Interesting readings

Ramchandra Guha in the Hindu on Narendra Modi.


Asif Ezdi writes in The News about how Indian culture is undermining Pakistan's `distinct way of life, values and language, which we have successfully preserved through the centuries in an alien and hostile environment'. The loony right in India thinks similarly about Valentine's day. It's interesting to see that Ezdi retired from the Foreign Service.



A lot of new material has come out about the draft Indian Financial Code; I have been updating my blog post on this.

Joseph Sternberg in the Wall Street Journal, on family businesses in India.

Manoj Nagpal in Mint on what NPS is doing wrong.

Bibek Debroy says that something big is brewing on the Delhi-Bombay Industrial Corridor with `NMIZ's.

The SEBI/IRDA conflict was a pivotal event in financial sector policy of recent years. Everyone interested in the field, and in the problems of consumer protection in India, should read Deepti Bhaskaran's interview with outgoing IRDA chairman Hari Narayan in Mint.

Big Cats in Our Backyards: Persistence of Large Carnivores in a Human Dominated Landscape in India by Athreya et al in PLOS One.


A great article by Husain Haqqani in Foreign Affairs about the US-Pakistan relationship.

Mira Sethi has a great piece in Caravan magazine about contemporary politics in Pakistan.


Joseph Sternberg in the Wall Street Journal on how industrial policy in China, on rare earths, has backfired.

Living with less. A lot less. by Graham Hill, in the New York Times, helps us go back to basics.

Francis, Hasan and Wu, 2013 find that professors are valuable in the board room.

For the first time, in 2013, the sum total of Windows installs will be smaller than the sum total of iOS installs.

Watching your body more effectively, by John Hewitt on ExtremeTech.

Obtaining liquidity for illiquid stocks

The problem

While there are thousands of listed companies in India, for all practical purposes, stock market liquidity is the exclusive preserve of large companies. For small securities, the conventional continuous market presents daunting problems of liquidity. In conventional continuous trading, the price is made by the orders that come in from one second to the next. However, within a few seconds, there may not be many orders. The price may get swayed sharply by one large order.

An illiquid market suffers from two main problems: Investors suffer large transactions costs when entering and exiting, and there is a heightened danger of market abuse. Market abuse is the falsification of information about prices, spreads, turnover, etc. Innocent participants get sucked into making wrong decisions about investment when they see prices, spreads, turnover which are not the result of normal market forces, but are caused by a deceptive scheme. The possibility of market abuse, in turn, deters market participation and exacerbates illiquidity. This sets up a vicious cycle where fear causes illiquidity, illiquidity engenders market abuse, and the presence of market abuse causes fear. Detecting and blocking market abuse is the central function of infrastructure institutions and regulators.

While illiquidity is partly inherent to the listed firm, it is also influenced by the market design. There are mechanisms through which an improved market design can yield improved liquidity. As an example, when we moved from floor trading to continuous screen-based trading in India, liquidity improved.

The call auction

An alternative design -- the call auction -- helps address this problem. In a 30 minute call auction (say), orders that come in over a 30 minute period are pooled. The equilibrium price is worked out based on the supply and demand over this 30 minute period. This is likely to be a more robust price when compared with the price that is discovered moment to moment, under certain circumstances. 

In India, at present, the call auction is used in three settings:

1. The opening price is discovered using a call auction. This allows the market to absorb overnight news.
2. When trading halts owing to a circuit breaker (i.e. a large price movement), the news is absorbed into the market using a call auction when trading recommences. Example.
3. At first listing (or after re-listing), the price discovery in the first 60 minutes is done using a call auction.

In general, trading through call auctions is not exciting to securities firms since turnover is more limited. However, call auctions are good for investors (zero impact cost), issuers (lowered liquidity premium) and the economy at large (reduced market abuse).

SEBI announcement on new market mechanism for illiquid stocks

On 14 February, SEBI announced that for illiquid stocks, the market design shall constitute a series of one-hour blocks in the day which are call auctions. The SEBI circular gives a precise definition of what constitutes an illiquid stock. This is a fairly big initiative: it will affect 263 stocks on NSE and 2050 stocks on BSE. The new market mechanism will be in place from Monday the 8th of April onwards.

