The drama of monetary policy

Ben Bernanke's statement

Everyone interested in the world economy should watch Bernanke's recent speech and the press conference:

(Switch to full screen, it works well). Here is the base URL which collects together all the materials about the Fed's announcement. The `exit strategy principles' are in the June 21-22, 2011 meeting.

The announcement reinforces the sense that the US economy is healing. The US Fed is keen to have inflation of 2% and believes the NAIRU is around 6.5%. Hence, once they come into the range where unemployment has achieved a few strong improvements and is trending to get below 6.5%, while price stability has not been compromised in that inflation expectations are still at 2%, they will start unwinding the extreme expansionary stance of monetary policy that has been in place in recent years. All through, there is no fixed calendar about what the Fed will do when. There is a clear articulation of the decision rules that will be employed, about how future data releases will generate future policy.

Why did the world see this badly?

One element is the shift from an unclear sense that the Fed will keep buying $85 billion a month of bonds for a long long time, to a specific sense about how this pace of purchases will decline and ultimately end, surrounding a specific number -- 7% unemployment amidst strong economic growth (see Eric Morath, Michael S. Derby and Sudeep Reddy in the Wall Street Journal). The QE has to clearly end before you start raising rates. There is a certain amount of confusion between the 6.5% threshold about interest rates and 7% threshold about QE; some interpreted the new 7% threshold as replacing the previous 6.5% threshold, which is not the case.

The second key issue seems to be in the reading of the data. The FOMC has shifted to a more optimistic view about how the US economy is faring. The FOMC decision is the consensus of its 19 members, many of whom are top economists, and all of whom are backed by top quality researchers. However, some believe that the FOMC's view -- that there are signs of improvement in employment and output growth in the US -- is too optimistic. As an example, see Paul Krugman. Suppose the Fed is wrong; suppose they are starting to think about getting away from QE a bit too early. In that case, the FOMC decision is bad news.

On the other hand, Bernanke is careful to emphasise over and over that he is not making a statement about future paths of policy, but only about the decision rule that will drive policy. He is making statements about how policy will behave in future dates conditional on what the data looks like at future dates. If, in principle, the US lurches back into sluggish conditions (low inflation, high unemployment), the policy rule will push back towards monetary easing.

Let's make no mistake about it: Quantitative easing at the zero interest rate lower bound is a messy world, when compared with the clean operation of inflation targeting under normal times. I felt that Bernanke and the Fed are doing a good job of navigating this messy landscape.

Implications for India

1. The US economy is healing. This is great news, as the US remains the biggest country of the world. This will impact on short-term growth everywhere in the world through spillovers of demand from the US, and help long-term growth worldwide by increasing the rate of expenditure on R&D in the US. Specifically for India, this is good news, as India has two big trade exposures to the US -- directly (Indo-US trade) and indirect (Indo-Chinese trade).
2. For countries that peg their exchange rate to the USD, there is no monetary policy autonomy -- their monetary policy is set by Bernanke. This announcement tells them something about the horizons over which their monetary policy will tighten. This matters for (say) China or UAE who peg to the dollar, but not for India, which has a floating exchange rate and thus has monetary policy autonomy.
3. Some believe that loose monetary policy in the US sets off a search for returns by taking risk and by investing in illiquid securities, particularly by US absolute return investors. A different way of seeing the same phenomenon is to focus on long positions outside the US that are financed by borrowing in the US; the risk-reward profile of these positions has now become a bit less attractive. We have reason to believe that such phenomena might be present, but the proposition remains controversial. To the extent that such effects are present, the FOMC announcement suggests that in 2014 and 2015, US investors will start pulling investments away from risky and illiquid assets. This is mildly negative for India, given that India is an emerging market (i.e. high risk) and that many securities in India are relatively illiquid.
4. The US 10 year rate would go up after this announcement (as it should). This slightly reduces the interest rate differential between the US and Indian interest rates. This should adversely impact on capital flows to India and thus yield INR depreciation. I feel the magnitude of effects is small: The US 10 year rate went up from 1.95% on 21 May (before the previous Bernanke announcement) to 2.32% on 19 June. This is a small change in the interest rate differential for India.

There is another way of thinking about all this which helps us better understand what happened in India, which related to the large Indian current account deficit. When interest rates in the US are zero, just about everyone who aspires for the slightest return is forced to invest abroad in the search for yield. Bernanke has unveiled a story which suggests that from late 2013 and 2014 onwards, this will gradually change. This means that money which was leaving the US will stay home. This will imply that countries with a large current account deficit will need to become more attractive in order to attract the same amount of capital. This will require a mix of currency depreciation, increased interest rates and capital account decontrol in India.

Implications for India's monetary policy process

Watching US monetary policy in action inevitably makes one think about the monetary policy process in India. I am charmed by the extreme precision and clarity of the FOMC statement, the underlying staff quality, and the functioning of the MPC. For us in India, it teaches us how monetary policy effectiveness is achieved through clearly articulating a policy framework and through commitment to it. The phrase `multiple objectives and multiple instruments' that is used in India is a euphemism for the absence of a framework.  We should aspire to do better. The Indian Financial Code will begin the journey to a strong, autonomous, technically sound and accountable RBI.

College and knowledge continued

In continuation to Let's not confuse college with knowledge :

1. See the comments on that post.
2. Is the labour market return to higher education finally dropping? by Tyler Cowen.
3. Rasheeda Bhagat in the Hindu Business Line (ht: K. Satyanarayan).
4. Dale and Krueger, QJE, 2002. (ht: Aditya Kuvalekar).

Some people wrote me email asking: What should I be doing in an undergraduate degree in economics to make sure I actually get the knowledge? I feel that an economics education in college should bring you to the point where you get the stuff on this blog.

Let's not confuse college with knowledge

The cost-benefit analysis of a college education in the US

I was fascinated by this interview in the New York Times with Laszlo Block, Senior VP of People Operations at Google. They seem to be doing instrumentation and analytics in the HR function, giving new insights into how things work (as opposed to preconceptions or conventional wisdom). In this, he says:

One of the things we’ve seen from all our data crunching is that G.P.A.’s are worthless as a criteria for hiring, and test scores are worthless — no correlation at all except for brand-new college grads, where there’s a slight correlation. Google famously used to ask everyone for a transcript and G.P.A.’s and test scores, but we don’t anymore, unless you’re just a few years out of school. We found that they don’t predict anything.

What’s interesting is the proportion of people without any college education at Google has increased over time as well. So we have teams where you have 14 percent of the team made up of people who’ve never gone to college.

If this is true of Stanford -- happy hunting ground for Google -- it is triply true about every other university in the world. I believe neither students nor recruiters should leave much to universities. I was particularly fascinated with the tidbit about Google staff that have never gone to college, and that this number has gone up over time. Some BPOs and KPOs in India are also recruiting high school graduates; the marginal value of college is not as obvious as it used to be.

Universities in the US have built up an imposing cost structure, where a child spends between $150k and $250k for a college education. It is going to be harder to justify these price points in the future, given the twin problems of skeptical employers (e.g. a Google that does not demand a college degree as a pre-requisite) and the new phenomenon of Internet-based learning. I have also encountered similar things in the UK, where many young people are not confident that the years and expense in college will be worth the trouble.

I suspect there will be less fat in higher education in the days to come. Perhaps we could go closer to the MIT and Caltech of old: lean structures with great scientists and less money spent on cafeterias, gyms, and administrative staff.

India's experience with GDP growth despite the lack of education

India got explosive GDP growth, once socialist policies started getting reversed, from $0.22 trillion in 1993 to $1.73 trillion in 2013. GDP per working person went up at a compound rate of 9.4% per year over these 20 years, from $374 in 1993 to $2637 in 2013. This is nominal GDP expressed in US dollars, without adjustment for US inflation, and without adjustment for PPP. On average inflation in the US is 2% so 9.4% growth in output per worker expressed in nominal dollars is roughly 7.4% in real terms.

Some of this output growth per worker came from capital deepening, the remainder came from productivity growth. The universities were bad and did not contribute much to this growth. We should reflect on how India managed to get such remarkable growth despite the lack of universities. It tells us something about the potency of learning by doing (along with substantial capital accumulation) over these two decades.

