Heady Days For Finance

The Economic Times today carried an Op-ed piece written by me. Here it is.

Heady Days For Finance

Exciting proposals to overhaul the financial services sector are on the table — implement them

The financial services sector could be in for exciting times, if proposals now on the table are anything to go by. Many changes are being proposed and if these get implemented, the sector is in for massive churn. Spoiler alert: some legal hurdles could still play spoilsport.

First out of the gates is likely the issue of new bank licences. A range of new players is likely to get a shot at opening new banks. Banking is still considered a coveted business segment in India despite many risks and overwhelming regulation. This is because of two reasons. One, a growing economy will need credit to expand and build new infrastructure. In India only banks can offer savings bank deposits, which work out cheaper than other sources of finance. 

The real fun and games can be expected to kick off when the changes suggested by the Finance Sector Legislative Reforms Commission, a body set up by the finance ministry to look into the raft of laws and structures in financial services and suggest ways to recast them, are implemented. Going by the approach paper released by the commission recently, some of the changes have the potential to be a game-changer.

Under the proposed structure, the financial sector will have seven main pillars. Two proposals stand out. One is to convert the Reserve Bank of India into a pure-play monetary authority (with debt management of government bonds housed in a separate, independent office), one that will enforce consumer protection and micro-prudential laws in banking and payment systems. The second is to create a unified financial regulatory agency by collapsing different financial sector regulators into it: Sebi, Irda, PFRDA and the Forward Markets Commission.

The proposed structure is likely to create a completely new architecture for financial services regulation. The new design will be achieved primarily through re-visiting the sector’s existing legal framework, which is at odds with the changed financial landscape. As the approach paper mentions, the sector is governed by 60 Acts and multiple rules and regulations. According to the paper: “The superstructure of the financial sector governance regime has been modified in a piecemeal fashion from time to time, without substantial changes to the underlying foundations... The piecemeal amendments have generated unintended outcomes including regulatory gaps, overlaps, inconsistencies and regulatory arbitrage.” 

In all the changes being contemplated, there are two legislation-related challenges. 

• The commission is duty-bound to re-examine legislation governing central banking. The RBI Act was enacted in 1934 and is still a ‘temporary’ piece of legislation. But the real issue seems to be designing the right framework that enhances RBI’s independence as a monetary authority, insulated from the executive’s short-term outlook and pressures.

The commission does promise to “…draft a monetary policy law emphasising the issues of independence, enumerated objectives, enumerated powers, and accountability mechanisms.” The RBI Act has to be overhauled since it seems to have been designed to give control to the government, like the power to appoint the governor and his deputies, power to vary their tenure, power to issue directions (after ‘consultation’ with the governor), and so on. The challenge, of course, is marrying independence with accountability. The approach paper says that one of the strategies used globally is inflation targeting. However, RBI has rejected this time and again primarily because most of the factors influencing inflation in India are outside the central bank’s controls.

RBI’s website says: “The formulation, framework and institutional architecture of monetary policy in India have evolved around these objectives – maintaining price stability, ensuring adequate flow of credit to sustain the growth momentum, and securing financial stability.” Enumerating these can be tricky; as goalposts, they need to be moved around every time the landscape alters. 

• The commission has to remember that states also have varying degrees of interest in financial services. These could have a disruptive influence on the normal functioning of financial services. The Andhra government’s intervention in microfinance is a recent example.

The confusion arises because of the legal framework. The Constitution empowers states to legislate on moneylending and moneylenders. As a consequence, there are 22 Acts on money-lending enacted by different states (some states like Andhra and Orissa, have two Acts). However, provisions of these acts, which deal mainly with registering, licensing and regulating moneylenders, are mostly ignored, especially when the moneylenders are politically connected. The conflict heightens when the formal banking system encroaches. A technical working group was set up by RBI in 2006 to study the legislative framework for moneylenders. This group mentioned the need to modify existing legislation, but shied away from suggesting an overhaul of the framework. The commission now has the chance to do so, even if that requires Constitutional amendments.