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| Beyond Melting the Pot: | draft recommendations could risk fi nancial stability. In its final report, the |
| On the Financial Sector Blueprint | Committee needs to focus beyond melting the pot by addressing the core aspects of |
| liquidity and efficiency and dealing with | |
| potential risks more explicitly. | |
| MRIDUL SAGGAR |
The draft report of the Committee on Financial Sector Reforms has proposed a financial sector blueprint for creation of a level playing field, introduction of missing markets, greater participation of foreign investors and consolidation of regulation of trading under one roof. While many of the recommendations have merit, the broad approach to reduce regulatory costs, overlaps, silos and gaps appears to be characterised by “melting the pot” to create a homogeneous financial system. This runs the risk of putting financial stability to strain, as also of enhancing institutional and market inefficiencies. The quest for creating more efficient and liquid markets needs to focus beyond melting the pot to addressing the core aspects of liquidity, efficiency and stability, while retaining heterogeneity.
The views expressed in this paper are personal and do not necessarily reflect those of the institution to which the author belongs.
Mridul Saggar (mridul.saggar@kotak.com) is at Kotak Securities, Mumbai.
Economic & Political Weekly
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Rajan’s rigorous research in the area of finance has few parallels. This is evident from over 50 articles that he has published in reputed journals. Each one of them has policy implications. He has buffeted his academic credentials with practical insights on the world financial systems that he gained while advising policymakers in over 185 member countries of the International Monetary Fund as its chief economist for nearly four years. One could not have thought of a better expert to lay down the blueprint for financial s ector reforms. Another 11 very competent experts joined him on the Committee on Financial Sector Reforms (CFSR). Almost an equal number of experts acted as what the Committee calls “virtual members”. Naturally the outcome in the form of the draft report [GOI 2008] has been one of rare insights and several of its recommendations have merits.
However, its approach in totality has been characterised by melting the pot in which several ideas are assimilated with a view to develop a homogeneous financial system in which different players can act similarly to avoid conflict of interests. Creation of a level playing field, missing markets and unified trading regulation are at the heart of this framework. However, this may run contrary to the Committee’s c entral objective to promote more efficient and liquid markets, which are growth friendly. We also argue that some of the
Levelling the Field
The draft CFSR report devotes a full chapter recommending that a level playing field is required in the financial sector. It cogently argues that the public sector banks (PSBs), accounting for 70 per cent of the system, enjoy benefits but also suffer constraints. The constraints are more than the benefits. The ownership structure affects the efficiency with which financial services are delivered. Considering the political constraints in privatising PSBs, it recommends reducing government ownership below 50 per cent while retaining its control. It goes on to make six recommendations (proposals 7-12):
Before one takes up these recommendations one may ask a generic question – why is a level playing field necessary? Do we wish to create clones or preserve biodiversity? Different species can coexist in a good environment, but they need not drink from the same pond. As they may have different requirements, what matters is that the operating environment that they get should be incentive-compatible and efficiency-promoting.
Arguments Not Established
Far too much virtue has been made of the level playing field, suggesting that most financial institutions could slowly or speedily evolve into universal banks. Raghuram Rajan’s own research [Berger et al 2005] argues that with incomplete contracting, smaller organisations can have a comparative advantage in a ctivities that make extensive use of “soft” information.1 They are able to
DRAFT RAGHURAM RAJAN COMMITTEE REPORT
p rovide credit to smaller borrowers at lower transaction costs. Smaller non- financial firms may get rationed out of the credit market by large banks, but smaller financial firms form stronger links. They have more information-intensive relationship with borrowers and do a better job in e asing firm’s credit constraints. The draft CFSR report cites no evidence of its own or others to suggest that universal banks are more efficient. Prima facie this appears likely, but before pressing the accelerator in this direction, greater c onviction is necessary. One cannot j ustify policies for the same merely on grounds of efficiency, if they are seen to be risk-enhancing.
Universal Banking
This is not to say that large financial institutions should be curbed. On the contrary, the report needs to clearly spell out the policy changes it expects and the expected gains and risks out of the universal banking model it espouses. This would help build a political consensus in this direction. One of the gains is obviously economies of scale. Bigger size and lower costs could be important for banks which aspire to be globally competitive. More importantly, it is the scope economies which would make universal banking attractive. The scope economies benefit the bank as well as the customer. The customer gains because a universal bank can offer a full menu of financial services. This lowers search costs for their investment decisions and also helps them to diversify their p ortfolio to attain a right risk-return t rade-off. This may also lower transaction costs for the customers. The bank gains because, in a world of asymmetric information, a commercial bank has better knowledge and monitoring capabilities with its due diligence out of lending relationship that it has already established. So it would be in a better position to act as an investment banker, underwrite an issue, act as a lead manager in an initial public offer (IPO), etc.
