This essay focuses on five pending reform items in the financial sector, namely, moving monetary policy to inflation targeting; modernising the delivery of financial services to the priority sectors and vulnerable and weaker sections; introducing capital account convertibility; moving to a streamlined financial regulatory architecture; and restructuring the banking industry.

This is a compressed version of the 25th Purushotamdas Thakurdas Memorial Lecture delivered in Mumbai on 16 January 2009. The complete version is available at http://www. iibf.org.in/documents/ptml-lecutre.pdf. These are the author’s personal views.

Ashok K Lahiri (ashoklahiriin@yahoo.com) is India’s representative on the board of the Asian Development Bank.

1 Introduction

I

With a majority of historic economic crises preceded by financial liberalisation (Kaminsky and Reinhart 1999), there is a tendency to blame all crises on liberalisation, and for public and political opinion to turn against deregulation. This is what happened after the east Asian crisis of 1997. The report of the Committee on Capital Account Convertibility headed by S S Tarapore, submitted at end-May 1997, had a road map for moving towards capital account convertibility by 1999-2000. The report could not have come at a more inopportune time. Starting with Thailand in June, the countries of east Asia – Indonesia, Korea, Malaysia, Philippines, Singapore and Thailand – the then most rapidly growing economies in the world, were hit by a severe and sudden financial crisis. The Tarapore Committee’s recommendations were pretty much put in the cold storage. Safety first became the watchword of financial sector reform in India. Some argue that we learnt the wrong lessons, and safety was not only the first but also the last consideration.1 There were some reforms, such as, the introduction of the Fiscal Responsibility and Budget Management (FRBM) Act, 2003 and pension reforms. Nevertheless, with the benefit of hindsight, perhaps more could have been done to profit the Indian economy.

India is going through yet another period of seriously adverse external economic developments. The onslaught of a steep commodity boom followed by a severe global financial crisis may have raised doubts about the validity of the reform strategy drawn up in more tranquil times. The doubts need to be dispelled or a new strategy drawn up. Inaction is not the answer. With rising popular aspirations in India and a constant benchmarking with China, delivering high growth and rapid removal of poverty is an imperative for the new government.

Is the long and important pending agenda of financial sector reform, already drawn up by very distinguished experts such as M Narasimham, S S Tarapore, P ercy Mistry and Raghuram Rajan, going to be a victim of the current crisis? The answer to this question will determine the growth prospects of the Indian economy in the medium to long term. This essay f ocuses on five pending reform items: namely, moving monetary policy to inflation targeting; modernising the delivery of financial services to the priority sectors and vulnerable and weaker sections; introducing capital account convertibility; moving to a streamlined financial regulatory architecture; and restructuring the banking industry.

Recommendations of Important Committees

The nine years after the east Asian crisis saw important developments in the Indian economy. By 2002, the east Asian crisis blew over, and in sharp contrast to the past, the focus of monetary policy in India had to shift from managing chronic balance of payments difficulties, to tackling a problem of surfeit on the foreign exchange front. After a gap of 24 years, the external current account recorded a surplus in 2001-02, and remained in surplus for the

EPWRF AD

subsequent two years. It turned into a deficit subsequently, albeit a small one. With buoyant capital flows, foreign exchange reserves almost doubled from $76 billion at end-March 2003 to $145 billion at end-March 2006. By end-March 2006, the Indian economy seemed to demo nstrate a transition to a higher growth trajectory with more secure macro economic fundamentals. Growth in 2005-06 had exceeded 9%, inflation was below 4%, and the foreign exchange r eserves already in excess of 11 months of imports were growing.

With most of the preconditions specified by the first Tarapore Committee (for example, in terms of inflation rate, external debt and reserve adequacy) having been achieved, there was a need to revisit the subject and consider a fresh road map for achieving full capital account convertibility. To examine the issue afresh, the Reserve Bank of India (RBI), on 20 March 2006, appointed the second Tarapore Committee (Tarapore II).

