Thursday, March 19, 2009

At the heart of the problem is the task of fixing the financial architecture

Hank Paulson has an article in the Financial Times where he emphasises that a key part of fixing financial regulation in the US is the task of changing the architecture of financial regulation. This is essential for avoiding problems like AIG being regulated by the State of New York. As he says:

Creating a fundamentally different regulatory system is complex and will take months, if not years. But policymakers can achieve significant near-term regulatory reforms that represent progress towards the ideal. These include giving the Fed expanded powers to regulate market stability, combining the Office of Thrift Supervision and the Office of the Comptroller of the Currency to strengthen regulation by reducing duplication, centralising the scrutiny of mortgage origination, creating an optional federal insurance charter, beginning the process of integrating the Securities and Exchange Commission and Commodity Futures Trading Commission and continuing to improve arrangements for clearing and settling over-the-counter derivatives, including development of well regulated and prudently managed central clearing counterparties for OTC trades.

For some of the background, see this speech, and see here.

Like many democracies, the US is very bad at solving such problems under normal times. The SEC vs. CFTC separation was a silly thing to have, but for decades, it has lingered on. Now, in the aftermath of this crisis, there's a good chance that it will get fixed. I hope the merged agency draws its organisational culture more from the CFTC than from the SEC.

In the UK, the architecture was fixed in the late 1990s: regulation of all financial firms was placed at the FSA; investment banking for the government was placed at the DMO; the Bank of England was given independence in return for (a) transparency (b) accountability and (c) a narrow mandate to only do monetary policy. The gap in that framework was the lack of a deposit insurance mechanism akin to the US FDIC; this is now being fixed. In the new framework, FSA regulates banks; when FSA makes a decision that a bank is in a bad way, the bank gets handed to the Bank of England which chooses whether to give liquidity support or to shut it down. For the rest, the basic structure of agencies and laws is fine, unlike what's seen in the US.

In India also, the deeper problems of Indian finance are critically about the accidents of history, which have given us a warped financial architecture. The RBI Act, the FC(R) Act, SC(R) Act, etc., were all done decades ago when knowledge of finance in India was absent. That task before us is that of now replacing all these badly drafted laws by sensible ones.

In the UPA period, we have understood these problems and done a lot of the technical work that lays the groundwork for what comes next. The task for the next goverment is to implement this technical work. The regulation and supervision of all organised financial trading needs to be placed at SEBI (thus merging functions that are presently at FMC and RBI); banking needs to come out into a BRDA; the regulation of all pension activities (and not just the NPS) needs to be placed in PFRDA; the investment banking for the government that's presently done at RBI needs to go out into a professional and independent Debt Management Office (which is termed NTMA). At the end of this, we would be holding four regulators (SEBI, BRDA, IRDA, PFRDA), one investment banker (NTMA) and one independent central bank.


  1. why should we have 4 regulators in india as you suggest, SEBI and the 3 RDA's. there are problems already existing between SEBI and the IRDA wherein the indian investor is being taken for a ride by the distributor who escapes regulation by playing one against the other.

    when we device a solution it should not be half baked wherein the problems of turf are not resolved. therefore it is imperative that we have just on regulator for all types of asset class and all types of intermediaries and investors.

  2. Ajay:

    Let's face paulson is coming out with spinning words, but the fact remains, GS folks managed to save their rear. They made AIG a scape goat. Not to say AIG was clean, but it just got magnified... where was LB's bailout...

    Reg. our regulations: why not have one regulatory authority?

  3. the regulatory enviroment in UK may undergo a major change with the Turner report. looks like the soft touch approach to regulation may be overhauled.

    what is your view in terms of india follwing the UK model, given that the UK model will change in the coming months.

  4. There are strong arguments for having separate regulator for commodity derivatives. Commodity is a global asset, whereas the security is country-specific. One cannot equate commodity to security because of the ADRs and GDRs. The purpose of commodity derivatives is price-risk management whereas the purpose of security market is return on investment. Trading in security or its derivatives is a zero-sum game, whereas commodity derivatives can have positive and negative externalities. The focus of commodity regulator is to ensure that pries reflect the fundamentals, whereas the securities regulator is happy if the settlement of contracts is smooth.A veterinary doctor, though a doctor cannot be allowed to operate on human beings. Some appear to have penchant for convergence of regulators. Then how was the opportunity to have a unified regulator for pension missed? If the key question is quality of human resources, who is to certify, which regulator should has better human resources and capacity. Can it be said about SEC and CFTC or even FSA? Who is to judge the judge? The experience shows that every regulator, credit rating agency and free-lancer public policy economists sitting in judgment, have their share of problems. I therefore do not agree with the prescription, which, it appears to have been mooted initially to enable NSE to extend its monopoly to commodity derivatives segment, but was opposed vehemently by all other stakeholders on the above grounds. Stalwarts like Dr. Rangarajan endorsed such separation. I have full faith in objective assessment of Dr. Rangarajan, whose professional integrity is beyond doubt.

  5. Your comments seem to be anger against NSE rather than analysis of the type of regulation needed. Even the US treasury secretary is talking about a British model.

  6. Has this crisis not seriously tested all regulatory design as it stands, both the messy US version and the principles-based, separation-of-powers UK style? The common element is perhaps that they both seem to have been politically induced to fall asleep at the wheel. This is not the traditional form of capture by lobbying (as these bodies are nominally independent) but capture by ideas. What is truly remarkable is that, in the wake of the crisis, these ideas are not being questioned, most especially not by this fantastic blog.


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