We have finished an important generation change in this period. The persons who were age 20 in 1993, who are now 40 years old, have experienced a full 20 years in the workforce while being connected to a competitive market economy, to globalisation, and to the Internet. This environment is one that is conducive to knowledge building. It is this learning by doing that gave the remarkable 9.4% per year compound growth in GDP per worker expressed in nominal US dollars, over the last 20 years.

While we have awful universities, I feel the outlook for the future is good for three reasons:

1. Having a brand name college is not that important. How a person builds herself is far more important than a brand-name that she carries. If individuals and recruiters shift away from looking at the brand-name, and focus more on the person, that will help.
2. The forces of competition, globalisation and the Internet are hitting India on a bigger scale today than they ever were. Twenty years ago, there was no choice of attending online courses.
3. The children of liberalisation are now coming into leadership roles [example]. When we recruit a 40 year old CEO today, we are getting someone who grew up with 20 years of the new world. This often implies better knowledge and instincts when compared with people who suffered from Indian socialism and deprivation in their formative years. The application of this human capital into important decisions will exert a positive impact. More than in other places, we need to propel this generation into leadership roles as soon as possible.

State capacity in India, vs. the early 1990s

The problem of State capacity

A defining theme of India's challenge today is capacity constraints. Even when an objective is sound (a public good is sought to be created), and when the resourcing is adequate, the Indian policy landscape is littered with failure. We are very bad at achieving the desired objective. To get to sensible outcomes, we need to push on three things: Focusing the government upon the small class of problems which are public goods (i.e. doing fewer things), ensuring adequate resources, and achieving better State capacity.

There is a palpable sense that State capacity in economic policy has declined in recent years. On one hand, this is about a relative and not absolute problem: Every doubling of GDP brings forth new challenges, and requires both new kinds of knowledge and new kinds of agencies and laws. In India, our stasis on the organisation chart of government, where we perpetuate laws and agencies designed for a very different India, has led to a gross mismatch between the requirements of the country and the existing capabilities of the government. As an example, there are big problems visible in RBI that is over 75 years old and in SEBI that is 25 years old which have been left unattended. In addition, the staff continuity at the Ministry of Finance from the early 1990s onwards was significantly disrupted when Pranab Mukherjee became FM in 2009. These two factors put together have created a serious gap in capacity.

The role of think tanks

The mismatch between the capabilities of government and the requirements of the economy has led to a bigger role for organisations such as think tanks that are outside government. Four think tanks in Delhi matter -- NCAER, ICRIER, CPR and NIPFP. In the Economic Times today, I have a column about an interesting process of reinvention that is taking place at these four institutions, and its larger consequences for the economic reform process, and for the life of the mind in India.

Hurdles in the next phase of financial reform

In the Economic Times, Shaji Vikraman has a fascinating piece where he takes us back to the successes of the last 20 years in financial reform, and reminds us of the role of leadership teams. The achivements of that period were critically about the MoF team including Dr. P. J. Nayak, the SEBI team including S. A. Dave, G. V. Ramakrishna, S. S. Nadkarni and C. B. Bhave, and the NSE team including R. H. Patil, Ravi Narain, Chitra Ramakrishna, and others. The capabilities of these three teams, and their ability to work together, was crucial to the success of the reforms of the equity market.

Shaji says that we are now on the cusp of the next wave of institution building, as the FSLRC architecture is implemented in coming months and years. This involves rebuilding RBI towards clarity of purpose and quality of work, and building six fairly new things: the Unified Financial Authority (UFA, the regulator of all finance other than banking and payments), the Financial Sector Appellate Tribunal (SAT on steroids), the Resolution Corporation (starts from scratch), the Financial Redress Agency (FRA, starts from scratch), the Public Debt Management Agency (PDMA, starts from scratch) and building out the Financial Stability and Development Council (FSDC, which has to go from tiny to substantial). Shaji says that this will require inspired leadership akin to that found at MoF, SEBI and NSE in the 1990s.

On this same subject, see the talk by Chitra Ramakrishna at the recent FSLRC meeting in Delhi organised by the Institute of Company Secretaries.

In many respects, we are in better shape when compared with the early 1990s

There is no question that we will need all the implementation capacity that we can find in making this big transition work. It will require capabilities at MoF and the seven agencies that are quite different from the behaviour of these organisations in recent times. To some extent, Shaji and Chitra are right in stressing the importance of leadership at MoF and at the seven agencies in their formative years.

At the same time, there are four elements which make me see this differently:

The unique difficulties of a startup

When SEBI was founded by S. A. Dave, Ravi Narain and others, they were starting from a blank slate. The very concept of SEBI had to be invented from scratch. Political battles had to be fought against the Controller of Capital Issues at the Ministry of Finance who was not keen on ceding authority on merit-based clearance for raising capital, and against the BSE that was not keen on having regulation and supervision.
These issues are all now behind us. Other than one minor part of Indian finance that is hostile, the bulk of Indian finance will accept the expanded-and-restructured regulation and supervision of the draft Indian Financial Code without a whimper.
And, with the draft Code in hand, the journey does not start from scratch. The 450 sections of the draft Code constitute a clear blueprint for what each of the seven bodies has to do. It is more like building NSDL in 1995 -- where there was full clarity about the mission -- and less like building SEBI in 1988.

Insourcing vs. outsourcing

All the staff capacity does not have to be in the government. While government and regulatory agencies have weaknesses, numerous other organisations have capacity of various kinds, which can be pressed into service. This includes domestic and international consulting firms, think tanks, universities, industry associations, practitioners, etc. These choices were not available 20 years ago.
From 2007 to 2013, we got a paradigm shift in financial economic policy thinking in India, where the experiences of 1991--2007 were digested and turned into a program for action through the Mistry, Rajan, Sinha and Swarup reports, and then FSLRC. This showed capacity of a kind which was not present in the early 1990s. If an FSLRC-like project had been attempted in 1992, it would not have been possible to find the 146 persons required to man it.

Leapfrogging to IT-driven processes

In many situations, achieving the objective is synonymous with building and running a large IT system. By now in India, there is quite a bit of experience and achievement in building such government organisations. The Indian State does not have, and probably never had, the ability to run FRA in the pre-computer world [counter-example]. But if the FRA is an IT-driven process, then implementation is within reach. This implementation capacity is something that India did not have in the early 1990s.

Sound institutional design embedded in the law

Laws in India have been skimpy in their drafting. As ane example, the Payments and Settlement Systems Act of 2007 gives RBI power over the payments industry. It says little else. It does not state regulatory objectives, it does not establish checks and balances; there are no feedback loops of accountability mechanisms. Under these conditions, the individuals who lead regulatory bodies possess power without matching responsibilities. The behaviour and functioning of each regulatory agency then changes dramatically based on the individuals found within it. It is, hence, not surprising that Shaji sees such a profound impact of the individuals at the helm.
In contrast, the essence of the draft Code is a framework of institution building for these seven organisations. For each of these organisations, there is clarity of objective, there is specificity of powers and there are elaborate accountability mechanisms. While setting them up at first will be hard, it is likely that the Code will make them behave as genuine institutions that are bigger than the individuals that inhabit them.

Conclusion

Shaji looks back at our glorious past, and bemoans the lack of heroes. But as Bertolt Brecht had Galileo say, sad is the land that needs heroes.

The essence of the draft Code is a system of checks and balances, and a framework for accountability, through which the seven bodies will deliver results when manned by ordinary public servants who are not heroes. This is the way regulation works all over the world, and this is what we should aspire for in India. Let us make financial economic policy an everyday and humdrum process. As Keynes wrote in Essays in Persuasion in 1931, If economists could manage to get themselves thought of as humble, competent people on a level with dentists, that would be splendid.

Dr. Subbarao's comments about FSLRC's treatment of systemic risk

On 5 June, Dr. Subbarao did a speech at the Indian Merchants Chamber, which expressed views about the FSLRC treatment of systemic risk, which has spawned an interesting discussion:

• Speech by Dr. Subbarao, 5 June
• A pointwise response to the material on systemic risk in this speech, by Sowmya Rao.
• Why the RBI Governor D. Subbarao is wrong on regulating systemic risk, a column in the Economic Times by K. P. Krishnan.
• A column in Mint by Sowmya Rao and Sumathi Chandrashekharan.
• A helicopter tour of systemic risk regulation in the draft Indian Financial Code, by me.

