'm not accusing you of anything, merely requesting clarity that I'm sure all your readers would like: Are comments on this blog edited or not?

  10. "There are places on the net where civilised conversation takes place. There are places where it doesn't. A regular feature of the latter is where tempers get raised, bellicose statements get bandied about, etc. It's best to not go down that route."

    Fair Enough Prof. Shah! My apologies for the earlier posts. But I hope you will give point-wise replies on the issues raised.

  11. Anonymous: The way blogger works, the only decision I get to make is to delete a given comment or not. There is absolutely no way to edit a comment once it's appeared. Perhaps you are thinking of comments on some different post?

    Rheoleiddiwr: As I said, I really appreciate the effort which you put in to bring new knowledge into this discussion. I hate to engage in censorship. I will write a careful response.

  12. Ajay,switching off the comments is a terrible idea.Let not the stupidity of some disturb a healthy exchange of ideas which,ultimately,is in larger interest of all.I understand that there can be personal attacks in guise of comments which can be an irritant and might make one wonder the point of whole effort.If at all, you can disallow anonymous comments. Anonymity allows users to behave in manner they wont otherwise indulge in. Now that Ajay is on twitter, those that dont fit here can used that as an alternate feedback mechanism.

  13. I have certain observations on the way a complex and technical issue like supervision of financial system is treated in the article ' The new question of financial stability' By Ajay Shah in Financial Express. By way of the following couple of posts (my apologies for long posts) I will point out these contradictions:
    The article starts with the statement that in India, it is being claimed that the role and
    function of RBI, as it presently stands, is the right way to address the goal of financial
    stability. In fact, in majority of the countries, Central banks are responsible for financial
    stability and publish financial stability reports. Even Ben Bernanke's speech to which Ajay Shah’s article alludes says that the Federal Reserve is already the consolidated supervisor of some of the largest and most complex institutions in the world and the expertise developed in supervising large, diversified, and interconnected banking organizations, together with broad knowledge of the financial markets in which these organizations operate, makes the Federal Reserve well suited to serve as the consolidated supervisor for those systemically important financial institutions. Bernanke goes on further and says that Fed's involvement in supervision is critical for ensuring to carrying out essential functions as a central bank of promoting financial stability and making effective monetary policy. So Fed Chairman is also of the view that Central banks' essential function is safeguarding financial stability. Then where is the disconnect between the so called claim in India on Central Bank's goals. If Fed can ask for consolidated supervision then why not RBI? The annual Geneva Conference organised together with CEPR by the International Centre for Monetary and Banking Studies looked this year at financial market regulation and brought out a report titled “The Fundamental Principles of Financial Regulation ”. This report prepared by Markus Brunnermeier (Princeton and CEPR), Andrew Crockett (JPMorgan), Charles Goodhart (LSE), Avinash Persaud (Intelligence Capital) and Hyun Shin (Princeton and CEPR) opined that Macro and micro-prudential instruments differ in their needed professionalism and Macro-prudential regulation should be carried out by Central Banks where as micro-prudential regulation may be undertaken by Financial Services Authorities. Martin Cihák and Richard Podpiera of International Monetary Fund (IMF) in their paper written in 2007 titled 'Are More Integrated Prudential Supervision Agencies Characterized by Better Regulation and Supervision?' reviewed the international experience and concluded that whether supervision is located inside or outside the central bank does not have a significant relationship to the quality of supervision.

  14. Secondly the talk about macro-prudential supervision was engaging the attention of policy makers and academics since eighties though now it has become fashionable without anybody really clear about what it means. [See this excellent blogpost by Claudio Borrio : and this one by Avinash Persaud : ] This includes the present article by Ajay Shah under discussion. His contention that financial stability's technical meaning about examining the interconnected set of financial markets and firms as a whole, and not just the safety and soundness of financial markets or firms taken one at a time is at best a partial depiction of the concept. One may like to refer to Garry Schinasi's paper 'Defining Financial Stability' {IMF Working paper- WP/04/187 of October 2004 for a scholarly discussion on the definition.
    Prof. Shah writes that looking outside the country, in field of financial stability; very different picture is seen as compared with that being put out by speechwriters at RBI. In fact speeches from RBI are more or less in line with what is being talked about globally. For example : RBI Deputy Governor Usha Thorat in a recent speech said that the presence of complex and interconnected financial entities across several jurisdictions with regulators has posed huge challenges in ensuring that there is no regulatory arbitrage and that there is need for coordination amongst regulators to deal with systemic risk and inter regulatory dialogue and vigilance is essential. []
    RBI Governor D.Subbarao while talking about 'Financial Stability' said that Strengthening the macro prudential framework is the need of the hour and regulation typically focused on individual institutions is necessary but not sufficient and tt is equally important to monitor systemic stability. []
    One can see similar themes in the Bernanke speech and the speeches of Mervyn King and Paul Tucker of Bank of England.

  15. Finally, Prof. Shah summarizes that an international consensus is developing around propositions like the largest financial firms should face unified supervision; micro-prudential regulation of all organized financial markets should be unified into a single agency and a committee of all financial regulators should look at financial stability etc. If trends are observed it is difficult to notice such convergence of thinking. For example, Financial Stability Board's report on Improving Financial Regulation submitted to the G-20 leaders in September 2009 does not talk much about the ideas listed by Prof. Shah. To cite other research: in the paper 'Issues in the Unification of Financial Sector Supervision' Richard Abrams and Michael Taylor of International Monetary Fund (IMF) argue that the strongest arguments for unification are the enhanced oversight of financial conglomerates and the economies of scale they can potentially deliver; there are a number of potentially serious disadvantages to unification, especially the risk that the change process will be mismanaged and will result in a reduction in regulatory capacity. They concluded that the issue requires careful deliberation and ultimately depends on a matrix of factors which vary in importance from country to country. International Survey of Integrated Financial Sector Supervision (World Bank Policy Research Working Paper 3096, July 2003) by José de Luna Martínez and Thomas A. Rose analyzed cross-country experience and concluded: “the group of integrated supervisory agencies is not as homogeneous as it seems. Important differences arise with regard to the scope of regulatory and supervisory powers the agencies have been given. In fact, contrary to popular belief, less than 50% of the agencies can be categorized as mega-supervisors. The survey also identified practical problems faced by the group of countries in establishing their unified supervisory agencies”.
    Should we follow the so-called international consensus propounded by Prof. Shah after spectacular failures of supervisors like Financial Services Authority of UK?
    Exposition on a complex and important issues like regulation of financial system and financial stability in media in a superficial way without in-depth analysis puts a question mark on the credibility of ideas expressed in the article by Prof. Shah.
    Incidentally, I am still waiting for point-wise replies promised by Prof. Shah!


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