Tarapore II observed that there was progress towards capital account convertibility, but “….on an ad hoc basis and the liberalised framework continues to be a prisoner of the erstwhile strict control system” (Tarapore 2006a: 130). The committee recommended measures such as r eduction of the gross borrowing requirement of the government, adopting the public sector borrowing requirement (PSBR) as a clear indicator of the public sector deficit, setting up of an Office of Public Debt outside the RBI, and a clear setting out of monetary policy objectives jointly by the government and RBI, for fuller capital account convertibility. The committee recommended a gradual approach towards fuller capital account convertibility consisting of three phases: 2006-07, 2007-09 and 2009-11. The substantive recommendations of Tarapore II included raising the annual ceiling on external commercial borrowing (ECB), relaxing restrictions on rupee-denominated and on long-maturity ECBs, easing restrictions on end-use of ECBs, easing up on FII investment in debt securities, and liberalising outward investment by both individuals and corporates.

Two other important committees appointed in recent times by the government and the Planning Commission are the High Powered Expert Committee on Making Mumbai an International Financial Centre headed by Percy Mistry and the Committee on Financial Sector Reforms, headed by Raghuram Rajan, respectively. We shall call the two reports submitted in February 2007 and April 2008, respectively, the PM Report, and the Rajan Report.2

Perhaps the PM Committee report has not attracted the right attention it deserves because of its name. The name may have given the mistaken impression to some that the report is all about making Mumbai an enclave for a few “super-rich investment bankers and bonus-obsessed currency-and-options traders” supplying international financial service to the rest of the world. On the contrary, the PM C ommittee makes it very clear that making Mumbai an International Financial Centre is as much or more about the whole of India as it is about Mumbai. In its report, it argued for introduction of full capital account convertibility, an inflation-targeted monetary policy, a move from a rule- based and fragmented to a principlesbased and unified financial sector regulatory architecture.

The Rajan Committee’s very broad terms of reference included identification of the emerging challenges in meeting the financing needs of the Indian economy, examination of the performance of the various sectors of the financial sector, identification of changes needed in the regulatory and supervisory infrastructure. The committee made 33 recommendations, of which the salient ones can be grouped into six categories: (i) Inflationtargeting by RBI through the repo and reverse repo rates. (ii) Reform of regulatory architecture with principles-based regulation. (iii) Deregulation for more efficiency with opening up rupee bond markets to foreign investors, being more liberal in allowing takeovers and mergers, freeing banks to set up branches and ATMs anywhere, and creation of a more innovation-friendly environment. (iv) Deregulation for financial inclusion by allowing more entry of well capitalised deposit-taking small finance banks, liberalising banking correspondent regulation to allow local agents to extend financial services, allowing a system of exchangeable priority s ector loan certificates (PSLC), and liberalising interest rate on loans subject to full disclosure, transparency and restrictions regarding eligibility under PSLC scheme.

(v) Reforms for financial inclusion by improving the collation of credit history, expediting the process of creating a unique national ID number with biometric identification, and opening up credit bureau information to subscribers subject to verification of “need to know and authorisation to use” of the subscriber; and improving land registration and titling. (vi) Restructure public sector banks (PSBs) by selling small underperforming PSBs to strategic investors and observing outcome; strengthening board of directors, and either creating bank holding companies or bringing down government’s share below 50%.

The three recent reports provide valuable inputs for policymaking. There are a large number of issues on which the two most recent committees have reiterated not only much of what Tarapore II said in 2006, but also what the second Narasimham Committee (Narasimham II) entitled “Committee on Banking Sector Reforms” had emphasised in 1998.3

Perhaps some of these recommendations would have been implemented had it not been for adverse external developments in the form of a large commodity price shock in the world market and for the ongoing global crisis. Before any action could be taken on these recommendations, international petroleum prices started to rise steadily and food prices came under severe pressure. Relative to May 2007, the price of rice and wheat, for example, rose by 197% and 137%, respectively, by May 2008 and March 2008. Simultaneously, with extremely buoyant capital inflows, foreign exchange reserves more than doubled again to $310 billion by end-March 2008.