If this works well, it will have four effects:

1. From the viewpoint of investors, the ability to enter and exit a stock with zero impact cost should yield a reduced liquidity premium. The valuation of stocks that trade through the call auction should be better when compared with the valuation of stocks that trade in the continuous market, where the round-trip transactions cost (i.e. two payments of impact cost, at entry and exit) can be a substantial expense.
2. When an episode of market abuse comes together, there are extreme fluctuations of prices or turnover. This should take place to a reduced extent; the problems of market abuse are smaller for illiquid stocks under the call auction.
3. For unsophisticated investors, the call auction is more attractive as there is a reduced possibility of market abuse. Firms in this mechanism should be able to achieve a more diversified investor base. This would also yield an improved valuation.
4. The price in the call auction, revealed each hour, should be a better estimator of true value when compared with the price seen under continuous trading. There should be fewer departures from market efficiency, such as mean reversion. This will reflect a combination of two effects: avoiding the temporary price pressure associated with illiquidity, and avoiding market abuse.

Reflections on the regulatory process at SEBI

Now that the draft Indian Financial Code is in front of us, we see regulation-making in new light. This gives us a fresh perspective upon what SEBI has done. Why does SEBI use a `Circular' as a legal instrument? The only two legal instruments that SEBI should use are Regulations and Orders. It is nice to see that this circular was discussed at an Advisory Council (the existing SEBI SMAC). However, the SEBI document does not do enough in terms of analysis. What is the problem that this regulation seeks to solve? How will this intervention solve this problem? What are the costs and benefits? Where was the notice-and-comment period?

S.59 of the draft Code requires that three years after the issue of regulations, a review should take place. It requires measuring the costs and benefits. The clarity of articulating objectives (e.g. points 1..4 above) becomes the natural frame through which this review would be done. The extent to which these four outcomes are achieved constitutes a mapping of the benefits.

When we think of how one specific regulation (e.g. period call auction trading for illiquid securities) would work out under the Code, we see that the superior regulation-making process embedded in the Code would  push regulators towards more thought, and thus improve the quality of regulation-making.

Sunshine in the court room

by Pratik Datta.

In the functioning of liberal democracy, some of the strongest transparency provisions are required for the judiciary. Indeed, openness of trials is integral to the legitimacy of the judiciary. Secret trials are almost always rigged trials.

'Sunlight is said to be the best of disinfectants'. So observed Justice Brandeis in 1913. Almost a century later his observation would find use in naming a Bill in the US - the Sunshine in the Courtroom Act. This Bill paves the way for broadcasting of all federal court proceedings in the US. This is a big step forward for liberal democracy. With this, we step up from the traditional notion that any citizen can make himself present in the courtroom, to a new level of transparency where we are utilising computer technology so as to make courtrooms visible to all citizens. Currently the US Supreme Court website provides access to audio recordings of all oral arguments before it, which may be downloaded or heard online.

On a similar note, the Supreme Court of Canada provides a live feed of all appeals to the Canadian Parliamentary Press Gallery. The Supreme Court of Victoria in Australia permits audio webcasts of some judgements and sentences are streamed live and are available for listening to on demand. The hearings before the UK Supreme Court are televised live.

In comparison, no Indian Court has any facility to record transcripts of the oral arguments made by the counsels, nor are there any official records of remarks made by judges inside the Court room. The only source of these oral conversations are media reports which are not quite reliable. In one instance, the Supreme Court issued a suo moto contempt notice to a newspaper for misreporting court proceedings leading to an unconditional apology by the newspaper.

So does India need to legislate for sunshine in court rooms? Recent controversies suggest that it may be time for us to start thinking about audio-visual coverage of court proceedings:

• A 54 year old Government school teacher was detained in a Delhi Court for video recording of the court proceedings of a CBI case in which his relative is an accused; (link)
• An Indian origin law professor from the US sought permission to record court proceedings. The High Court hearing reportedly turned into an altercation between the Judge and the Professor, and security personnel confiscated the recorder; (link)
• A businessman recorded a court proceeding without taking permission of the Court, prompting a Single Judge of the Delhi High Court to order a mental examination of the person. However, subsequently this order was set aside by a Division Bench of the Delhi High Court.

In all these incidents, the concerned individuals wanted to make audio-visual recordings of specific court proceedings but were denied the opportunity. In an era where Parliamentary debates are televised/streamed online, this judicial reluctance to permit recording of Court proceedings seems absurd and archaic. Two informative pieces (here and here) on this issue also conclude in favour of recording Court proceedings.

