Friday, December 15, 2006

Financial regulation of a third world country

In the best of times, financial regulation is hard. A lot of the time, in India, we get the financial regulation of a third world country. Business Standard has an editorial linking up three recent developments:

  1. FMC banning advisory services by securities firms on the commodity futures markets,
  2. New guidelines from RBI on derivatives and
  3. SEBI granting BSE a monopoly corporate bond reporting platform.

The editorial says:

In recent days, three distinct announcements have come out, highlighting the low quality of financial sector policy in India. The first element was an announcement from the RBI about financial derivatives. For many years, the RBI has had profound flaws in the treatment of financial derivatives. Unfortunately, the new guidelines make no progress; they are old wine in an old bottle. Derivatives are the foundation of the new approach to risk in a mature market economy. Liquid and efficient derivatives markets change the functioning of every firm in the country, both through direct participation and indirectly through superior financing. Banks are key players in hedging, speculation and arbitrage, which enable the derivatives markets to function. This requires commensurate knowledge in the regulation and supervision of banks. The new RBI guidelines do not put India on the trajectory of becoming a mature market economy.

The second element was an announcement from the Securities and Exchange Board of India (Sebi) about a `corporate bond reporting platform', where a monopoly has been granted to the Bombay Stock Exchange (BSE). This is wrong at two levels. First, the hallmark of a mature market economy is competition, not monopoly. And, if Sebi felt that the right solution was a monopoly, the award of a concession requires a commensurate procurement procedure. Alternatives to the BSE need to be judged transparently based on technical and financial bids.

The third element was an announcement from the Forward Markets Commission (FMC), banning securities firms from offering clients portfolio advisory, portfolio management and other services in the commodity derivative markets. This move is in the wrong direction because the direction for progress consists of building up greater knowledge, greater sophistication and a bigger mass of capital which is able to trade in the commodity futures market and induce market efficiency. In every country, commodity trading has started out as the exclusive preserve of a small group of merchants. The transition to a mature market economy comes about by breaking the stranglehold of this small group of merchants, by broadening participation, by bringing in analytical thinking backed by capital. The FMC is doubtless responding to complaints from traditional merchant communities who find the modern development of commodity futures markets to be a threat. But the FMC has done wrong by giving in to these demands. The FMC announcement is, of course, completely futile because nobody can come in the way of an advisory relationship between person X and person Y. That advice will continue to be given. The only thing that will change is the mechanism through which the advice will be paid for. The FMC has only achieved a greater level of mis-representation in the accounts of both the buyer and the seller of advice. The FMC has lapsed into 1970s-style economic policy, where a ban drives a legitimate activity underground.

In certain aspects of the reforms process, the ruling United Progressive Alliance faces constraints owing to its inability to be tough with the Left parties. Such reasons explain the failure of the UPA government to pass the pension reform Bill. But no such reasons hold back the government when it comes to solving key bottlenecks in the financial sector. These policies of the RBI, Sebi and the FMC are not designed to help India move into the world of developed markets.

At present in India, too much power has been placed in the hands of these agencies without adequate mechanisms for transparency and accountability. When these agencies go wrong in this fashion (or in other ways), the system does not have an adequate homeostatic response.

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