The rise in world prices got transmitted to domestic prices of primary commodities. Inflation continued to accelerate reaching a peak of 12.91% in the week ending 2 August 2008. Rising inflation b ecame a matter of concern. Some alleged that India was “Too hot to handle” or overheating, because it was growing beyond its growth potential thereby straining its labour force and capital stock and hence engendering inflationary instabilities (Economist 2006).

In response to the inflationary surge, the government and RBI started to act on both the fiscal and monetary front. Relief on the inflation came from the middle of the third quarter of 2008. But as inflation started to decelerate, there was another major problem at hand. The global financial crisis was in full bloom. As preoccupation with curtailing inflation subsided, short-term concerns about risk-proofing the economy from the fallout of world recession became much more pronounced than financial sector reforms.

2 Five Pending Reform Issues

Policies in many countries, for example, the US in recent times, often reflect a preoccupation with short-run firefighting. In every country, however, there is the need for a satisfactory reconciliation of policies appropriate for the short run (to manage the present crisis) with those suitable for the long run (to sustain growth and reduce the likelihood of future crises). With the compelling need to grow and to ameliorate widespread poverty, policies need to have a longer-term vision in India. So, let us now turn to five pending reform issues highlighted by the three r ecent committees.

2.1 Moving to an Inflation-Targeted Monetary Policy

Perhaps it would be appropriate to describe RBI’s approach to monetary policy as a combination of monetary targeting and “just do it” discretionary approach. The objective of monetary policy, like that of overall policy, in India is accelerated inclusive growth with macroeconomic stability. The issue, however, is essentially one of Tinbergen’s “assignment rule”: what objective do we assign to which policy? Both the PM Committee and Rajan Committee have strongly recommended the move to an inflation-targeted monetary policy. In contrast, Tarapaore II has recommended a real effective exchange rate (REER) rule. It reiterated the earlier recommendation of the first Tarapore Committee in 1997 about intervening in foreign exchange market to contain the REER in the band of ±5% around the “neutral” REER. All the three recent committees have been much clearer about the objective that monetary policy should follow than the earlier committees. It may be recalled, for example, that the Chakravarty Committee had recommended a flexible monetary targeting with feedback, that is, a system of targeting money stock with the target being revised in the light of the information available on expected output performance. While conceding that multiple objectives tend to dilute the effectiveness of monetary policy and therefore disperse responsibility, on grounds of pragmatism, earlier committees had rejected the goal of monetary policy pursuing the single objective of an inflation mandate. As late as in 2000, for example, the Narasimham Advisory Group on Transparency of Monetary Policy and Other Financial Policies had suggested that there should be a primary objective (ostensibly an inflation target) and subsidiary objectives with a clear ordering of priorities.

There are four concerns that normally are raised with regard to inflation-targeting. First is the issue of trade-off between growth and price-stability, or the so-called Philips curve. The temporary nature of this trade-off has been well established in the literature (Kannan and Joshi 1998). Furthermore, there is evidence that inflation beyond a single-digit threshold of around 6% actually hurts growth. Second is the fear of fixing too low an inflation target. But, this objection is not sustained as it is possible to fix an inflation rate such as between 4% and 5%, which is not too low. Third is the sacrifice of a fixed nominal exchange rate with the pursuit of an inflation target. Fourth is the sacrifice of a real exchange rate or REER rule. Let us turn to the last two objections one by one.

The advantages of maintaining a fixed exchange rate are well known. It provides certainty to exporters and importers about their rupee income stream, and a nominal anchor to the economy. With a fixed exchange rate, when inflation gets out of line with price rise in partner countries, the balance of payments adjusts to bring about equilibrium. If inflation is too high relative to partner countries, exports become u ncompetitive and imports surge, money supply contracts through balance of payments deficits and inflation declines. The obverse happens when inflation is too low compared to partner countries. But, in r eality, with the compulsions to avoid too much volatility in money supply, we know what happens is something else.