However, universal banking also means a bank’s entry into the securities business and by its very nature equity investments are more risky. This is why equity risk-premia has existed over all other competing financial assets [Mehra and Prescott 2003]. In fairness one must say that universal banks have the advantage of supplementing their interest income out of lending with fee-generating business. In contrast, pure commercial banks are dependent on large balance sheets and larger maturity transformation and run a greater risk of asset-liabilities mismatches. If their balance sheets become fragile they often have to convert into narrow banks. This, however, may not always be easy [Ghosh and Saggar 1998].
CFSR apparently encourages the idea of commercial banks entering into the securities business. There have been debates in several parts of the world on whether specialised commercial banks should be allowed to become universal banks and provide additional financial services such as underwriting, brokerages and insurance [Rajan 2002].2 The issue needs to be settled based on the answers to two key questions. First, we need research to answer whether banks will become more, or less, efficient when they become universal banks. The available evidence in other parts of the world seems to suggest that indeed there are efficiency gains by allowing banks to enter into a full range of financial services. Second, we need assurance that a banking firm’s entrance into the securities market would not endanger stability of the banking or the financial system. The Committee needs to spell out how best this can be done.
It needs to be pointed out that universal banking already exists in India in some form, as most banks today have securities affiliates. But some investment banks may be undercapitalised. It is in this context that the CFSR needs to deliberate on the optimal capital structure for banks in India and whether the capitalisation requirements need to be different for universal and commercial banks. It is argued that larger bank capital reduces liquidity creation by the bank but enables the bank to avoid distress and improves the survival rate [Diamond and Rajan 2000]. Considering this trade-off, it is important to have a sense of the optimal capital requirements.
In conclusion, it may be said that the CFSR needs to argue more strongly for removing the regulatory impediments in the way of universal banks, while at the same time making it clear that strong and stable specialised financial institutions, including stand-alone commercial banks, can coexist and need not be seen to have an adverse impact on the efficiency of the financial system. The issue is one of the structure of the holding company.
Constraints of space make it difficult to talk about other recommendations on the level playing field. But there is merit in the stake sale approach to restricted privatisation of the PSBs. Value creation and enhanced efficiency is possible by adopting this approach. Greater access to capital markets may bring in greater discipline and higher efficiency. It is this policy which has helped the PSBs bring about the greatest efficiency gains in post-reform period amongst all bank groups [Mohan 2005; Das and Ghosh 2006].
However, a fuller discussion on the branch licensing policy is necessary before accepting and implementing the committee’s recommendation for completely freeing branch expansion and ATMs. A widely quoted paper [Burgess and Pande 2005] shows that the 1:4 branch licensing policy supported branch expansion to unbanked areas and also helped reduce poverty between 1977 and 1990. The only credible challenge to this finding has come recently [Kochar 2005] through evidence, using an IV-FE model, that the fall in poverty may have been the result of anti-poverty programmes of the government and not due to the branch licensing policy. However, even if branch expansion provided the least cost strategy for poverty reduction in the 1980s, it is highly doubtful if we can achieve the same outcome in the future [Panagariya 2008]. Thankfully, the p olicy choice on branch licensing is not binary, in that either you have a mandated
1:4 type rule or complete freedom. It can be sub stantially liberalised without
NEW
EPW Index 2006
Readers can download the complete author and article index (PDF files) for 2006 from the EPW web site.
The index for 2005 is also available on the same page.
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DRAFT RAGHURAM RAJAN COMMITTEE REPORT
sacri ficing financial inclusion or financial s tability rules.
Creating Missing Markets
The draft report makes seven key recommendations (proposals 13-19) for creating more efficient and liquid markets. They are: (1) bringing all trading under the r egulation of the Securities and Exchange Board of India, (2) creating missing markets such as exchange traded interest rate and exchange rate derivatives, (3) avoiding banning of markets, (4) establishing one consolidated membership of an exchange, (5) setting up of professional markets and exchanges with high order size,
(6) creating financial innovation-friendly environment, and (7) allowing greater participation to foreign institutional investors (FIIs). We look at the first of these recommendations along with other recommendations of the Committee which relate to regulatory architecture. We focus here mainly on the missing markets.
