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Rediff News  All News  » Business » Britain has a cure for India's ailing banks, Mr Rajan are you listening?

Britain has a cure for India's ailing banks, Mr Rajan are you listening?

August 18, 2015 10:32 IST

In 2009, Lord Turner's main message was that Britain and the world had been following the wrong policy model and the time had come to look for a better way of doing things.

Image: RBI governor Raghuram Rajan addressing a press conference after announcing the monetary policy in Mumbai. Photograph: PTI

Remember 2005-08? When a group of dedicated economists launched an all-out attack on the Reserve Bank of India (RBI)?

There followed two major reports that sought to lay the intellectual groundwork or this.

One was the Percy Mistry report, funded by the finance ministry; the other was the Raghuram Rajan committee report, funded by the Planning Commission. RBI more-or-less boycotted both.

Then, Lehman Brothers crashed in September 2008, followed by the global crash a few weeks later.

All the assumptions and certainties of the previous 15 years, when finance ruled the roost — which means there was a lot of money to be made on commissions and fees — went up in smoke.

In December 2008, Gordon Brown, then the prime minister of Britain, asked a committee headed by the chairman of the now defunct Financial Services Authority of the UK, Lord Adair Turner, to review the British financial system.

The report, known as the Turner review, was given in record time, in March 2009.

Section 1.4 of that report spelt out the theoretical and philosophical issues.

Its main message was that Britain and the world had been following the wrong policy model and the time had come to look for a better way of doing things.

Basically, said Turner, the indulgent “boys-will-be-boys and let-them-do-what-they-want” view of the financial world was grossly flawed. Financial firms needed reining in.

This conclusion was almost entirely ignored in India.

Turner’s advice

This is what Turner had to say: “The financial crisis has challenged the intellectual assumptions on which previous regulatory approaches were largely built, and in particular the theory of rational and self-correcting markets.

Much financial innovation has proved of little value, and market discipline of individual bank strategies has often proved ineffective.”

The rest of the world paid heed.

Not India, where the move to dismantle RBI’s powers gained momentum.

Given the scant attention the Turner review has received in India, the time has come for the principal advisor in the finance ministry to make a summary of it for the minister.

He has a right to be acquainted with it so that he at least asks the right questions of the economic Taliban.

The review blamed macroeconomic imbalances, inadequate bank capital and the need for better liquidity regulation and “financial innovation that was of little social value” for the 2008 crisis.

On bank capital, the review asked for “counter-cyclical capital buffers, building up in good economic times so that they can be drawn on in downturns, and reflected in published account estimates of future potential losses”.

Most important, it strongly recommended “a central role for much tighter regulation of liquidity”.

That is, no free for all and a very strong regulatory agency, like RBI.

One of the strongest underpinnings of the argument to lower market regulations is that markets are both efficient and rational.

However, as the review points out, “market efficiency does not imply market rationality”.

The fact that prices move somewhat randomly and cannot be predicted from any movements in the past does not preclude the possibility of “self-reinforcing herd effects and of prices overshooting rational equilibrium levels”.

The review then goes on to break down the assumption of individual rationality.

“There are, moreover, insights from behavioural economics, cognitive psychology and neuro science, which reveal people often do not make decisions in the rational front of brain way assumed in neoclassical economics, but make decisions which are rooted in the instinctive part of the brain, and which at the collective level are bound to produce herd effects and thus irrational momentum swings.”

The need for a boss

The review then goes on to say that, even if an individual is rational, a collection of individuals certainly is not. Any marketing major worth his degree will tell you this.

A consumer is not a thinking animal, he is usually a feeling animal — led around by emotional manipulation, rather than rational convincing.

The same holds true for any individual, really.

In such a scenario, where nothing really works as predicted, the need for a strong regulator becomes all the more important.

That’s why, the world over, the aftermath of the financial crisis has been one of consolidating regulatory responsibilities under one body, mostly the central bank.

The roles of a central bank are varied, but one of the most important has to do with inspiring confidence in a system that works so largely on sentiment, as the current financial system does.

In addition, it would do well for economies to have roles delineated.

Here is what Turner had to say: “When crises occur, it is national central banks which have to provide lender-of-last-resort support and national governments that provide fiscal support.”

And, when it comes to reposing in the central bank all the responsibilities of securing financial and macro prudential security, the review minced no words.

“The arguments for combining responsibility for the prudential regulation and supervision of all financial market sectors, e.g. banking and insurance, are very strong, with no apparent counterarguments,” it said.

“Macro prudential analysis should cover all sectors: Problems in the banking industry and trends in bond prices can, for instance, have significant implications for insurance companies.

And, any separation of prudential regulation and supervision creates the risks of inadequate coverage and regulatory arbitrage.”

Combining the central bank functions with the prudential supervision of banks has some clear advantages, such as ensuring an integrated approach to liquidity risk management.

That is why this war on RBI is totally misplaced. It is quite literally taking an axe to one’s own foot.

If something really needs to be done, then it should be in the region of enabling communication between the regulatory bodies we already have — RBI, Sebi, Irdai, et al — so they can share from each others’ expertise.

Discarding that expertise in favour of a new, and frankly superfluous, system is not only silly, it borders on the suicidal.

The sooner the government sends these ideas to the trash bin and deletes forever the better.

TCA Srinivasa-Raghavan was associated in the writing of RBI’s history

TCA Srinivasa-Raghavan