Judicial reluctance and legislative void

Whenever the Indian Courts had to pass a reasoned order explaining why an individual may not be permitted to make audio-visual recording of any judicial proceeding, the usual response has been the lack of any law or policy to permit the same. The usual trait of judicial activism in Indian judges is curiously missing in this regard.

In Deepak Khosla v. Union of India, 182 (2011) DLT 208, Deepak Khosla (the petitioner) approached the Delhi High Court to restrain the Registrar General and the Registrar of the Delhi High Court from preventing him from audio recording the Court proceedings. The matter first came up before a single judge, who referred it on to a larger bench. The larger bench observed that there is no specific provision of law mandating audio-visual recording of Court proceedings. Citing a catena of decisions on judicial restraint, the Court concluded that 'framing of a rule is a matter of policy'. Since there is no legislative policy allowing audio recording of Court proceedings, the Court refused to provide any relief to the petitioner. The Court further went on to refuse a certificate of appeal to the Supreme Court under Article 134A of the Constitution, since in its considered view, the case did not involve a 'substantial question of law of general importance'. However, reportedly in another matter, the Supreme Court has expressed willingness to examine the proposal of audio-visual recording of proceedings.

Treatment in the Indian Financial Code

In this backdrop of judicial reluctance coupled with a policy void regarding audio-visual coverage of court proceedings, the work of the Financial Sector Legislative Reforms Commission ('FSLRC') assumes special significance. FSLRC has delivered a draft law along with its report. This draft Indian Financial Code, 2013 ('IFC'), which forms Volume II of the Report of the FSLRC, has a path-breaking provision on the issue of recording and transmission of proceedings at the proposed Financial Sector Appellate Tribunal (FSAT). Section 431(2)(e) imposes a duty on the registry of the FSAT to enable public viewing of proceedings, including by way of transmission of hearings by electronic means. Section 438(4) of the IFC states: The Tribunal must ensure that the entire proceedings of the Tribunal are recorded and published. This is undoubtedly a great leap towards bringing transparency in judicial functioning in India.

However, the draft provision in its present form may not provide the nudge required to override the existing judicial reluctance towards audio-visual recording. Section 438(5) gives the Presiding Officer (that is, the Judge in the FSAT) the discretion to prevent 'publication' for reasons to be recorded in writing. In a departure from the usual principles-based drafting style adopted by FSLRC, section 438(5) does not specify what are the exact principles in accordance to which the Presiding Officer can prevent publication of recordings of the proceedings. The duties imposed on the Presiding Officer under section 428(2) are too general and might be counter-productive. For example, on the grounds of fair trial under section 428(2)(b)(i), the Presiding Officer may impose a blanket prohibition on publication. In other words, the law does not lay down any objective parameter which restricts the discretion of the Presiding Officer to prevent such publication. This leaves unfettered discretion in the hands of the Presiding Officer to refuse publication.

The unwarranted reluctance of the judiciary

Before trying to hunt for an alternative formulation of the law on this point, it is necessary to understand the reasons for judicial reluctance towards audio-visual coverage of court proceedings. The classic conundrum quis custodiet ipsos custodes? (who will guard the guards themselves?) is squarely applicable to judges. The judiciary which pro-actively passes judgments mandating complusory audio-visual recording of legislative proceedings, takes recourse to absence of any legislative policy to prevent individuals from recording judicial proceedings. This contradiction is not unique to Indian judges, but has happened in other advanced common law jurisdictions too. Daniel Stepniak in his treatise Audio-Visual Coverage of Court: A Comparative Analysis tells us how judges who had otherwise been vigilant in promoting transparency and freedom of speech, somehow do not seem very inclined to open up their Courts to media coverage and the consequent public scrutiny.

Judges of the US Supreme Court are vocal about their uneasiness in front of the camera. For example, Justice Souter (US Supreme Court) was clearly not amused at the idea of having a camera in his Court as is evident from his remark before a congressional committee in 1996: the day you see a camera come into our courtroom its going to roll over my dead body. Chief Justice Rehnquist (US Supreme Court) was more concerned about the loss of mystique and moral authority that might result from camera exposure. An interesting piece in the New York Times reports that Justice Sonia Sotomayor and Justice Elena Kagan have turned against audio-visual recording of Court proceedings after their elevation to the US Supreme Court.