We know of many cases from Latin America and east Asia where a fixed exchange regime came to an end because the currency was overvalued. Central bank intervened until it ran out of reserves, and then abandoned the fixed rate and devalued. But, what happens when the currency is undervalued? In such a case, the central bank or the government has to purchase foreign exchange to defend the rate and sterilise the injected liquidity to contain the monetary impact. Ultimately the cost of sterilisation becomes prohibitive, the peg has to be abandoned and the currency revalued. Though not as common as the breakdown of an overvalued peg, we know a few cases when an undervalued peg broke down in developed countries.4 For example, even under the Bretton Woods agreement about fixed exchange rate regime, Canada floated its currency from October 1950 under heavy upward pressures from rising commodity prices, improving trade balance, capital inflows and the speculation about a likely revaluation.5

Now we come to the problems of following the REER rule recommended by T arapore II, which, in effect, is an indexation of the nominal exchange rate to the price level. First, is the problem of choosing the target REER. If we do not fix the REER at anything but the equilibrium level, there will be either chronic deficits or surpluses in the balance of payments leading to persistent declines or rises in money supply, downward or upward price-nominal e xchange rate spirals and a total loss of monetary control. This is not just a theoretical possibility, but a real one that has been observed in some countries, for example, in the former Yugoslavia. In Yugoslavia, with the emergence of external financing difficulties in the late 1970s, the dinar was devalued by almost 30% in 1980, and throughout the 1980s there were successive devaluations in line with inflation aimed at maintaining the real effective exchange rate at the new lower level. With a large degree of dollarisation through foreign currency deposits, Yugoslav inflation, which was in double-digit levels throughout the 1970s and 1980s, unfolded as a classic wage-price-exchange rate s piral and exploded into hyperinflation in the last quarter of 1989 (Lahiri 1991).

Second, quite apart from getting the REER level wrong, a REER rule can exacerbate instabilities in output levels. In the late 1970s and early 1980s, for small open economies, such an indexation was quite popular to isolate the foreign trade sector from the vagaries of the macroeconomy. But, it can be demonstrated that such an indexation of the exchange rate not only creates potential instabilities in the price level, but also results, under realistic assumptions, from supply side interactions, in increased instabilities in output as well (Dornbusch 1982).

On the institutional arrangements, the PM Committee recommends (p 95) “an explicit and legally mandated de jure inflation-target regime” over “a de facto pegged exchange rate regime…or a de facto inflation targeting regime (as is the case in the US)”. What is needed is a debate as to whether we need to move immediately to an explicit and legally mandated inflationtarget regime, or pending such legislation, to a de facto inflation target regime with adequate understanding between the government and the RBI.

There are three very compelling reasons to shift to an inflation-targeting regime amidst the current international financial crisis. First, inflation, worldwide, is on a downward phase. Targeting moderate inflation when world prices are soft is easier to achieve than when the world commodity markets are flaring up. Reputation for delivering a modest inflation target is easier to build now than it was a year ago when world petroleum prices were around $150 per barrel. Second, targeting a moderate inflation rate will also effectively provide a floor to the extent the RBI will allow deflationary forces to operate. A modest inflation target, in case the world crisis proves to be more severe than what is expected now, will act as a guarantee for reflation. Third, with aversion to risk growing among the international financial investors, capital flows have reversed direction. The r upee is no longer under upward pressure.

2.2 Modernising Delivery to ‘Priority Sectors’

Ever since 1933, when the Reserve Bank of India Bill was referred to the Joint Select Committee, two issues of some serious discussion have been (i) how to provide adequate finance in the rural areas, particularly for agriculture, and (ii) the inclusion of indigenous bankers and other parties doing banking business in the country within the RBI’s scope (Reserve Bank of India 1970: 111-14). The legislature was very keen that the services of the indigenous bankers and moneylenders should be utilised in the scheme of provision of credit to the rural economy. By statute, the RBI, in its Central Office, has always had an Agricultural Credit Department (Section 54, RBI Act). It is important to note, however, that starting from the Darling Report of June 1935, the emphasis has been on a ffording credit and other assistance through cooperative banks (including land mortgage banks). Unfortunately, this emphasis on cooperative banking has not produced enough success in extending adequate and timely credit to the agricultural sector. It is in this context that the Rajan Committee recommendation of liberalising banking correspondent regulation to allow local agents to extend financial services becomes important (p 8). This needs to be implemented.