I find myself repeating two things all the time on the draft Indian Financial Code. The first thing I say to people is: `Read the draft Code!' It is plain English and is fully comprehensible by anyone.

The second thing I say is: `Don't think about one section or one chapter at a time, understand the fuller interlinkages about how the whole thing fits together'. Very often, an apparently small modification to one section or one chapter would have legal effects beyond what is envisioned at first blush.

A helicopter tour of systemic risk regulation in the draft Indian Financial Code

The field of financial regulation has traditionally focused on consumer protection, microprudential regulation and resolution. However, the 2008 financial crisis highlighted systemic risk as another important dimension of financial regulatory governance. Subsequently, governments and lawmakers worldwide have pursued regulatory strategies to avoid systemic crises and provide for systemic oversight.

At present, Indian law is silent on the subject of systemic risk. RBI often implies that it has been doing work on `financial stability', however at present, there is no legal mandate, no powers, and no actions.

To some extent, systemic crises are the manifestation of failures in the core tasks of financial regulation, consumer protection, micro-prudential regulation and resolution. Proper functioning of these core tasks, as envisaged in the draft Indian Financial Code, will reduce systemic risk, but not eliminate it. There is thus a strong need for a legal strategy for systemic risk regulation. This has been done for the first time in India in the draft Indian Financial Code.

You should of course read the draft Code and the underlying report. However, in order to help you get a hang of how the FSLRC thinks about systemic risk, here is a bird's eye view which points you to the right places in the Code.

We now turn to the sections of the IFC that directly deal with systemic risk:

S. 2(36), page 3

introduces the phrase `the Council' which is used in the IFC to refer to the Financial Stability and Development Council (FSDC).

S. 2(78), page 7

defines a `financial system crisis'.

S. 2(154), page 13

defines `systemic risk'.

S. 20, page 19

sets up the FSDC as a statutory body. A careful study of the composition of the FSDC in S.21 shows that the day-to-day functions of the FSDC will be run by a Chief Executive. There will also be an administrative law member to ensure that regulatory governance norms are followed.

S.65, page 34

is an example of the inter-regulatory co-ordination function of the FSDC. Where two regulators are to take joint action under the IFC, but are unable to reach a consensus, they must work with the FSDC to figure out a solution. While inter-regulatory coordination can be an issue in many contexts (e.g. SEBI/IRDA on ULIPs), it is certainly a dimension of systemic risk where the thinking and work cut across all regulators.

S.141(1)(a)(iii), page 66

asks that when regulators such as RBI and UFA are regulating SIFIs, they should take the relevance of the systemic risk perspective into account. There is no role for FSDC in what they do here.

S.141(1)(k), page 67

asks that micro-prudential regulation should be mindful of systemic risk and particularly pro-cyclical consequences of regulation.

S.187(1)(c), page 86

asks that Infrastructure Institutions (such as exchanges, depositories etc., defined in S.183, page 85) are obliged to promote the objective of the FSDC to mitigate systemic risk, when they write bye-laws (which will be approved by the UFA and not FSDC).

S.221, page 96

sets up the Resolution Corporation at the level of the entire financial system and details its objectives.

S.224(1), page 96

asks that the officers and employees of the Resolution Corporation have knowledge and expertise in resolution of SIFIs.

S.287(2), page 121

asks the Resolution Corporation to consult with the FSDC where the Resolution Corporation is contemplating certain resolution measures against a SIFI.

S.290, page 122

defines the objectives of FSDC. The agency will pursue the objective of fostering the stability and resilience of the financial system by, (a) identifying and monitoring systemic risk, and (b) taking all required action to eliminate or mitigate systemic risk.

S.291, page 122

says that the FSDC consists of its board, an executive committee, a secretariat and a data centre. Of particular importance is the data centre, which is defined in S.294.

S.295, page 123

sets out the five main activities of the FSDC. It will study data and do research on the financial system; it will designate certain financial firms as SIFIs; it will formulate and implement system-wide measures, it will promote inter-regulatory cooperation, and it will assist the Ministry of Finance and all other agencies during a systemic crisis.

S.296, page 123

establishes principles that must guide the FSDC. These principles ensure that systemic risk regulation does not degenerate into achieving the silence of a graveyard.

S.297, page 123 and 124

sets forth the analysis and research objectives of the FSDC. Accordingly, S.298 gives the FSDC the powers to obtain relevant data.

S.299, page 124

sets up the legal process through which the FSDC will determine the criteria to designate certain financial firms as SIFIs. A financial firm can be adversely affected when it is designated as a SIFI, hence the full legal process of an order is required.

S.300, page 125

sets up the legal process through which firms would be designated as SIFIs.

S.301, page 125

asks the FSDC to issue policy frameworks and regulations for implementing system-wide measures, in the class of those defined in the Third Schedule (page 185). In the future, if other system-wide measures are thought useful, Parliament would have to approve amendments to the Third Schedule to add such measures.

S.302, page 125 and 126

sets up the legal process through which the FSDC will ensure the implementation of system-wide measures.

S.306, page 127

asks the FSDC to identify what parameters it would use to determine a financial system crisis. S.306(4) asks the Council to assist the Government and regulatory agencies as specified in S.306(5) (through analysis of data, providing advice, and assisting in efforts).

S.307 to S.313, page 128 and 129

constructs the Financial Data Management Centre (FDMC), a single database about the entire Indian financial system, which allows the regulators to have a full picture about the state of the financial system at any point in time, and particularly during a crisis. As a side effect, the unification of all supervisory data filings to FDMC also leads to de-duplication of data and reduces costs for financial firms. This database is essential for thinking about systemic risk (i.e. about the overall financial system) and is conspicuously absent in India today.

S.345 and S.346, page 141

define the lender of last resort (LOLR) functions of the central bank. S.345 (temporary liquidity assistance) relates to assistance given to participants in the central bank's payment system, and S.346 (ELA) is about lending against collateral to a more broad class of financial firms.

S.362, page 147

defines the notion of an emergency, which can motivate capital controls against inflows under S.365. Similar provisions for outward flows are specified in S.368.

A response to Dr. Subbarao's comments on systemic risk regulation in the draft Indian Financial Code

by Sowmya Rao.

At a recent conference organised by the Indian Merchants Chamber, the Reserve Bank of India (RBI) Governor, Mr. Duvvuri Subbarao, shared his views on lessons learnt from the global financial crisis. The full text of his speech is available here. While discussing financial stability, Mr. Subbarao discussed the recommendations of the Financial Sector Legislative Reforms Commission (FSLRC) on the Financial Stability and Development Council (FSDC). This post is a pointwise response to his text.

The big picture of FSLRC

The draft Indian Financial Code deals with all aspects of financial law, including consumer protection, microprudential regulation, resolution, systemic risk, and monetary policy. Accountability mechanisms and clarity of regulatory objectives are key themes of the recommendations.

The recommended regulatory architecture consists of a Resolution Corporation which will manage the resolution of failing firms, while regulators (RBI and the proposed Unified Financial Agency (UFA)) will pursue consumer protection and microprudential regulation. RBI (as the central bank) will perform monetary policy functions.

Since the legislative mandate of regulators will define their perspective and information access, an individual regulator dealing with say, banking, is likely to focus its operations on banking alone, and not the entire financial system. Systemic risk analysis, in contrast, requires a bird's eye view of the entire financial system, especially to identify interconnections or trace interdependencies. The heart of systemic risk thinking is to look at the woods and not the trees, while the instinct of micro-prudential regulation is to look at trees.

Hence, FSLRC recommended that systemic risk oversight was best executed by a council of regulatory agencies - the FSDC - assisted by a technical secretariat. The board of the FSDC comprises the Minister of Finance (Chairman), the Chairman of RBI, the Chairman of the UFA, the Chairman of the Resolution Corporation, the Chief Executive of the FSDC and an Administrative Law Member of FSDC.

Responses to Dr. D. Subbarao

What are the relative roles of monetary policy and macroprudential policies?

While terms such as financial stability, macroprudential regulation and systemic risk oversight are often used synonymously, the most technically sound term is 'systemic risk'.

FSLRC views monetary policy and systemic oversight as distinct, to be employed by relevant agencies best suited for each. The draft Indian Financial Code (IFC) clearly lays out the process of defining monetary policy objectives alongside quantified medium-term targets (government's responsibility), as well as that of implementing the objectives (RBI's responsibility). This would create accountability in monetary policy, which can then make possible monetary policy independence.