The judicial reluctance on audio-visual coverage of the court room stems from the fact that judges, left to themselves, do not have much incentive in permitting the camera into the court room to enhance transparency. The world over, there has been a tripatite tussle among the rights of the press to report court proceedings, the litigant's right to a fair trial and judicial reluctance towards having a camera in the court. Stepniak shows how this judicial reluctance is slowly yielding to demands for more open justice.

The way forward for us in India

There are two lessons to be learnt. First, public choice theory applies to judges as much as it applies to any bureaucrat. The law must not presume that the judge will permit audio-visual coverage of his court to enhance transparency. Therefore, the default rule should be to compulsorily record and publish (as has been correctly hardwired into section 438(4) of the IFC). However, the law must clarify that such recording must be done officially by the FSAT's administrative staff only and it must not allow private persons or media personnels to use their own devices in the Court room. Otherwise it may lead to administrative problems in managing court rooms. Everyone must be permitted free and easy access to such official audio-visual recordings of the Court proceedings and such recordings should be published.

Second, any provision that gives power to the judge to restrict coverage must mention the conditions subject to which such restriction may be imposed. Otherwise, untrammelled power will be a potential tool for pepetuating the existing judicial reluctance towards cameras in court-rooms. Drafting these conditions into the law will entail a survey of similar legal provisions in other jurisdictions. For example, section 218(3)(c) of Judiciary Law of New York instructs the judge to evaluate:

• The type of case involved;
• Whether the coverage would cause harm to any participant in the case or otherwise interfere with the fair administration of justice, the advancement of a fair trial, or the rights of the parties;
• Whether any order directing the exclusion of witnesses from the court-room prior to their testimony could be rendered substantially ineffective by allowing audio-visual coverage that could be viewed by such witness to the detriment of any party;
• Whether such coverage would interfere with any law enforcement activity;
• Whether such coverage would involve lewd or scandalous matters.

Such an enumerated list of principles in the statute would be of much assistance to a judge in deciding whether an application for restricting audio-visual coverage of a particular proceeding or part of it should be allowed or not.

Conclusion

The IFC is the first draft statute mandating audio-visual recording of proceedings before a Tribunal in India. Considering the growing interest and demand for audio-visual coverage of court proceedings here, this feature of the FSAT could be emulated for other Indian Courts and Tribunals. Laws like the Code of Civil Procedure (1908), Criminal Procedure Code (1973), the Indian Evidence Act (1872), the Contempt of Courts Act (1971), the Indian Copyright Act (1957), the Supreme Court Rules (1966) and the respective High Court Rules may also need to be reviewed. This list is not exhaustive. It is also necessary to fine tune the present draft IFC provision on restictions to audio-visual coverage of court proceedings, as argued above.

The author is grateful to Sumathi Chandrashekaran, Smriti Parsheera and Ambarish Mohanty for useful conversations.

A sea change in the knowledge of the young in India

In 1887, roughly 14 million children were born in India, and we got one Ramanujan. It seems reasonable to think that there were 9 others who went undiscovered. We may guess that the Ramanujan rate is roughly one in a million. Applying this to the 28 million newborns per year that we have today, we may guess that there are 28 Ramanujans being born every year. Our challenge is to find them and nurture them.

So far, we are doing a terrible job of this. Pritchett & Viarengo suggest that while 18% of the 15-year olds in South Korea have a strong knowledge of mathematics, in India, this fraction is only 0.8%. Also see. We are doing roughly 20 times worse than we could, in achieving high quality mathematics knowledge among 15 year olds. Education in India is deeply broken and as long as the status quo remains in charge, improvements are unlikely.

India is experiencing a higher education revolution on quantity. Here is the age-specific probability of having graduated from college, drawn from the CMIE Consumer Pyramids database:

On the x axis are age groups such as age 20-25, 25-30 and so on. On the y axis is the fraction of persons who have graduated from college. The oldest available survey (December 2009) and the latest available survey (September 2012) are shown. We see a sharp surge in today's young, when compared with conditions one or two decades ago, when going to college was much more exotic: i.e. the 40 year olds of today are much less likely to have attended college (reflecting conditions 20 years ago) when compared with the 20 year olds of today. The age profile of educational attainment is a cross-sectional picture that expresses the time-series of historical experience, much like the rings in a tree.

