Last Updated : Dec 27, 2018 09:50 AM IST | Source:

Opinion | Make financial sector reform mainstream political agenda in 2019

Counterintuitively for a sector that is so heavily dominated by regulatory agencies, the road to reform goes through Parliament

Moneycontrol Contributor @moneycontrolcom

Bhargavi Zaveri

The year 2018 was an overwhelmingly eventful year for Indian finance as it demonstrated all the vulnerabilities of the financial sector and the regulatory architecture governing it. It was the year in which the RBI governor resigned and the central government reportedly invoked formal mechanisms to issue directions to the central bank. It was the year in which several critical regulatory actions of RBI, a regulatory institution that remains relatively unchallenged, were questioned in court a record number of times (herehere and here); and the year which saw some of the most intense debates on the functional and financial independence of the central bank.

In the months preceding these debates, the ILFS crisis demonstrated the fragility of the wholesale funding market, the shallowness of the bond market and the direct impact of this on retail consumers through mutual funds. In March, the Nirav Modi scandal demonstrated the operational weaknesses of poorly managed public sector banks. While the NPA crisis continued to dominate the discourse for such banks, the ongoing troubles with the management of Yes Bank and ICICI demonstrated the governance issues at privately held banks.

Even as the 'mainstream' financial sector struggled with these issues, the fledgling fintech sector that is often seen as supplementing (and optimistically, disrupting) traditional channels of finance, was halted in its tracks. Issues of disproportionate operational burden such as heightened KYC costs and the data localisation mandates as well as an effective RBI ban on crypto-currency, continued to plague the fintech sector.

In short, 2018 can safely be termed as the year that exposed multiple chinks in the armour of Indian financial regulatory architecture, which often prides itself in ring-fencing the country from the impact of the global financial crisis ten years ago. The relentless spate of financial crises in 2018 can potentially dent the trust that people have in formal financial systems. When people lose trust in formal financial systems, they keep their savings in inefficient or un-regulated or under-regulated investment avenues, making them more vulnerable to fraud. Keeping savings away from the capital market impacts capital formation and consequently, overall economic growth. The potential second-order effects of the multiple crises of 2018 underscore the urgent need for pursuing financial sector reform as a mainstream agenda in 2019. Perhaps, counter-intuitively for a sector that is so heavily dominated by regulatory agencies, the workplan largely begins with a legislative agenda. That is, the road to reform goes through Parliament

First, much of the trouble on central bank independence emanates from the text of the Reserve Bank of India Act. A key learning from the independence-and-accountability crisis of 2018 is that the legal foundations for an independent, accountable and a modern central bank in India are weak. As the events demonstrated, the law allows the central government to issue directions to the RBI board in 'public interest'. It specifically empowers the central government to remove members of the RBI board and supersede the RBI board. At the same time, over time, the law has been repeatedly amended to confer wide powers on the RBI exercisable in ambiguous circumstances, without a corresponding accountability framework for exercising these powers. For example, RBI's decisions are not subject to appellate scrutiny by an independent quasi-judicial authority, unlike those of other Indian financial sector regulators, and orders taking enforcement actions against regulated entities are not published in the public domain.

This can be equally said of statutory provisions governing the distribution of RBI's reserves. Unlike legal frameworks governing central banks in several economies, there is no clarity in the RBI Act on the proportion of profits that RBI may allocate to reserve funds or the purpose of the reserve funds; the cap, if any, on reserves; the proportion of profits which must be distributed to the central government; the timing of distribution of profits; and the manner in which these decisions must be made.

In the absence of clarity in the law itself, the decisions on distribution of surplus will be driven by individuals in power. Similarly, as long as the law contains provisions allowing the central government to issue directions and supersede the RBI board on ambiguous grounds, clarion calls for central bank independence will tend to be short-lived and futile. The assumption that these powers will not, never or rarely be used, offers no solace. Equally dangerous is a call for revising the RBI Act to ensure "full" independence, but without asking for an equally robust framework for RBI's accountability.

Second, the ILFS crisis was a manifestation of three deep structural issues in the Indian financial market. It was a stark reminder of the lending needs that NBFCs have managed to serve, in the absence of competition in Indian banking. Even today, public sector banks account for 70 percent of the deposits and advances made, and only two full-banking licenses to privately-held banks have been issued in the last decade and a half. It equally reinforced the liquidity crisis of the bond market and a nearly absent securitisation market that could mitigate the damage to retail consumers and institutional holders by being ready buyers of distressed debt. Most importantly, the ILFS crisis exposed a gaping hole of a sound legal framework for the orderly resolution of financial firms.

This brings us to the NPA problem that was ubiquitous in all public discourse through 2018. So far, the government's strategy for resolving the NPA crisis has been two-fold: to push large distressed assets into the Insolvency and Bankruptcy Code, 2016 (IBC) and repeated rounds of re-capitalisation of public sector banks. However, both of these remain a fool's errand, as neither strategy is sustainable in the long run. For instance, 90 percent of the RBI12 cases are pending one year after they were mandatorily pushed into the IBC. Similarly, indiscriminate re-capitalisation of public sector banks without a credible commitment to improve governance and disinvest over time, creates a vicious cycle of moral hazard and weak micro-prudential regulation. To be sure, although re-capitalisation plans for the government have in the past been linked to performance targets of PSBs, the CAG report on recapitalisation of PSBs (2017) observes that these targets have been abandoned due to various intervening events such as RBI's asset quality review. The back-to-back rounds of recapitalisation incentivise the government, as a shareholder of such banks, to insist on lax asset recognition and provisioning norms for such banks.

The ILFS and the NPA crises owe their origins to faulty micro-prudential regulation and incentive structures built into government ownership. However, these crises equally demonstrate the dire need for a legal framework for the orderly resolution of financial firms in India, an area that the IBC did not touch.

The introduction of a Financial Resolution and Deposit Insurance Bill, which sets out a comprehensive regulatory framework for dealing with stressed financial firms, was a valiant effort on the part of the central government to address this gap. However, its untimely withdrawal,  reportedly over political pressure due to bail-in provisions mistakenly seen as anti-depositor , was symptomatic of the populist inclination that dominates a pre-election year. It is less clear, however, why the bill could not have been pursued after dropping the bail-in provisions.

There are three key learnings for India from the onslaught of financial crises in 2018. First, that no political dispensation can now credibly procrastinate financial sector reform. For the financial markets to continue serving their purpose as engines of growth, reform must be as much a part of mainstream political agenda as economic and job growth.

Second, the time for incremental reform is long gone. Crises of the kind witnessed in 2018 demand structural reforms, such as sound governance frameworks for a modern central bank, and a credible commitment for reducing government ownership in banking. That two of the largest structural changes in the last five years, namely, the IBC and the adoption of inflation-targeting, were achieved through Parliamentary legislation demonstrate the effectiveness of law as an instrument to make such credible commitment. Moreover, much of this reform agenda, being structural, is legislative and cannot be left to regulatory diktats. Several constraints on the governance of public sector banks and the absence of a resolution framework for financial firms, are embedded in the law itself. It is time we re-visit these laws and incorporate our learnings in them.

Finally, like all structural reform, the workplan assumes capacity in the implementing ministry that is able to see the vision, carve-out a coherent and consistent implementation strategy and take the reform through.

The author works with the finance research group at IGIDR. Views are personal.
First Published on Dec 27, 2018 09:50 am
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