Similarly, the IFC also clearly defines the scope and extent of systemic oversight which is the responsibility of the FSDC. The FSLRC recommendations specifically note that there ought to be strict separation between microprudential regulation (the domain of regulators alone) and systemic oversight.

Under what circumstances should one, rather than the other, be invoked? How do these policies interact with each other?

If institutional synergy between monetary policy and systemic risk is emphasised, this leads to a blurring of accountability. Instead of placing multiple objectives within the same institution, which could cause a conflict of interest, FSLRC has recommended that there be clear regulatory objectives assigned to separate institutions that best serve the issue at hand. There must be no impediment to holding a body accountable for lapses; multiple objectives only serve to reduce such accountability.

In furtherance of this, FSLRC has carefully carved out the contours of these two roles, with monetary policy implemented by RBI and systemic risk oversight carried out by FSDC. These agencies will invoke their enumerated powers when the situations call for it as specified by the IFC.

When these agencies follow their mandates as defined under the IFC, an overlap of these roles is unlikely. To the extent that decisions taken under the rubric of monetary policy may affect systemic risk and vice versa, RBI's presence on the FSDC table should ensure that open conversations about such intersections take place.

If they are handled by different agencies, is it possible that they can work at cross purposes? Is there an inevitable political dimension to macroprudential policies?

Within microprudential regulation, there is little need for any authority other than the regulator to exist. However, the presence of the political dimension takes on particular relevance in systemic risk. When there is a threat of an imminent systemic crisis, many actions that are required must have the authorisation of the political executive. Such actions cannot be taken by any technically ground and non-political and independent regulatory agency. The Finance Minister's leadership of the board of the FSDC reflects India's experience with the role of ministers such as P. Chidambaram and Yashwant Sinha -- and the role of finance ministers worldwide in the global crisis -- in dealing with systemic crises.

FSDC is a forum for regulatory bodies to discuss their concerns, especially if any one agency (including FSDC itself) appears to be working at cross-purposes with the mandate of any other agency. The possibility that such a concern may arise should not preclude the creation of a body to mitigate systemic risk.

If yes, how does one protect the autonomy of the institution responsible for macroprudential policy?

In an area such as monetary policy or micro-prudential regulation, there is a case for autonomy of the institution. With systemic risk, there is an inescapable role for the political authority in dealing with crises. No RBI Governor could have dealt with the 2008 crisis or the 2001 crisis. These required the authority and decision-making powers of the Minister of Finance.

In its submission to the Commission during the consultative stage, the Reserve Bank argued that the financial stability mandate that the Reserve Bank has been carrying out historically by virtue of its broad mandate should be clearly defined and formalized.

At present, the RBI has no mandate to carry out the function of systemic risk oversight, nor is there a work program of this nature.

In law: The words `systemic risk' or `financial stability' or `macroprudential regulation' do not occur in the RBI Act. That mandate, as well as powers to perform that mandate, are absolutely absent in the RBI Act.

In fact: RBI does not have a database about the overall Indian financial system, nor does it have executive authority over financial firms which are not banks. It has no meaningful way of assessing inter-connectedness or risk in sectors other than banking and payments. As an example, much of the complex dynamics of the crisis of late 2008 took place beyond the information set of the RBI. Further, the RBI does not have powers to do anything about the overall Indian financial system. In terms of financial regulation, RBI is only a sectoral regulator dealing with two sectors (banking and payments).

The Commission has acknowledged comments made by RBI and responded as follows (see FSLRC Report, Volume I, Chapter 9): In the consultative processes of the Commission, the RBI expressed the view that it should be charged with the overall systemic risk oversight function. This view was debated extensively within the meetings of the Commission, however, there were several constraints in pursuing this institutional arrangement. In the architecture proposed by the Commission, the RBI would perform consumer protection and micro-prudential regulation only for the banking and payments sector. This implied that the RBI would be able to generate knowledge in these sectors alone from the viewpoint of the safety and soundness of such financial firms and the protection of the consumer in relation to these firms. This is distinct from the nature of information and access that would be required from the entire financial system for the purpose of addressing systemic risk.

The FSLRC recommendation that the executive responsibility for safeguarding systemic risk should vest with the FSDC Board runs counter to the post-crisis trend around the world of giving the collegial bodies responsibility only for coordination and for making recommendations.

The international experience comprises some important examples which shaped the working of FSLRC.

Financial Stability Oversight Council (FSOC) in the United States: Created post-crisis, this body consists of the US Treasury Secretary and heads of all regulatory bodies. FSOC has powers similar to those envisaged for FSDC, including designating non-bank institutions as Significantly Important Financial Institutions (SIFIs), where designated institutions are subject to heightened prudential and supervisory provisions.

(See Section 113 of the US - Dodd-Frank Wall Street Reform and Consumer Protection Act, 2010. Further, See Section 295 (Functions of the FSDC) and Section 299 (Designation of Systemically Important Financial Institutions) of the IFC.)

The European Systemic Risk Board (ESRB) in the European Union: Consisting of the heads of the European Central Bank, the Governors of the national central banks of the EU member states and the regulatory heads of insurance, pensions and securities, the ESRB has the power to issue recommendations and warnings. These are issued with a specified timeline for the addressee to respond with a relevant policy response. It is crucial to note that addressees of such a recommendation are required to communicate to the ESRB and to the EU Council the actions undertaken in response to the recommendation or justify any inaction on a comply or explain basis.

To date the ESRB has published recommendations touching upon a wide range of issues, namely; lending in foreign currencies; the macro-prudential mandate of national authorities; US dollar denominated funding of credit institutions; money market funds and funding of credit institutions.

(See Regulation (EU) No 1092 /2010 of the European Parliament, para 17)

The Reserve Bank is also of the view that in a bank dominated financial sector like that of India, the synergy between the central bank's monetary policy and its role as a lender of last resort on the one hand, and policies for financial stability on the other, is much greater.

India is not a bank-dominated financial sector. As an example, the market capitalisation of all listed companies is over twice the size of non-food credit by banks to all companies. A perusal of the aggregative balance sheet of firms in India shows that bank financing is an important, but small, component. This is particularly the case if the balance sheet is re-expressed using market value of equity instead of book value.

The knowledge and expertise required to tackle systemic risk to the entire financial system is unlikely to be located within any one sectoral regulator. The knowledge about the Indian financial system will be dispersed across RBI, UFA, and Resolution Corporation. Hence, it would be inappropriate to place the systemic risk function in any one place.

RBI will only have expertise and information relating to the banking and payments industries. In equal measure, UFA will only have expertise in the non-banking non-payments financial sector, and the Resolution Corporation, will only have knowledge about handling failing firms. Each will be able to bring those respective nuances to the conversations on FSDC's board. Each of these agencies has synergies in its own right with the function of mitigating systemic risk.

The function of being a lender of last resort does not equate with performing systemic risk oversight. The IFC envisages that RBI will continue to provide funds to participants for which the RBI directly operates payment systems. Further, IFC establishes a mechanism through which RBI will also provide emergency liquidity for non-banking financial firms in times of severe or unusual stress in the financial system, on provision of collateral. There is no contradiction between a central bank that is a lender of last resort and a central bank that is not the systemic risk regulator.

We need to think through whether the responsibility of FSDC Board should be extended from being a coordination body to one having authority for executive decisions? What will that imply for the speed of decision making?

The FSLRC envisages two executive functions at FSDC: naming certain financial firms as Systemically Important Financial Institutions (SIFIs), and making decisions on system-wide counter-cyclical capital. Both these decisions will be taken by the board of FSDC, which will include the Chairman of RBI, the Chairman of UFA and the Chairman of the Resolution Corporation. FSDC is a council of regulators.

A loose coalition of regulators that does nothing more than meet has been tried in India. It was called the HLCCFM. It failed to solve problems such as the SEBI/IRDA dispute, and it played little role in the crisis management of 2008. The task ahead in designing sytemic risk regulation is one of understanding how to do things differently.

In the spirit of FSLRC's overall recommendations, establishing FSDC as a statutory body endows it with legal process, transparency and accountability that ought to accompany a financial sector agency. This means that FSDC can be held accountable for lapses, and that the possibility of external influences affecting its functioning is significantly reduced.