What is remarkable is the increase seen from just 2.75 years ago (the oldest available survey) when compared with the latest data: in the overall population, the share of college graduates went up from 6.14% to 6.97% over this period. There is truly a revolution taking place in terms of the young going to college. The bottleneck is that almost all college education in India today is quite faulty.

Consider the software industry, which is believed to employ 3 million persons today. A wonderful story by Harichandan Arakali and Tony Munroe, from Reuters last week, tells us that the labour market is walking up the value chain; low-grade coding skills don't cut it any more. Most of the young people with freshly minted college degrees are not good enough for the firms. Entry level wages in computer technology have dropped; skill premia have gone up. On this subject, see my article Will BPO hit a staffing crisis? from 2005. I have long felt that it is dangerous for a young person to build job-oriented vocational skill: Broad intellectualisation is essential. What a person needs is the ability to think; the mere ability to code is no substitute.

Most young people in India today are not on a journey that gets them to think. As an example, IGIDR is arguably the best economics Ph.D. program in India today. Yet, I have been disappointed at how many students at IGIDR don't read books more broadly, don't read blogs, and don't read the Economist. While these problems afflict economics more broadly, we seem to face a greater danger of  narrowness of knowledge.

How is a young person to break free of mediocrity? For the first time, we now have a concrete set of answers: Plug into Internet-based education offerings, and read the great books of the world, across a diverse array of subjects. Plug into the blogs, and get connected to the great conversation about the world today.

The game changer is access to world class materials over the Internet. The Internet in general, and Internet-based education in particular, makes a significant difference to how we harness our human raw material. As a working approximation, an undergraduate education in Economics in India teaches little, but a student who will persevere and understand this blog will get somewhere. I recently wrote about the enormous gains that are possible for young people in India thanks to the new world of Internet-delivered education.

In this context, I found a fascinating fact about the nationality of the students at Coursera, which is one of the modern Internet-centric education offerings. Coursera has an enrolment of 2.9 million. The biggest single nationality is the US, at 27.7%. The second ranked country is India, at 8.8%. In other words, 255,200 persons in India are users of Coursera today. I would hazard a guess that across all the modern Internet-based education offerings, the enrolment from India might be 4x bigger than this, or a million. These are large numbers compared with the size of the knowledge workforce in India. And, this is only the beginning.

There is another angle through which the Indian labour market is getting connected up into the world, and thereby global skills, which is through Internet-based systems where the end-customer directly connects to the worker. These can be deployed for all problems where the task definition is unambiguous and payments can be done on a piece rate. While a lot of this is low end work, this is not necessarily the case. E.g. it is possible to pose pretty high skill challenges while retaining the idea of machine-driven verification that the work is done. I wrote a blog post about the fact that roughly a third of the persons working for Amazon's `mechanical turk' are in India. Ghani, Kerr and Stanton have a similar fact from a competitor to Amazon, oDesk. While the bulk of this work is low end, there is also high skill work here.

The overall picture that I see is one of enormous change in education and work in India, with four big themes:

1. There is a surge of young people studying for the IIT JEE (and thus getting up to world class knowledge at age 17), and attending college.
2. They are facing opportunities such as the mechanical turk and oDesk for low end work, and also some high skill work.
3. Indian firms that engage with globalisation are pushing in favour of higher skills; there is a substantial mismatch between what college/university is doing and what the firms want.
4. Internet-based offerings such as blogs and courses are giving access to the world of knowledge that go beyond what colleges and universities in India offer. 

In all four areas, the numbers are big. These are not fringe phenomena; they are of first order importance. World class knowledge is being demanded of the young, and for the first time, they have opportunities to build this knowledge on their own, without waiting for education policy makers to reboot the Indian education system. I feel that this phenomenon -- millions of young people bulking up with knowledge that is qualitatively superior to the knowledge of the old -- is the ultimate growth fundamental for India.