Creation of missing markets is a noble objective provided there is clarity on the reasons why these markets are missing, as also the reasons why they need to be created. The CFSR gives examples of currency and interest rate futures markets as missing. The problem is deeper. In India, there are actually five main missing financial markets. These are: (i) term money m arkets, (ii) corporate bonds market,
(iii) credit derivatives market, (iv) interest rate futures and options, and (v) currency futures and options.
While India’s overnight market is one of the most vibrant with daily average t urnover of Rs 52,194 crore ($ 13 b illion) in 2007-08, the term money market is almost absent with a turnover of a mere Rs 350 crore. The dichotomy here is that most state-owned banks often find it hard to take a medium-term view or do not have the incentive to do so. On the other hand, the more sophisticated traders from new private and foreign banks use the Overnight Indexed Swaps (OIS) to take a longer -tenor view and so bypass the need for using a term money market.3 In this milieu, the CFSR needs to debate and r ecommend if there is a need to create a term money market. If yes, should it be done through regulatory intervention (in which case the principle advocated by the
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draft committee for regulators to keep a hands-off approach would be violated). It also needs to explicitly recommend what specific steps should be taken to encourage the term money market to develop.
The bond market has perhaps been the biggest missing link in the Indian financial markets and there is merit in the argument that both the corporate bonds and the government securities markets are underdeveloped or at least lack in liquidity. Only two or three of the government bonds get actively traded, while the corporate bond market hardly sees any daily trading. So there is clearly a case to further develop both these markets. Sadly, the draft CFSR report has avoided getting into the specifics. The problem of liquidity in G-sec market can be best addressed through consolidation of securities on the fiscal account, with help of securitisation if necessary. In the case of the corporate bonds, the Patil Committee [GOI 2005] had clearly charted a path. The CFSR now needs to spell out where and why it d iffers. It can do the following: (i) look into why repo in corporate bond could not be kickstarted, (ii) how settlement risk can be minimised in corporate bonds, (iii) review the prudential norms for credit enhanced debt instruments, and (iv) suggest ways to start market-making in this segment of the market. Market-making would be critical, as in the absence of price discovery, repos in corporate bonds cannot take off. Parti cipants would not have prices to execute the ready leg deal.
Clearly, there is also a case for enhancing FII investment in the bond markets and recent moves in this direction are in sync with this objective. The Committee, however, may like to give its opinion on whether the corporate bond markets need to be as open as equity markets for FII investments and whether the absence of a level playing field between these two markets affects the leverage choice for the corporates and if that impacts the real investment decisions of the firms. If in principle, symmetry is necessary between the two markets, is it best achievable by free c apital mobility in both or with reasonably liberal FII limits that are consistent with capital account management in face of the impossible trinity? One does need a recommendation on the policy instruments and choices when markets are open to f oreign investments and when exogenously determined excess global liquidity threatens to damage macroeconomic and financial stability.
Nobody doubts the need for credit derivatives and structured products. The credit derivatives market was toyed with but has been temporarily shelved by the regulator taking into account the kind of risk management practices prevailing in the banking system and the lack of clarity on the full dimensions and implications of the ongoing credit market crisis in the US. Even if markets are not casinos, there is a case for a fuller evaluation. Our entire approach to the reform process has been marked by gradualism, but with credible steps forward with minimal backtracking.