The speed of decision-making is enshrined in process, the efficiency of which depends on the stakeholders involved. Acting decisively is of importance where a crisis is at hand, but in a world that seeks to uphold principles of rule of law, there is little value in hasty decisions made by a non-statutory body with no accountability for its actions. A statutory FSDC is more likely to ensure that decisions relating to crisis situations are taken responsibly, and with full disclosures.

During a crisis, we need the executive to lead the fight and stem the sources of systemic risk, and all regulatory bodies will have to work together with the Ministry of Finance. This is what happened everywhere in the world during the financial crisis is the best model for tackling a crisis. FSLRC recommendations have legislated this model to increase accountability for actions taken during a crisis.

Can we clearly define the boundaries between financial stability issues falling within the purview of the FSDC and regulatory issues falling exclusively within the domain of the regulators?

Systemic risk may arise due to various reasons, such as regulatory arbitrage, excessive leverage ratios, or procyclical fluctuations in the economy. None of these issues can be handled exclusively by any one regulator.

IFC has laid down the process of identifying and implementing measures to mitigate or eliminate systemic risk. One measure of counter-cyclical systemic risk regulation, i.e the countercyclical capital buffer to address pro-cyclical effects in the financial system, has been explicitly provided for in the law. The implementation of such measures may commence only at the instruction of FSDC.

Regarding the intersect between the roles of FSDC and the regulators, under the IFC, the FSDC cannot interfere with microprudential regulation or the monetary policy function of the RBI. Any concerns can always be raised at the FSDC table, and discussed in full view of the public and the markets.

The author is grateful to Sumathi Chandrashekaran, Bhavna Jaisingh, Radhika Pandey and Ankur Saxena for useful inputs.

The saga of criminalising and then decriminalising cheque bouncing

by Shubho Roy.

The criminalisation of writing cheques without a sufficient balance was introduced in India in 1988. It was an addition to a much older British law called the Negotiable Instruments Act, made in 1881. The reason for the amendment was the endemic problem of cheques being dishonoured. This had made it difficult to do transactions where payment and delivery don't happen instantaneously. Mistrust of cheques was encouraging cash transactions, with consequent problems of counterfeiting, costs of storing and moving cash, and the law enforcement problems of an underground economy.

It has been estimated that about 30% of criminal cases in Indian courts are either cheque bouncing or traffic offences. The government has now proposed to amend the Negotiable Instruments Act (N.I. Act) to decriminalise the offence of bouncing cheques (called `138 N.I.' in legal circles) (See here). This move is aimed a decongesting the judicial system.

In 1988, when the amendment was brought in, no estimation was done of the additional burden on the criminal court system because of the law. This episode has taught all of us that every time legislation is enacted, careful calculations need to be made about the costs of enforcing the law and these costs should find their way into budgets.

The de-criminalisation of cheque bouncing is a good move. It will reduce the burden on criminal courts. However, the cheque bouncing cases are symptomatic of a deeper malaise: poor contract enforcement. While we may cheer the demise of a poorly thought out and draconian measure in 1988, there is a dark side to this as well.

Consequences for contract law

One of the best achievements of the World Bank is their `Doing business' database. India ranks poorly on many counts in the Doing Business 2013 report. Of the 10 indicators tracked by the report, India's rank is worst in Enforcing Contracts, where it is ranked 184th out of 185 countries:

1. It takes 1,420 days to resolve a contract dispute.
   
2. 39.6 percent of the contract value is lost, of which 30% is paid out as fees to lawyers.
   
3. Even after getting a judgment in your favour, it takes 305 days to enforce the judgment.

Given the absence of good contract enforcement, after 1988, cheques were often used by the recipient of funds to create a deterrent against reneging. A common method of ensuring regular payment of rent is to use post-dated cheques. The landlord takes the entire year's rent in post-dated cheques. This allows the landlord to bypass the entire rent-controller and court system for evictions when rent is not paid on time. With the voucher from the bank (recording the dishonouring of the cheque), the landlord can file a criminal complaint against the tenant.

This is a bad system of contract enforcement! It is biased towards the party which expects payments and has no remedy to the party which is getting a service or good. As an example, if the tenant sets off some rent because of mandatory repairs which the landlord failed to carry out, the tenant is perfectly allowed to take a defence of `set-off' in a contractual relationship. However, underlying the NI act is a presumption of debt, which will let the criminal case continue till the tenant is able to establish that there had been a valid set-off.

On a similar note, while the existing Section 138 of the NI Act is a draconian idea and bad in many ways, it has interesting positive effects when placed in an environment of bad contract enforcement. Consider the penalties for bouncing a cheque:

1. Imprisonment for up to 2 years, or,
2. Fine up to twice the amount involved, or,
3. Both of the above.

This is draconian, but there is considerable legal certainty. In contrast, when a contract is violated, there is no statutory method for calculating the amount of damages that the violator has to pay. Given the delays in contract resolution, and the legal and administrative costs, which are usually not awarded, the net receipt is generally much lower than the amount owed. Indian courts are not bound by a strict statutory requirement of calculating litigation costs and interest accrued is rarely granted from the date of dispute. For this reason, there was some method in the madness of S.138 of the N.I. Act.

Consequences for courts

The proposed withdrawal of 138 N.I. has not adequately been thought through, in terms of the implications for the judiciary and the legal system. It is being argued that for many cases, arbitration will be done. However:

1. What about the increased civil court burden? As argued above, post-dated cheques were used as a substitute for contract enforcement services of civil courts. When this mechanism is no longer available, there will be a surge in contract disputes. This flow of cases will atleast partially counteract the de-bottlenecking of courts that will come from removing cases associated with S.138.
2. Where will we get the increased number of arbitrators? There are very few arbitrators in India, and there is no institutional system of providing arbitration services outside the larger cities.
3. Who will bear the costs? The costs of arbitration are very high in India. While it may be appropriate for large businesses to internalise their dispute resolution mechanisms, smaller businesses should have access to a court system.
4. Will arbitration be faster? There is no standardised procedure in the arbitration system in India for cheque bouncing cases. Evidentiary and procedural variety will lead to more challenges in appeal and increase the burden of the judiciary where every appeal will have to be checked for procedural propriety.
5. Does the judiciary have the bandwidth to cope with the case load that will appear for review? Orders of arbitrators will be appealed to the higher judiciary. In many cases the courts will have to intervene to appoint arbitrators.
6. Will people write more bad cheques? The authority of the arbitration system is based on the efficiency of the court system. The rational violator knows that the arbitral award will go to the same over-burdened judiciary where penal costs are rarely imposed, so there will be little incentive to honour arbitration awards.

Conclusion

S. 138 of the N. I. Act is a reminder to us of the complexity of public administration reforms. When liberal democracy works well, it is a Rube Goldberg machine with immense complexity of many moving parts. Simplistic reasoning will almost always lead us astray with unintended consequences. Hurried changes of law (such as those produced through weekend drafting projects) will almost always go wrong. Well done law will almost always require enormous effort, will require sophisticated thinking about incentives in envisioning legal effects, and will involve a certain element of complexity.

Faced with a problem like S.138 of the N. I. Act, what is a thinker of government to do? There is a real opportunity in thinking outside the box. The solution to making payments lies not in making cheques work better but in fundamental change in technology: by moving to electronic payments. All these problems go away if you pay me on an electronic system, and within one second, I know whether I got the money or not. Our job is to dematerialise money, just as we have dematerialised shares. This will also require consequent changes in the Payments and Settlement Systems Act, which has mistakenly copied S.138 of the N. I. Act. This requires new thinking in financial policy so that India can get to a sensible payments system.

Electronic payments is of course no substitute for the public goods of contract enforcement. India desperately needs a good legal system, which comprises laws, lawyers and courts. But in this specific case, the storm of complexity associated with cheques is actually something that can be completely side-stepped. Amidst the debate around S.138 of the N. I. Act is a failure of imagination on policies about the payments system.

FSLRC ki ABC

We worked with CNBC Awaaz to make simple video content, in Hindi, about FSLRC. The overall 24 minutes of this video is composed of six self-contained capsules of 4 minutes each.

Fluctuations of the rupee

I have a column in the Economic Times today titled Do not mourn rupee fluctuations.