Capacity constraints in public policy

India's failures in defence and international relations

The Economist has a great article about Indian strategic / defence thinking, in which they say:

Strategic defence reviews like those that take place in America, Britain and France, informed by serving officers and civil servants but led by politicians, are unknown in India. The armed forces regard the Ministry of Defence as woefully ignorant on military matters, with few of the skills needed to provide support in areas such as logistics and procurement (they also resent its control over senior promotions). Civil servants pass through the ministry rather than making careers there. The Ministry of External Affairs, which should be crucial to informing the country’s strategic vision, is puny. Singapore, with a population of 5m, has a foreign service about the same size as India’s. China’s is eight times larger.
...
With the army training for a blitzkrieg against Pakistan and the navy preparing to confront Chinese blue-water adventurism, it is easy to get the impression that each service is planning for its own war without much thought to the requirements of the other two. Lip-service is paid to co-operation in planning, doctrine and operations, but this “jointness” is mostly aspirational. India lacks a chief of the defence staff of the kind most countries have. The government, ever-suspicious of the armed forces, appears not to want a single point of military advice. Nor do the service chiefs, jealous of their own autonomy.
...
Instead of clear strategic thinking, India shuffles along, impeded by its caution and bureaucratic inertia. The symbol of these failings is India’s reluctance to reform a defence-industrial base that wastes huge amounts of money, supplies the armed forces with substandard kit and leaves the country dependent on foreigners for military modernisation.
Since independence India has got away with having a weak strategic culture. Its undersized military ambitions have kept it out of most scrapes and allowed it to concentrate on other things instead. But as China bulks up, India’s strategic shortcomings are becoming a liability. And they are an obstacle to India’s dreams of becoming a true 21st-century power.

The malaise is deeper

I think the malaise that is described here is a reflection of something deeper: a failure of capacity in the public policy process, across the board. This is not just about defence or international relations; it's a gross mismatch between what is required of the government, and the capability of the government, across the board.

In the field of economic policy, we have much the same story. We have multiple squabbling government agencies, all of which are less than capable, and failures of coordination are the norm. We know that the old statist policies are broken, but there is a vacuum in its place. Most persons in the policy process do not have an instinctive ability to focus on the market failure and thus the intervention, when faced with new situations.

India is now a $2 trillion GDP. Macro policy should now be about business cycle stabilisation. The old focus on agriculture and monsoon shocks is a useless way to think about the economy. However, we have simply not reconstructed our economic policy apparatus to reflect these new issues. The Ministry of Finance is not organised as a Treasury should be, and the RBI is not organised as a central bank should be.

Examples of this malaise are plentiful. We made great progress on the political challenges of pension reform, but we have fared poorly on the institutional capacity within government to follow through, to convert the courage of the political leadership into gains on the ground.

Underperformance is writ large across the landscape of the government. The school teachers are missing in action in schools; the police in Bombay was missing in action when the shooting started on 26/11; the central bank was missing in action in the inflation crisis. Consider a mundane problem like surveying the country, i.e. the Survey of India. How hard can it be, to walk around the country with GPS handsets, make map datasets, and release them on a website for download? We in India do a terrible job of this.

How would we make these things work properly? How do we construct agencies that have punch in execution, that are held accountable for delivering results? This public administration question is our problem #1 in India.

Why does the private sector renew itself, but the government does not?

In the private sector, as a thumb-rule, across every doubling of firm revenues, a ground-up rethinking of the organisation is required. The firm has to be re-organised, and brand-new process manuals have to be written. In my intuition, this thumb rule applies in public administration also. Across each doubling of GDP, we need to rethink the block diagram of how government is organised, and write fresh process manuals. At roughly 7% growth, this means we have to do such an exercise roughly every decade. But we in India find it phenomenally difficult to modify the process manuals and boundaries of agencies. This inability to change is a serious bottleneck to achieving competence.

The HR function has just not kept up with the demands. The sheer number of skilled professionals that we have, manning important functions in economic policy, is abysmally small. As an example, you may have heard a lot about the Financial Stability and Development Council (FSDC). It will come as a surprise to you to know that for all the sound and fury surrounding FSDC, at present it has no IT systems and no staff.

Suppose a private firm grew by 2x, 4x and 8x, and it was fossilised and did not re-org. Suppose it clung on to the old organisation chart, old staffing and old process manuals. The mismatch between the organisation structure and the requirements of growth would worsen through time, and exert a negative impact upon the success of the firm. In similar fashion, I believe that every day, as India becomes bigger and more complex, the mismatch (between the requirements of public goods versus the organisation of government) worsens, with increasingly harsh consequences for growth.