After the two drought years and associated shortfall in food production in 196566 and 1966-67, under the concept of social control over banking introduced in December 1967, came the directed credit programme involving loans on preferential terms and conditions to priority sectors. Priority sector was initially defined as agriculture, exports and small-scale industry.6 Fourteen banks were nationalised and one of the objectives of nationalisation was to ensure that no productive e ndeavour in agriculture and small-scale industries fell short of credit support.

As a matter of record, the instrument of directed credit has been used by many developing countries. Japan used direct government allocation of funds to industry during the reconstruction period of 194555, and in a less direct fashion, but with a rigidly segmented financial system under wide-ranging controls, between 1955 and 1970 (Vittas and Cho 1995). Korea used directed credit through government-owned banks for promoting exports and industrial investment in the 1950s and 1960s, and heavy and chemical industries during the 1970s. The conclusion from evaluation of directed credit programmes appears to be that they should be small, narrowly f ocused, and of limited duration with clear sunset provisions. Experience in most countries shows that they stimulated c apital-intensive projects, that preferential funds were often diverted for non-priority purposes, and were associated with low repayment rates. Subsidies should be low to minimise distortion of incentives as well as the tax on financial intermediation.

As far back as 1991, the first Narasimham Committee had recommended a reexamination of the continued relevance of the directed credit programme and its phasing out. It had also recommended that the priority sector be redefined to comprise small and marginal farmers, tiny sector of industry, small business and transport operators, village and cottage industries, rural artisans and other weaker sections and the credit target for this redefined priority sector should be reduced from 40% of aggregate credit. The RBI rejected the proposal “…to ensure that any changes in the policy on priority sector credit did not result in a disruption in the flow of credit for productive purposes” (RBI 2008: 118).

The effect of financial repression through micro-level controls on financial deepening and hence growth is also wellknown (see for example, Demetriades and Luintel 1996). After the first Narasimham Committee in 1991, the second Narasimham Committee in 1998 again recommended reduction of the scope of directed credit to priority sector from 40%. Recently, the Rajan Committee concluded that “India’s experience with directed credit has been abysmal, with flows historically going into sectors with low productivity that happen to be favoured” (p 101).

The fact that important segments of the Indian economy are credit-constrained is well-accepted by most economists. Many farmers, and small and medium firms in developing countries such as India take loans at 60% interest rates or more and defaults are rare showing that rates of return or marginal products of capital in related activities are sufficiently large (Banerjee and Duflo 2004). Yet, some of these farmers or firms are credit-constrained. The productivity loss as a result of misallocation of capital due to credit constraints can be fairly large. The second Narasimham Committee clearly stated that “The Committee believes that it is the timely and adequate availability of credit rather than its cost which is material for the i ntended beneficiaries”.

Can we have the desired results of financial inclusion through a more market-friendly hybrid approach with directed credit? Directed credit with far belowmarket interest rate harms the priority sectors and the weaker sections by denying them adequate and timely institutional credit and compelling them to borrow from non-institutional sources at usurious rates. Too low a rate of interest d enies the banks any incentive to lend. Perhaps, a good way of starting the r eform for financial inclusion is retaining the directed credit programme, while d eregulating and increasing the interest rate that can be charged on such directed credit. Allowing a higher interest will create an i ncentive for banks to lend more to the priority sectors and also d iscourage non-credit-constrained farmers and firms from pre-empting such d irected credit.

2.3 Capital Account Convertibility

The two Tarapore Committees, PM Committee and Rajan Committee have unanimously recommended a move towards fuller capital account convertibility. Such convertibility, by reducing the cost of capital, can stimulate investment and growth. By allowing residents to diversify their portfolio into foreign assets, it can reduce the variability of their income and wealth from domestic shocks and also diffuse the risk of an asset-price bubble. Capital a ccount restrictions tend to turn progressively ineffective, costly and even distortive. The PM Committee has observed that India has a de facto open capital account for the real economy, but not for financial services (p 99). Lack of capital account convertibility has reduced competition in the Indian financial sector and denied the country competition-induced efficiency gains. According to some experts, the benefits from capital account convertibility for the financial sector in India will be analogous to the benefits that accrued to the real sector from the policy of opening up in the early 1990s.