The methodology for identifying dates of structural change in the exchange rate regime is from Zeileis, Shah, Patnaik, 2010.

You may find The rupee: Frequently asked questions, 1 December 2011, to be of interest.

The demise of Rupee Cooperative Bank: A malady

by Radhika Pandey and Sumathi Chandrashekaran.

The facts: A troubled decade for the Rupee Cooperative Bank (2002-2013)

It was a little over a decade ago when Rupee Cooperative Bank (RCB) began to show signs of distress. In 2002, the bank faced a liquidity crisis due to non-recovery of loans, prompting RBI to appoint an administrator for the bank. This involves the bank coming under the supervision of the administrator, and is usually accompanied with the bank losing the freedom to carry on certain basic functions, such as accepting deposits or giving out loans.

In the case of RCB, after five years under the 'supervision' of administrators, fresh elections were held and a new board of directors was elected. The task at hand for the new board was to recover overdue loans of Rs 360 crore. As things turned out, they could not recover the full amount. Over the years, RBI's watchful eye on the bank did not wane. In 2011, RBI imposed a fine of Rs 5 lakh on RCB for violating its directives regarding the limits and scope of business permitted to be carried out by cooperative banks. The violations included discounting a cheque for an amount higher than Rs 25,000; and releasing a loan of over Rs 25 lakh for land purchase which exceeded the general limits set by RBI for cooperative banks. In 2012, another similar fine was imposed because RCB had unauthorisedly sanctioned cash credit facility exceeding Rs 1 lakh to four customers.

Anyone looking at the dateline of events would expect trouble to be looming large ahead. Earlier this year, with effect from close of business on 22 February 2013, RBI placed RCB under harsh restrictions, under the Banking Regulation Act, 1949. There were also restrictions on banking activities - RCB would not be able to grant or renew loans and advances, make investment, incur liability (i.e., borrow funds or accept fresh deposits), disburse or agree to disburse payments, enter into compromise or arrangement and sell, transfer or otherwise dispose of any of its properties or assets, and so on. RCB has not as yet lost its license, according to the RBI, which issued a clarification that the directions should not be construed as cancellation of banking licence.

Before the directions were issued, six directors of RCB had resigned in early February 2013 "over differences on loan recovery". A day after the directions were issued, on February 24, the six directors withdrew their resignation "to work in the interest of the bank". RBI would not have any of it, and dissolved the Board of Directors on 26 February. In its place, it appointed a two-member administrative board, chaired by a career bureaucrat, and an experienced administrator, who had earlier handled the merger of another bank with a public sector entity.

Why is this a malady?

These events have been bad for the depositors. They are now allowed to withdraw only upto Rs 1000 per account. Effectively, they have lost their money (other than what is protected under deposit insurance).

What is the source of this malady?

Cooperative banks, being cooperative societies that offer banking services, have a peculiar status in India because of how the two subjects are treated in the Constitution of India: 'cooperative societies' are a subject of state governance; whereas 'banking' is a subject of central interest.

There are legal arrangements that permit RBI to partially handle cooperative banks, but managing the failure of cooperative banks has problems:

1. Long delays before RBI takes serious action: The administration of a bank is given multiple opportunities to salvage its position. RCB, for instance, showed early signs of distress in 2002, but was permitted to stay alive for over a decade before final directions were issued. The position of cooperative banks is perhaps more problematic because of the political stake involved: some of the more prominent cooperative banks failing in the recent past died a slow death because high-ranking politicians were associated with them.
2. Long delays to close down the failed bank: The process of managing the failure of a bank is slow, and the tools available to RBI are limited. This problem, in theory, is shared by all failing banks. In practice, however, most failing banks have been only cooperative banks, which are therefore at the receiving end of procedural and administrative delays.
3. Long delays for claim settlement: Due to the frequent failure of cooperative banks, combined with fixed deposit insurance premiums, the DICGC invariably has to pay out claims of an order far higher than premiums collected from these banks. This hits the ordinary depositors the most, who, in the case of cooperative banks, are more likely to be small depositors, from the unorganised sector, farmers, or small traders.

The Centre is not entirely powerless when it comes to cooperative banks. Under Part V of the Banking Regulation Act, RBI has some micro-prudential powers with respect to cooperative banks, similar to but significantly weaker than those it has with respect to commercial banks. But the application of these powers is made difficult, particularly in the context of winding up of cooperative banks, because of the centre-state arrangement.

Additionally, the Deposit Insurance and Credit Guarantee Corporation (DICGC), the RBI subsidiary that pays out to depositors of failed insured banks, covers ''eligible cooperative banks'' under its deposit insurance scheme. Eligible cooperative banks, according to the DICGC Act, are those functioning in such states/union territories that have amended their Co-operative Societies Act to incorporate two features: first, that RBI may order the concerned Registrar of Cooperative Societies to wind up a cooperative bank or to supersede its committee of management; and second, that the Registrar may not take any action of its own accord for winding up, amalgamation or reconstruction of a cooperative bank without prior sanction from RBI.

The IFC solution

The Financial Sector Legislative Reforms Commission (FSLRC), through the draft Indian Financial Code (IFC) offers a solution to this malady. While other solutions are possible, the present centre-state governance arrangement allows only limited room for maneuver with regard to the resolvability of cooperative banks.

The IFC creates a Resolution Corporation, which will resolve financial service providers that show signs of financial distress. This would include those who offer banking services. The Resolution Corporation will detect financial trouble at an early stage and will be empowered with a significantly more robust set of tools to close down a failing financial service provider than the RBI is presently empowered with.

The IFC recognises that the process of resolving failed financial institutions is closely intertwined with micro-prudential regulation. Therefore, the IFC provides for a structured framework of regulatory intervention and information-sharing between the micro-prudential regulator and the Resolution Corporation. The Resolution Corporation will have a wider mandate than the present DICGC. It will be responsible for prompt resolution of trouble financial service providers and for paying compensation to the consumers of failed financial service providers.

Under the IFC, the Resolution Corporation has the duty to insure (Section 260):

(a) each consumer of a specified category of covered obligations with a covered service provider to the extent of a specified limit; and
(b) each covered service provider to the extent of a specified limit.

The IFC permits the Resolution Corporation to manage the failure of only eligible financial service providers who fall within the ambit of micro-prudential regulation. This narrower class of financial service providers are referred to as ''Covered Service Providers'' i.e. those who make covered obligations. How is this determined?

The ultimate goal of resolution is consumer protection. Keeping this goal in mind, the specified categories of covered obligations, who will fall within the ambit of the Resolution Corporation, will be determined by the Regulator, in consultation with the Resolution Corporation. The determination will be based on the following principles Ssection 260(4)) :

(a) the detriment that may be caused to consumers if obligations owed to them are not fulfilled by a covered service provider;
(b) the lack of ability of consumers to access and process information relating to the safety and soundness of the covered service provider; and
(c) the inherent difficulties that may arise for financial service providers in fulfilling those obligations.

In addition to the financial service providers who make covered obligations based on the above principles, the class of covered service providers will also include systemically important financial institutions (SIFIs).

These principles are in consonance with the test for the intensity of micro-prudential regulation that is followed in the IFC. Applying these tests on the activities of cooperative banks shows that similar obligations are made by such banks to their consumers, and they would logically be covered by the Resolution Corporation. By extension, cooperative banks that make such obligations will have to apply for Corporation insurance, and in order to do so, will have to first submit to the micro-prudential regulatory conditions set by the regulator.

Therefore, for cooperative banks, it will no longer be sufficient for RBI to be empowered to order the State Registrar of Cooperative Societies to liquidate, amalgamate or reconstruct a cooperative bank, or to supersede management. Instead, in order to be eligible for insurance from the Resolution Corporation), State governments will have to co-opt RBI as the banking regulator of cooperative banks in that state under law. Upon becoming eligible for Corporation insurance, cooperative banks would be charged premia according to their risk position. This is contrary to the present practice of collecting fixed deposit insurance premia from all eligible banks.

If the State governments do not co-opt RBI as the banking regulator under law, then banks such as RCB would not be eligible for insurance cover from the Resolution Corporation, and by corollary, may not be permitted to carry on certain types of activities that need Corporation protection (refer to the discussion earlier on specified obligations).

