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.