Re-organising a firm, rejuvenating the workforce, rewriting process manuals: none of this is fun. It is very comfortable for any group of humans to put off this hard work, to perpetuate the past into the future. Why do private firms not suffer such organisational death? What keeps them moving forward? The external impetus of competition! Private firms do not reinvent themselves because it's fun: the market economy kicks them into shape. Those that won't reinvent themselves tend to fade away.

In similar fashion, left to themselves, government agencies will wallow in the warmth of the past. Strong accountability mechanisms are required in order to make every arm of government uncomfortable in the mere perpetuation of the past. Every time we see a fossilised government agency, we should go to the root cause: A failure of accountability.

Fixing one area: Finance

FSLRC is unique in constituting a full rethink of the landscape of law and agencies in one field (finance). Reasonable men can disagree about what is the ideal legal framework for finance. But all of us can agree that the Indian Financial Code is a quantum leap compared with the present arrangement.  It is the much-needed reorganisation of government agencies that gets them going with sensible role definitions.

It is one thing to make a nice block diagram, but it is another matter to make each agency perform. This requires two elements: empowerment of the board, and enough pressure on the board to perform. For each of the seven agencies, the Code has empowered boards who would control their own organisation design and HR policy. The Code embeds strong accountability mechanisms, which would push the board and the chairperson to improve organisation design and HR policies. These accountability mechanisms would make it costly for the chairperson and the board of any agency to limp on under present conditions of performance.

FSLRC gives the draft Indian Financial Code

The Financial Sector Legislative Reforms Commission closed its journey yesterday with the delivery of a report and the draft Indian Financial Code (IFC). Here is the report and here is the draft law. Here is commentary in the press on the subject:

• Interviews with Justice Srikrishna: Business Standard, Indian Express, Outlook magazine.
• K. P. Krishnan in the Economic Times.
• Turf war in the offing in the Financial Express, and Selling it right in the Indian Express, both by Ila Patnaik.
• Mobis Philipose in Mint.
• New financial code provides for ponzi-killer, by N. Sundaresha Subramanian, in the Business Standard.
• Sunshine in the court room, by Pratik Datta on this blog.
• The cast of 146 on this blog.
• Falls short on banks, by Dhirendra Kumar in the Economic Times.
• K. P. Krishnan on financial regulatory governance in the Hindu Business Line.
• Financial code provides compounding provisions by N. Sundaresha Subramanian in the Business Standard.
• Will government get a greater say in fixing monetary policy? by Niranjan Rajadhyaksha in Mint. Editorials on monetary policy in Mint and the Hindu Business Line. Parnika Sokhi talks with me in DNA. Errol D'Souza in Mint.
• Anand Sahasraman has a series of posts on the IFMR Blog: The FSLRC approach; FSLRC moots shift in onus of consumer protection from consumer to provider.
• Sandeep Parekh in the Financial Express.
• Will FSLRC recommendations be a game changer? by Shaji Vikraman in the Economic Times.
• Is a unified financial regulator a good idea? Yes, by Biswa Swarup Misra and No by Ashoak Upadhyay, both in the Hindu Business Line.
• SEBI brass feels delay is inevitable, by Samie Modak in the Business Standard.
• Gautam Chikermane on his blog.
• Remya Nair and Kirthi V. Rao in Mint.
• Super regulator pushed back by Megha Mandavia in DNA.
• Surabhi in the Indian Express.
• Editorial in the Business Standard.
• Editorial in the Economic Times.
• Editorial in the Indian Express.
• Editorial in the Business Standard.
• Editorial in the Financial Express.
• Surabhi in the Indian Express.
• Reportage by K. R. Srivats in the Hindu Business Line.
• Remya Nair in Mint.
• Hema Ramakrishnan on the ET blogs.
• Reporting in the Business Standard.
• Aswathy Varughese in DNA.
• Reporting in the Hindu.
• Anindita Rey in the Business Standard.
• K. A. Badarinath and K. R. Sudhaman in the Financial Chronicle.
• Super cop idea spares RBI in the Telegraph.
• Treatment on CNBC-TV18.

The signing:

And a subset of the team that did it:

Important work by cobrapost that illuminates high-powered incentives

The investigative journalism by cobrapost, their videos, and Monika Halan in Mint add up to an important story.