Cooperative banks that are regulated poorly, or not at all, because of the present dual regulatory arrangement, will continue to pose considerable risks to the soundness of the financial system until some drastic changes occur. The IFC, being a central legislation, comes with its challenges, because it is not able to directly impinge on what is otherwise a subject of state supervision under the Constitution of India. But through structural design, it is possible to compel the State governments to embrace the well-defined regulatory and supervisory expertise of an RBI and a Resolution Corporation as laid out in the IFC.


The authors are grateful to Smriti Parsheera for useful inputs.

Author: Suyash Rai

Suyash Rai is a researcher at the National Institute for Public Finance and Policy.

On this blog:

• The economics of releasing the V-band and E-band spectrum in India, 9 February 2018.
  
• A Pragmatic Approach to Data Protection, 29 May 2018.

• Movement on the law for the Resolution Corporation, 19 June 2017.
• Notes on Union Budget 2017-18, 9 February 2017.
• What does the tax data tell us about the state of the economy?, 16 January 2017.

• The Demonetisation Decision: Event, Impact, Narrative and Meaning, 2 December 2016.
• Questions of law in demonetisation, 18 November 2016.
• Trumping black money, 16 November 2016.
• Does the role of the Rajya Sabha in the legislative process require reform?,  12 January 2016.

• Going from strong as in scary to strong as in capable, 25 February 2015.

• Rethinking the policy framework in coal, 27 October 2014.
• RBI vs. Uber, continued, 18 September 2014.
• A dramatic cost reduction for KYC using the e-KYC API of UIDAI, 14 September 2014.
• Shutting down Uber in India was unwise, 24 August 2014.
• Difficulties with Special Guidance and General Guidance in the IFC, 11 February 2014.

• Taking a stand on the equity risk premium in India, 17 July 2013.
• Identifying each individual in financial firms that performs customer-facing functions, 8 June 2013.
• Regulatory strategy for savings/investment schemes, that would address ponzi schemes, 30 April 2013.
• Correctly defining the scope of financial regulation so as to block ponzi schemes, 30 April 2013.

• RBI vision document on payments: An evaluation, 5 July 2012.

Identifying each individual in financial firms that performs customer-facing functions

by Suyash Rai.

The growth of the Indian financial system has generated opportunities for individuals to get jobs in sales and distribution roles. It is easy for individuals to switch jobs, and with that it has become easier to indulge in abusive practices, enjoy the financial benefits that accrue, and leave the firm before the consequences become visible. There is ample anecdotal evidence about sales persons and agents who have got away scot free after doing the wrong things. These individual stories add up to the overall evidence at the level of the financial system of an upsurge of difficulty in consumer protection.

This problem is greatest with agents, who can switch between firms more than employees can. Similarly, sales persons switch easily from a field such as banking to another such as insurance.
For many in this field, the prevailing notion is that some individuals in sales and distribution are bad eggs and must be stopped. While there is some value in this perspective, it is important to not blame the entire failure of consumer protection in India upon individuals. Deeper reform of the system is required, as is envisaged in the consumer protection framework of the draft Indian Financial Code.

While we strive to build systems that generate better financial health for consumers, even in the most pro-consumer system, it will be possible for individuals to indulge in abusive practices, and leave before the consequences show up. This is because of certain inherent features of financial products and services:

• For many products (eg. pensions), the consequences take years to be realised.
• Much of the discussion between a salesperson/advisor is verbal, and, even if a written advice is insisted on, it is possible to lie or mislead an unsuspecting consumer.
• Internal control systems usually work with random checks, and do not catch everybody, but consumer abuse must be comprehensively prevented or redressed.

Logically, this potential for harm goes with the potential for doing good - outliers will be on both sides. Ex-post action on consumer abuse must involve understanding what happened, compensating consumers, and punishing those responsible. This has a deterrent effect as well. In the present system, if the individual has moved on, little can be done against him. The firm has to take responsibility, and it has no recourse to the individual.

This is a malady, and a system must be developed, at least within the financial system, to keep track of individuals. This is important not just for punishment, but also for research on how different profiles, trainings and experiences lead to different consumer outcomes.

A recent initiative pushes in this direction. Association of Mutual Funds of India (AMFI), under direction from SEBI, has now notified regulations that speak to this concern. Every individual (employee or agent) dealing with the consumer is now required to be assigned an Employee Unique Identification Number (EUIN), which will be a permanent number. EUIN can be used to keep track of the individuals even as they switch jobs. This is a good step, but, given the generic nature of the sales/advise skills, this will work well only if all sub-sectors in finance adopt this approach.

The registration requirement in the Indian Financial Code

When something needs to be done by everybody, it is a good idea to put it in the law in some form. The draft Indian Financial Code (IFC) encodes this idea of identifying the individuals who deal with consumers. Section 104 of the IFC mandates every financial service provider to ensure that any individual dealing with consumers in connection with the provision of a financial product or financial service is registered with the Regulator. The provision also empowers the regulators to specify pre-conditions for registration in respect of different financial products or financial services.

Registering individuals with regulators will be expensive. Nothing in the IFC prevents the regulators from allowing self regulatory organisations or product manufacturers to implement the process and send a batch file to the regulators, who would just supervise the integrity of the process. The draft Code does not interfere with such efficiency.

If this provision is enacted, over time, the database of registered individuals will develop. It will start showing interesting patterns, and firms and regulators will be able take preventive measures, as well as strict action against abusers. The idea is necessary and will go a long way in solving this malady.

Conclusion

SEBI and AMFI are doing an interesting thing. In the short term, it will have a limited effect as IRDA and RBI and FMC and PFRDA are not part of this initiative. In addition, we should see consumer protection as a much bigger question, of which pinning responsibility upon employees is only one component. When the Indian Financial Code is enacted as law, the capacity building that would have taken place at SEBI and AMFI in building the EUIN will be a useful building block.

Iran may have developed offensive cyberwar capabilities

After Stuxnet, Iran seems to have developed offensive cyberwar capabilities, possibly with Russian help.

Catnip, organised by me in chronological order. First, the Stuxnet story:

• Israeli test on worm called crucial in Iran nuclear delay, by William J. Broad, John Markoff, David E. Sanger, in the New York Times, 15 January 2011.
• A declaration of cyber war, by Michael Joseph Gross in Vanity Fair, April 2011.
• Obama order sped up wave of cyberattacks against Iran, David E. Sanger, New York Times, 1 June 2012.
• Confront and conceal by David E. Sanger, 5 June 2012.
• Stuxnet: Leaks or lies, Steven Cherry interviewed Larry Constantine, IEEE Spectrum, 4 September 2012.

And then, the recent developments:

• Cyberattacks against US corporations are on the rise, by David E. Sanger and Nicole Perlroth in the New York Times, 12 May 2013.
• New computer attacks traced to Iran, officials say, by Nicole Perlroth and David E. Sanger, in the New York Times, 24 May 2013.
• Silent War, by Michael Joseph Gross in Vanity Fair, July 2013.

Interesting readings

Indian historical linguistics in the Economist.

A lecture by Lant Pritchett titled Folk and the formula - Pathways to capable states.

Anil Padmanabhan on Myanmar in Mint.

A great travel story from Nagaland.

Trampling on the individual in India: Saurav Datta in the EPW, and Spicy IP, on the attack on a blogger by the Times of India.

I was in Los Angeles when the Rodney King incident took place, and I thought to myself that when video cameras become ubiquitous in India, it will really make a difference to the behaviour of the police. One is seeing some examples of this, and the exponential rise of video-capable phones will help. In Canada, some are carrying this further: mounting a camera on every policeman. Also see Tarun Wadhwa in Forbes.

Who will audit the RBI? by K. P. Krishnan.

N. Sundaresha Subramanian in the Business Standard about what the independent directors of Ranbaxy were thinking and doing in 2004.

Regulation that is attacking something that is not a market failure: Tarun Shukla in Mint on forced hiring of domestic pilots.

Somasekhar Sundaresan on what SEBI should do on its 25th birthday.

Ila Patnaik on the messy issues of defining FDI, portfolio investment and foreign control.

Ellen Barry in the New York Times tells the story of the flight of a key figure in Russian economics: Sergei Guriev. A country that cannot keep its intellectuals safe has no future. Also see.