Many of the milestones recommended by the first Tarapore Committee of 1997 have already been achieved. What about the others? While considerable progress has been made on the fiscal front both by the centre and the states after the implementation of the FRBM Acts, some susceptibilities remain on account of off-budget liabilities such as oil bonds. It is also wellknown that “Running a large fiscal deficit constrains a country’s ability to open its capital account without running undue risks. Countries that have opened capital accounts and stabilised or pegged their exchange rates – while running large fiscal deficits financed in foreign currencies

– have triggered an economic crisis” (p 88). Now, with the current global crisis, we need not look any further than the US for vulnerabilities on the external front from large fiscal deficits.

Is fiscal consolidation the right policy when most countries in the world are talking about fiscal stimuli? There seems to be a consensus among mainstream economists that there is no case for “one-sizefits-all fiscal expansions but for fiscal a ctions tailored to the circumstances of individual country and taken with a view toward the impact on the rest of the world” (Eichengreen and Baldwin 2008). India does not have a trade or current account surplus and the case for a fiscal expansion in a country with a large trade deficit needs a careful examination (Rodrik in Eichengreen and Baldwin 2008). A large part of any fiscal stimulus will spill over as benefits to the rest of the world. Furthermore, it is important to remember the long and variable lags with which policies a ffect the economy.

We need a clear deadline for solving the problem of attaining the necessary milestones, including removal of fiscal susceptibility, and introducing capital account convertibility. It is possible that capital account convertibility, with its magnified penalty scheme for policy lapses, may become the cause for preferred institutional outcomes even with regard to fiscal prudence.

The current crisis may provide an opportunity for introducing capital account convertibility. The dominant worry about introducing convertibility has been an upsurge of capital flows with large upward pressure on the exchange rate of the rupee followed by a sudden sucking out of such capital, precipitating a crisis. Risk aversion on the part of international investors is an all-time high now, and the risk of large inflows is limited. The residual risks, as the PM Committee has observed, can be managed given: (a) the proven skills and capabilities of the RBI in managing India’s external accounts with extraordinary competence; (b) the trends that are now manifest in accelerating two-way financial flows at a very rapid rate – i e, at two or three times the output growth rate; and

2.4 A Streamlined and Principle-Based Regulatory Architecture

The ongoing global financial crisis has raised important questions about the optimal regulatory architecture. This is best exemplified by the case of derivatives. D erivatives market grew exponentially during the 1990s and quintupled between 2002 and 2008 to over $500 trillion under the regime of Alan Greenspan, the former Chairman of the US Federal Reserve. Greenspan saw derivatives as “an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so”. Warren Buffett, the legendary US investor, however, had presciently observed in 2003 that derivatives were “ financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal” (Goodman 2008). There were demands for stricter regulation of derivatives, but Greenspan favoured self-regulation on Wall Street.

We know now the absence of rules requiring institutions to disclose their positions, to be adequately capitalised, to limit leveraging, and to set aside funds as a reserve against bad bets, and protection against counterparty risk in settlement, and stripping the Commodity Futures Trading Commission (CFTC) of regulatory authority over derivatives may not have been good ideas. At the same time, there is a lot of force in Greenspan’s argument that “You can have huge amounts of regulation, and I will guarantee nothing will go wrong, but nothing will go right either.”

Currently, in India, what we have is a regulation by silos with banks regulated by the RBI, stock markets by SEBI, pensions by Pension Funds Development and Regulatory Authority, insurance by Insurance Regulation and Development Authority, and commodity futures by Futures Market Commission. India is not alone in having such a fragmented regulatory structure. In the US, for example, four regulators – Federal Reserve, Federal Deposit Insurance Corporation, Office of the Controller of Currency, and State regulators – r egulate banks, two regulators – Securities and Exchange Commission (SEC) and CFTC – control securities

comparable organisation and management structures. Consequently, the balance of the argument has moved away from retaining or creating multiple financial services regulators differentiated by the types of firm they regulate, the activities they regulate, or the objectives of regulation. Many countries have moved to unified regulation (Table 1).