That the CFSR has zeroed in on interest rate and currency futures as the key missing markets is somewhat surprising. Currency futures still comprise less than 2 per cent of the worldwide currency markets that remain essentially over the counter (OTC). Similarly, OTC interest rate forwards and swaps are far more popular than futures. Furthermore, the draft CFSR report does not take cognisance of the recommendations of the groups set up by the Reserve Bank of India on interest rate and currency futures [RBI 2008a; RBI 2008b] with the sole exception of suggesting that the RBI report on interest rate futures as a principle should not suggest the timing for the market. However, alignment of market timing is a legitimate regulatory activity which is consistent with orderly growth of the markets. In its absence there could be chaos in the financial markets. Since the recommendations of the two RBI reports are in the public domain and are being actively pursued for implementation, there is merit in the CFSR giving a specific opinion on these recommendations. It can also say whether in totality the approach envisaged for reintroduction of these markets would work or modifications are needed therein. There are several issues which merit CFSR’s attention. For example, one needs to deliberate whether futures in themselves would fill a substantial part of the missing markets or if options are equally necessary, or if at least options on futures could be considered. One also need to take a view on cash versus physical
DRAFT RAGHURAM RAJAN COMMITTEE REPORT
delivery in the futures market. Clearly the cash-futures arbitrage link is best served when physical deliveries are given primacy. Similarly, one needs to have a view on the weight which may be accorded to speculators versus genuine hedgers. The ongoing debate in the fully developed financial markets of the US is instructive. One needs to read the testimony of Michael Masters [US Senate 2008] to understand that while markets are not casinos, they can become such if left unconstrained. He squarely blamed the Commodity Futures Trading Commission of the US for inviting increased speculation that has led to the current surge in global commodity prices. It is in this context that one may reiterate that merely recommending the principle of creating missing markets would serve very little. Given the expertise of the Committee, it needs to delve into deeper and specific issues so that legitimate concerns are addressed.
On other recommendations, one would agree that markets should never be banned. One needs to put an appropriate market microstructure and risk management systems to avoid the need for banning markets. However, consolidated membership on an exchange may require several cross margining issues to be settled and this should not end up debilitating the risk management systems. Segmentation of the exchanges into public and professional exchanges can come in the way of liquidity and access of market finance for smaller players. When a common order book works so well for equity markets, where is the need for segmentation of institutional and retail participation on exchanges? Institutional investors are anyway able to trade OTC, the exchanges help increase the reach of retail investors by offering transparency and liquidity on a common platform. The issue of domestic entities as hedge funds needs to be handled with care as hedge funds are not regulated entities. While their i nitial corpus is made up of contribution from high networth individuals (HNIs) and entities looking at alternative investments for higher returns, it is their excessive leverage that draws in the banking system that raises systemic concerns. Therefore, while hedge funds can be p ermitted, the scope of participation by other financial institutions in these hedge funds would need to be settled upfront. A small amount of Securities Transaction Tax (STT) may be legitimate in highly liquid financial markets. It would also be le gitimate to bargain reciprocity before equal access to foreign banks is granted, unless the CFSR establishes that nonreciprocal access is welfare-enhancing, analogically the same way as unilateral tariff reduction may be superior to preferential tariff reductions.
One need not overplay the superiority of market finance to bond market finance or of the latter to bank finance. The financing hierarchies are not settled. All these markets can coexist and flourish. If markets or bond finance were indeed superior, what about the revealed preferences of household portfolio choices. Even in the current decade, the share of bank deposits in household saving in financial assets has been 40 per cent against just 3 per cent for shares and debentures. It is difficult to ascribe this entire gap to the lack of a level playing field. Not all savers have investment preferences for securities. Bank finance has an advantage in terms of better evaluation of the credit quality, while bond markets may have the advantage of lower transaction cost and better price discovery.
Regulatory Architecture
The regulatory architecture proposed by the Committee is a convex combination of a single super-regulator and the current
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DRAFT RAGHURAM RAJAN COMMITTEE REPORT
| model of multiple regulators. The draft | things. First, that uniform entities with |
| report acknowledges that there is no per | level playing field such as those modelled |
| fect regulatory system. The problems with | on universal banking principle are more |
| Northern Rock in the United Kingdom are | efficient than the specialised institutions |
| being attributed to the working of the | which exist in our financial system and |
| Financial Services Authority (FSA), with | offer product diversity. Second, that if a |
| the monetary authority having no super | level playing field is given, there would be |
| visory powers. At the same time, the Bear | a quick convergence of various financial |