Mohammed Hanif has a great piece in the Guardian looking back at the elections in Pakistan.

China's economic empire by Heriberto Araujo and Juan Pablo Cardenal in the New York Times.

A group of musicians in Lahore have an original take on Everybody hurts by R.E.M. Video.

A true war story by Simone Gorrindo.

The role of the board

The board is a critical ingredient of well functioning public bodies. The board must:

1. Have a big picture of the objectives of the organisation;
2. Get pushed, through accountability mechanisms, when these objectives are not being achieved;
3. Lead the top level thinking about the organisation chart and resource allocation, so that the organisation is constantly reshaped so as to fit its purpose;
4. Exert direct influence on key policy choices so as to push the management team towards delivering results.

In India, we lack experience with boards that perform these functions. All too often, organisations are little dictatorships where the chief executive holds all power and jealously resists any other influences upon decision making. I have been in situations where a chief executive stoutly claims that a policy discussion is not an appropriate matter for discussion in the board.

The draft Indian Financial Code works hard on establishing high quality boards, on establishing a sound work process for the board including powers of the board, and on setting up accountability mechanisms through which failures of the organisation would feed back to the board. This kind of establishment of the board is a critical component of the governance process.

In the Indian Express yesterday, Ila Patnaik and Shubho Roy reflect on the irrelevance of the RBI board. The Cobrapost expose showed a huge supervisory failure of the RBI. The entire board meeting of the RBI should have been devoted to identifying why this failure took place, and coming out with a list of actions through which things would change in the future. Instead, the board meeting dealt with things like skills development for horticulture.

SEBI does better than RBI on the role and functioning of the board, reflecting the fact that the RBI Act is ancient and these provisions in the SEBI Act are only around 20 years old. But with SEBI also, there is a lot to be desired about the working of the board.

Bureaucrats are not stakeholders

Indian democracy has become quite focused on bringing views of all stakeholders into the policy debate on any question. That is a good thing.

I have an article in the Economic Times today, where I argue that while we do this, we should be careful to not treat officials as stakeholders. When the merger of Indian Airlines and Air India is being evaluated, all viewpoints should be brought to bear on the decision but one -- the views of existing employees of Indian Airlines or Air India.

Should policy makers favour home ownership?

The argument in favour of home ownership

Many people believe that more home ownership is a good thing. It is felt that people who own homes have a greater incentive to get involved in local politics as they have a stake in higher house prices. In contrast, people who rent lack this commitment device. Indeed, in a short run sense, a person who is renting benefits when the neighbourhood goes bad : his rent goes down.

From the viewpoint of the individual, renting is always better as it preserves flexibility. Owning a house imposes limitations on the locations where one could live and work, as the frictions of moving home are substantial. This biases individuals in favour of renting.

In the four-part classification scheme of market failures (monopoly power, asymmetric information, externalities, errors by consumers), this falls under the heading of externalities. If home owners become better citizens and better voters and induce better urban governance, this induces positive externalities upon all residents of cities. To the extent that this is the case, some elements of State policy should favour home ownership, so as to counteract the market failure.

This argument has limited value in India today, given that urban governance is organised in a terrible way. We have just not established the feedback loops of accountability from voters to the city mayor. Even if a voter wanted to get involved in more political action, and wanted to nudge his city administration forward, he does not have the levers to do so. If one only looked at the India of the present, we would reject this externality argument and say that there should be a pure level playing field between owning and renting.

Or, one could be an optimist and think that in the future, as the political system is reformed, these feedback loops will fall into place. One could then argue that large scale home ownership sets up interest groups today that have a stake in cities doing well in the future, as their portfolio value is bound to the quality of the city. The presence of such interest groups may help increase the probability of political system reform, when households get worried about potential damage to their portfolios as a consequence of urban mis-governance.

Today we're highly distorted in favour of owning

If one started out at a undistorted market, one could have a reasonable discussion about whether there is something intrinsically good about owning as opposed to renting, and possibly envision whether levers of policy might be applied to favour home ownership, and the scale of intervention that is justified. In India today, unfortunately, the game is highly stacked against renting:

1. Tax policy favours owning in the divergent treatment of interest payments as deductible versus deductibility of rent.
2. Rent control laws inhibit renting.
3. High inflation disrupts rental contracts by forcing repeated renegotiation. 
4. House owners that are corporations have not yet emerged. It is, hence, hard to find professional contracting in this field. Search costs are high, and there are often restrictions such as owners that won't rent to single women or muslims out of social conservatism. Our failures on property as a fundamental right, and on achieving a capable judiciary, have led to the risk of expropriation when the renter is elderly, a journalist or a lawyer. This has the perverse effect of diminishing access to rented houses for such persons.
5. Contracts are frequently disrupted, which induces costs of moving and frictions such as fees to brokers.
6. Less than professional owners imply that many practical issues such as smoothly functioning utilities don't work out properly. Under home ownership, a person has the incentive to make sure that utilities work correctly. With renting, this falls between the cracks and the service level is often poor.

The game is thus highly stacked in favour of owning. We need to level the playing field in favour of more renting.

The problems of home ownership

From first principles, the ownership of an illiquid asset (a home) diminishes flexibility. A person who lives in a home is much less likely to move.

In India, we need to achieve massive migration flows. Large scale migration will generate better matching between the requirements of the labour market at various locations all over India, and the requirements of production. Large scale migration will break down tribal and ethnic loyalties.

A country where people easily up and move is one in which the labour market is more flexible. This is a blessing and has consequences such as milder business cycle fluctuations. That's a different kind of market failure. The State should favour renting as this gives a more flexible labour market which yields milder business cycle fluctuations, which induces gains for all. Every person who owns a house imposes a negative externality upon everyone else in the form of a more inflexible labour market.

On this theme, here is a fascinating new NBER WP by Blanchflower and Oswald. The abstract says: We explore the hypothesis that high home-ownership damages the labor market. Our results are relevant to, and may be worrying for, a range of policy-makers and researchers. We find that rises in the home- ownership rate in a U.S. state are a precursor to eventual sharp rises in unemployment in that state. The elasticity exceeds unity: a doubling of the rate of home-ownership in a U.S. state is followed in the long-run by more than a doubling of the later unemployment rate. What mechanism might explain this? We show that rises in home-ownership lead to three problems: (i) lower levels of labor mobility, (ii) greater commuting times, and (iii) fewer new businesses. Our argument is not that owners themselves are disproportionately unemployed. The evidence suggests, instead, that the housing market can produce negative ‘externalities’ upon the labor market. The time lags are long. That gradualness may explain why these important patterns are so little-known.

Turning to international finance, the objective of international risk sharing is to remove home bias. In the real estate context, what works best is for a person in Bombay to rent a flat owned by Japanese investors and for a person in Tokyo to rent a flat owned by Indian investors. This achieves risk sharing: each party avoids the risk of real estate fluctuations that are correlated with the main portfolio which includes human capital. Capital controls that interfere with such investments are an obvious mistake that need to be removed. But as in trade integration, once overt restrictions are removed, an array of institutional factors that impede cross-border interaction come to prominence.

For the risk-sharing outcome (homes in Tokyo owned by investors in Bombay and vice versa), we need real estate to be owned by professional companies that rent it out. The shares of these professional companies, or securitisation instruments that generate cashflows out of rental streams, can then be purchased by foreign investors. As long as real estate ownership is in the hands of individuals in India, we will suffer from home bias with too much of the portfolio of residents being invested in local instruments. This is another dimension of owning versus renting that we need to keep in mind; we are better off when there is less home ownership.

Conclusion

Most people assume that home ownership is a good thing, that a country is better off if more people own homes. Like most interesting questions in public policy, the story is more complex than meets the eye. There are two different externality-based market failures running in different directions.

At present, in India, the first externality (more home ownership makes people better citizens) is absent since urban governance is unresponsive to voters. The only externality at work is running in the opposite direction (more home ownership gives a less flexible labour market). In the short term, policy should work on pushing towards more renting.

In the long run, urban governance in India might improve, and then we would need to understand the magnitude of these two opposing effects, and then one could choose whether it's worth pushing in one or the other direction. If one can't quantitatively estimate these things, then a cost benefit analysis is not feasible. The best thing is then to do nothing.

In either event, the mainstream view -- that policy makers should push in favour of more home ownership -- needs to be questioned.