While awaiting a careful analysis of the causes of the current global crisis from the regulatory angle, most experts seem to agree that the fragmented regulatory architecture in the US may have contributed to the problem. In the US, no regulator had the clear remit to regulate derivatives. It is in this context that it is important to note that the PM Committee has recommended a move towards unified regulation. Although the Rajan Committee has not stated such a move towards unification in explicit terms, the spirit of its recommendation appears to be in f avour of unification.

In the interim, until we move to unified regulation, the PM Committee has recommended a “Partial consolidation of extant regulators into a tightly-knit quartet covering: (a) banking; (b) insurance; (c) pensions; and (d) capital, derivatives and commodities markets”. Thus, it urged the transfer of all regulation/supervision of any type of organised financial trading to SEBI. The Rajan Committee has also e ndorsed the recommendation that all regulation of trading should be brought under the SEBI.7 The case for implementing these recommendations appears very strong.

Furthermore, both the PM Committee and Rajan Committee8 have recommended a move from rules-based regulation to principles-based regulation, by redrafting securities and banking laws as well as reskilling of all regulatory staff. PM Committee recommends scrapping the large repository of subordinate laws under a prescriptive approach. It argues against writing down every minute detail either into the basic legislation or into detailed subordinated rules and regulations. The spirit of the recommended move towards principles-based regulation is to promote financial innovation and avoid the mistake of over-regulation.9 What we need is a d ebate on the extent of innovation that we shall allow. But, it appears that we may have been rather conservative in allowing innovation. Let the excesses of derivatives in the US not detract us from the fact that it was mortgage-backed securities issued by Fannie Mae and Freddie Mac – two much maligned institutions in the US t oday – that promoted widespread homeownership in the US.

The transition from rules-based to p rinciples-based regulation may require a graduated move. Principles-based

Table 1: Countries with a Single Supervisor, Semi-integrated Supervisory Agencies and Multiple Supervisors in 2002a

Single Supervisor for the Financial System Agency Supervises Two Types of Financial Intermediaries Multiple Supervisors and SEC regulate investment Banks and Securities Banks and Insurers Securities Firms and At Least 1 Each for Banks, Insurers, Firms Insurers and Securities Firms

1 Austria 12 Japan 24 Finland 29 Australia 40 Bolivia 47 Argentina 64 Jordan

2 Bahrain 13 Latvia 25 Luxembourg 30 Belgium 41 Chile 48 Bahamas 65 Lithuania

3 Bermuda 14 Maldives 26 Mexicob 31 Canada 42 Egypt 49 Barbados 66 Netherlands

4 Cayman Islands 15 Malta 27 Switzerland 32 Colombia 43 Mauritiusb 50 Botswana 67 New Zealand

5 Denmark 16 Nicaragua 28 Uruguay 33 Ecuador 44 Slovakiab 51 Brazil 68 Panama

6 Estonia 17 Norway 34 El Salvador 45 South Africab 52 Bulgariab 69 Philippinesb blurred the borders between 7 Germany 18 Singapore 35 Guatemala 46 Ukraine 53 Cambodia 70 Poland

financial products. The easi-8 Gibraltar 19 Republic 36 Kazakhstanb 54 China 71 Portugal

est example of a hybrid prod-9 Hungary 37 Malaysia 55 Cyprus 72 Russiab

uct is a unit-linked insurance 10 Iceland 20 Sweden 38 Peru 56 Egypt 73 Slovenia

11 Ireland 21 Taipeic 39 Venezuela 57 France 74 Sri Lanka

22 UAE 58 Greece 75 Spain

23 UK 59 Hong Kong 76 Thailand

63 Italy products, they compete via a Sample includes only countries that supervise all the three types of intermediaries (banks, securities firms and insurers). b Countries reported to be considering adopting partial or full integrated supervision as well.

c Established in 2004. nels and increasingly have Source: Milo (2007).

MANAGER