| Sterns debacle in the US is being attr | institutions through M&As or by expan |
| ibuted to the absence of a single supervi | sions and restructuring so that large com |
| sor. So it goes on to suggest better coordi | plex conglomerates emerge with more |
| nation between regulators so that sys | uniform characteristics. There is no evi |
| temic risks are recognised and tackled in | dence for either. So possibly it does make |
| a coordinated way. It clearly states that, | some sense to have different regulations |
| “it is premature to move fully towards a | for different institutions at least at the |
| single regulator at the moment”. It then | present stage. As for single market regula |
| goes on to propose (i) consolidation of | tor, it would possibly make sense if and |
| all market regulation and supervision | only if two conditions are met. First, the |
| under the SEBI, (ii) consolidation of all | financial markets are completely inte |
| deposit-taking entities under one bank | grated and, second, the players in differ |
| ing supervisor, (iii) consolidation of | ent financial markets are common. Again, |
| m onetary policy and banking supervi | neither of these conditions is met. How |
| sion, (iv) bringing all financial inter | ever, one may easily argue that this is |
| mediaries governed by s pecial statutes | more a chicken and egg problem. Once a |
| under general statutes, (v) consolidating | super-regulator with a level playing field is |
| regulation of pensions, (vi) streamlining | in place, these problems would automati- |
| Tier 2 regulators such as the National | cally dissipate. The difficulty with sup- |
| Bank for Agriculture and Rural Deve | porting this view is that it is not clear if it |
| lopment, the Small Industries Develop | is desirable and, second, even if it is desir |
| ment Bank of India and the National | able there is a serious risk that conver- |
| Housing Bank, and (vii) bringing in an | gence may not be smooth and quick and in |
| improved system of audit for listed and | fact may lead to build up of a risk to stabil |
| unlisted companies. | ity of the system. |
| The regulatory architecture suggested, | In practice, it would be difficult to bring |
| by the Committee is a single regulator for | all trading under one market regulator. |
| all financial markets and multiple regula- | The OTC market works quite differently |
| tors for entity regulation. It is as if finan | from exchanges and while a single regula |
| cial markets are distinct from the entities | tor for all exchanges can be considered, |
| which operate therein. One would have at | bringing OTC regulation also under it |
| least appreciated the consistency of logic | appears to be a non-starter. Regulation of |
| had the report suggested unification of all | OTC trades can best be done through entity |
| types of supervision under a super | regulation. Core competencies required |
| regulator, but the wedge in treatment of | for exchange regulation are very different |
| markets and those who operate therein | from that required for the OTC dealings |
| leaves a wide schism in the logic behind | between entities. There appears to be no |
| recommendations. | sound reason to throw out the existing |
| One may ask why it is that the CFSR | system unless one is arguing for a new |
| wants level playing field for all financial | institution of a super-regulator which is |
| market participants, but at the same time | completely independent of the gov |
| different regulators for different entities. | ernment and which is endowed with the |
| The answer is obviously that the entities | best of the expertise from the financial |
| do not have a level playing field, are not | sector at market remunerations. The sug |
| homogeneous in either their balance sheet | gested changes by the CFSR are not even |
| structures or in terms of their goals and | the second best option and have the |
| functioning. So for logically arguing for a | potential for regulatory arbitrage in its |
| single regulator one needs to establish two | extreme form.4 |
| Economic & Political Weekly august 9, 2008 |
EPWNotes
1 Soft information is one which is not codified and is not verifiable, e g, perception of a loan officer from his personal interaction.
2 The debate over the 1993 Glass-Steagall Act which forced banks to leave securities business has been undoubtedly the most cited one.
3 OIS are rupee interest rate swaps where the floating rate is linked to an overnight rate (generally call money rate). OIS is convenient because it e nables entities to manage interest rate risk for flexible periods with small credit risk and virtually no liquidity risk.
4 Regulatory arbitrage refers to the situation where a regulated institution takes advantage of the difference between its real (or economic) risk and the regulatory position. For example, in India banks are required to maintain a CRAR of 9 per cent, but if it faces a low default risk, it may find it profitable to securitise its loans removing the low risk loan from its portfolio. Regulatory arbitrage also means situations where a company alters its nominal place of business to gain from lower regulatory, legal or tax costs. An ultimate form of regulatory arbitrage may occur when the choice of the form of incorporation of business is decided with a view to reduce regulatory costs. We use the term in this latter sense.
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Panagariya, Arvind (2008): India: The Emerging Giant, Oxford University Press.
Rajan, Raghuram (2002): ‘Should Banks Have the Power to Enter All Financial Business’ in A Meyendorff and A Thakor (eds), Designing Financial Systems in Transition Economies, MIT Press, Cambridge, MA.
RBI (2008a): ‘Report of the Working Group on Interest Rate Futures’ (Chairman: V K Sharma), February.
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US Senate (2008): Testimony of Michael W Masters to Committee to United States Senate, May 20.