Most of us have enormous respect for the achievements of Axis Bank, HDFC Bank and ICICI Bank. But as Monika emphasises, there are also genuine problems there. We saw it first with the hard-driving mis-selling in recent years, particularly with ULIPs, and now we see it here, with staffpersons supporting illegal activities.

Ordinarily, a media outlet in India bringing such information out has to worry about brazen strong-arm tactics being deployed against them, such as filing of criminal cases. In this case, luckily, there is a certain decency about these three organisations which precludes such concerns. It is ironic that the Indian media vigorously reports on the misdeeds of civilised people, and tends to be silent about uncivilised people.

In India, most of us are reverential about the power of incentives. To make people work, we think, you have to have high powered incentives. We revere incentive packages, stock options, stock grants, which whip the staffperson into a frenzy of hard work.

Economists led this charge, starting with Jensen and Murphy, 1990. The notion that high powered incentives are a good thing came out of academia and went into the real world. But increasingly, it has become clear that there are problems. By 2004, Jensen and Murphy themselves were saying that we should be more circumspect about using high powered incentives.

A person facing high powered incentives tends to focus on one thing. There is an excessive pursuit of that one thing, and all other considerations tend to evaporate. Similarly, when there are quantitative goals alongside qualitative goals, high-powered incentives will generate a focus on quantitative goals and tend to crowd out qualitative goals. Employees of a bank that are given powerful incentives to hit targets for deposit growth (sacked if you don't, given a 100% bonus if you do) are more likely to try to pull in that deposit growth by hook or by crook. If the internal controls of an organisation are weak, then employees are likely to achieve their targets by dubious means.

For all of us in India, coming from a backdrop of socialism and State, it is natural to have extreme hostility to the absence of incentive for a civil servant to do his job. We have seen how private organisations have triumphed by giving employees more incentive. But it's easy for us to overdo this message. In many situations, I feel it's better to go from no incentive to low-powered incentives, but not all the way to high powered incentives.

These issues are widely discussed in the global debate. When we transplant these ideas into India, a big difference lies in the weak governance environment. Super-charged employees in private firms seem to be willing to break laws in their pursuit of profit. Since CEOs weigh the costs and benefits of unethical behaviour, we may argue that when, in a weak governance environment, the expected punishment is small, an increase in the gains from unethical behaviour (through high-powered incentives) results in reduced fairplay. 

This suggests two things. First, HR managers needs to be more sophisticated in how the objectives of an employee are defined. If we could be more nuanced in clarifying what the employee is to maximise, this could yield better results. The second issue is about internal controls. When internal controls are strong, they become a non-negotiable constraint within which growing sales or profit has to be done. Unfortunately, once the top managers of an organisation are really hard-driving, chasing growth and profitability, these kinds of niceties (of both kinds) tend to fall by the wayside.

One of the most important mechanisms through which we get high powered incentives is : an entrepreneur who manages a company with family members, and who has dominant shareholding. The one area where this gets us into the most trouble is: Finance. A series of papers that have analysed the Great Recession have found that financial firms where CEOs had more high powered incentives got into more trouble. I am a great advocate of less public sector and more private sector in finance, but we have to be cautious about high powered incentives e.g. those that go with dominant entrepreneurs in a family business.

A prominent example of this debate has been `financial market infrastructure institutions' (FMIIs), a category that comprises organisations like exchanges, depositories, clearing corporations, all of which produce public goods for the financial system. In all these areas, the organisation is unique in that, alongside the goal of maximising profit, there is a regulatory function. This tiny handful of firms is unique, when compared with essentially any other part of capitalism, in that some government functions of regulation and supervision are placed in private, profit-maximising hands. High powered incentives to produce profit or valuation will lead to a dilution or worse of regulatory and supervisory functions. If profit-seeking owners/managers of these organisations under-emphasise or abuse the regulatory and supervisory functions in the quest for profit, this has far-ranging externalities. Failures of regulation and supervision at exchanges have given macroeconomic crises in India in 1992 and 2001. Hence, even though the revenues and profits of these firms is truly tiny on the scale of the economy, this conflict of interest is an important issue for policy makers.

Similarly, there has been a vigorous debate about entry by private banks. As a working approximation, we have to assume that RBI supervision is less than perfect. In this case, I feel that we should be quite circumspect about banks led by entrepreneurs.