Counterintuitively For A Sector That Is So Heavily Dominated By Regulatory Agencies, The Road To Reform Goes Through Parliament
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 (here, here 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.
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