Ajay Shah's blog

Dr. Subbarao's comments about FSLRC's treatment of systemic risk

2013-06-15T23:29:00.000+05:30

On 5 June, Dr. Subbarao did a speech at the Indian Merchants Chamber, which expressed views about the FSLRC treatment of systemic risk, which has spawned an interesting discussion:

Speech by Dr. Subbarao, 5 June
A pointwise response to the material on systemic risk in this speech, by Sowmya Rao.
Why the RBI Governor D. Subbarao is wrong on regulating systemic risk, a column in the Economic Times by K. P. Krishnan.
A column in Mint by Sowmya Rao and Sumathi Chandrashekharan.
A helicopter tour of systemic risk regulation in the draft Indian Financial Code, by me.

I find myself repeating two things all the time on the draft Indian Financial Code. The first thing I say to people is: `Read the draft Code!' It is plain English and is fully comprehensible by anyone.

The second thing I say is: `Don't think about one section or one chapter at a time, understand the fuller interlinkages about how the whole thing fits together'. Very often, an apparently small modification to one section or one chapter would have legal effects beyond what is envisioned at first blush.

A helicopter tour of systemic risk regulation in the draft Indian Financial Code

2013-06-15T23:27:00.001+05:30

The field of financial regulation has traditionally focused on consumer protection, microprudential regulation and resolution. However, the 2008 financial crisis highlighted systemic risk as another important dimension of financial regulatory governance. Subsequently, governments and lawmakers worldwide have pursued regulatory strategies to avoid systemic crises and provide for systemic oversight.

At present, Indian law is silent on the subject of systemic risk. RBI often implies that it has been doing work on `financial stability', however at present, there is no legal mandate, no powers, and no actions.

To some extent, systemic crises are the manifestation of failures in the core tasks of financial regulation, consumer protection, micro-prudential regulation and resolution. Proper functioning of these core tasks, as envisaged in the draft Indian Financial Code, will reduce systemic risk, but not eliminate it. There is thus a strong need for a legal strategy for systemic risk regulation. This has been done for the first time in India in the draft Indian Financial Code.

You should of course read the draft Code and the underlying report. However, in order to help you get a hang of how the FSLRC thinks about systemic risk, here is a bird's eye view which points you to the right places in the Code.

We now turn to the sections of the IFC that directly deal with systemic risk:

S. 2(36), page 3: introduces the phrase `the Council' which is used in the IFC to refer to the Financial Stability and Development Council (FSDC).
S. 2(78), page 7: defines a `financial system crisis'.
S. 2(154), page 13: defines `systemic risk'.
S. 20, page 19: sets up the FSDC as a statutory body. A careful study of the composition of the FSDC in S.21 shows that the day-to-day functions of the FSDC will be run by a Chief Executive. There will also be an administrative law member to ensure that regulatory governance norms are followed.
S.65, page 34: is an example of the inter-regulatory co-ordination function of the FSDC. Where two regulators are to take joint action under the IFC, but are unable to reach a consensus, they must work with the FSDC to figure out a solution. While inter-regulatory coordination can be an issue in many contexts (e.g. SEBI/IRDA on ULIPs), it is certainly a dimension of systemic risk where the thinking and work cut across all regulators.
S.141(1)(a)(iii), page 66: asks that when regulators such as RBI and UFA are regulating SIFIs, they should take the relevance of the systemic risk perspective into account. There is no role for FSDC in what they do here.
S.141(1)(k), page 67: asks that micro-prudential regulation should be mindful of systemic risk and particularly pro-cyclical consequences of regulation.
S.187(1)(c), page 86: asks that Infrastructure Institutions (such as exchanges, depositories etc., defined in S.183, page 85) are obliged to promote the objective of the FSDC to mitigate systemic risk, when they write bye-laws (which will be approved by the UFA and not FSDC).
S.221, page 96: sets up the Resolution Corporation at the level of the entire financial system and details its objectives.
S.224(1), page 96: asks that the officers and employees of the Resolution Corporation have knowledge and expertise in resolution of SIFIs.
S.287(2), page 121: asks the Resolution Corporation to consult with the FSDC where the Resolution Corporation is contemplating certain resolution measures against a SIFI.
S.290, page 122: defines the objectives of FSDC. The agency will pursue the objective of fostering the stability and resilience of the financial system by, (a) identifying and monitoring systemic risk, and (b) taking all required action to eliminate or mitigate systemic risk.
S.291, page 122: says that the FSDC consists of its board, an executive committee, a secretariat and a data centre. Of particular importance is the data centre, which is defined in S.294.
S.295, page 123: sets out the five main activities of the FSDC. It will study data and do research on the financial system; it will designate certain financial firms as SIFIs; it will formulate and implement system-wide measures, it will promote inter-regulatory cooperation, and it will assist the Ministry of Finance and all other agencies during a systemic crisis.
S.296, page 123: establishes principles that must guide the FSDC. These principles ensure that systemic risk regulation does not degenerate into achieving the silence of a graveyard.
S.297, page 123 and 124: sets forth the analysis and research objectives of the FSDC. Accordingly, S.298 gives the FSDC the powers to obtain relevant data.
S.299, page 124: sets up the legal process through which the FSDC will determine the criteria to designate certain financial firms as SIFIs. A financial firm can be adversely affected when it is designated as a SIFI, hence the full legal process of an order is required.
S.300, page 125: sets up the legal process through which firms would be designated as SIFIs.
S.301, page 125: asks the FSDC to issue policy frameworks and regulations for implementing system-wide measures, in the class of those defined in the Third Schedule (page 185). In the future, if other system-wide measures are thought useful, Parliament would have to approve amendments to the Third Schedule to add such measures.
S.302, page 125 and 126: sets up the legal process through which the FSDC will ensure the implementation of system-wide measures.
S.306, page 127: asks the FSDC to identify what parameters it would use to determine a financial system crisis. S.306(4) asks the Council to assist the Government and regulatory agencies as specified in S.306(5) (through analysis of data, providing advice, and assisting in efforts).
S.307 to S.313, page 128 and 129: constructs the Financial Data Management Centre (FDMC), a single database about the entire Indian financial system, which allows the regulators to have a full picture about the state of the financial system at any point in time, and particularly during a crisis. As a side effect, the unification of all supervisory data filings to FDMC also leads to de-duplication of data and reduces costs for financial firms. This database is essential for thinking about systemic risk (i.e. about the overall financial system) and is conspicuously absent in India today.
S.345 and S.346, page 141: define the lender of last resort (LOLR) functions of the central bank. S.345 (temporary liquidity assistance) relates to assistance given to participants in the central bank's payment system, and S.346 (ELA) is about lending against collateral to a more broad class of financial firms.
S.362, page 147: defines the notion of an emergency, which can motivate capital controls against inflows under S.365. Similar provisions for outward flows are specified in S.368.

A response to Dr. Subbarao's comments on systemic risk regulation in the draft Indian Financial Code

2013-06-15T23:26:00.001+05:30

by Sowmya Rao.

At a recent conference organised by the Indian Merchants Chamber, the Reserve Bank of India (RBI) Governor, Mr. Duvvuri Subbarao, shared his views on lessons learnt from the global financial crisis. The full text of his speech is available here. While discussing financial stability, Mr. Subbarao discussed the recommendations of the Financial Sector Legislative Reforms Commission (FSLRC) on the Financial Stability and Development Council (FSDC). This post is a pointwise response to his text.

The big picture of FSLRC

The draft Indian Financial Code deals with all aspects of financial law, including consumer protection, microprudential regulation, resolution, systemic risk, and monetary policy. Accountability mechanisms and clarity of regulatory objectives are key themes of the recommendations.

The recommended regulatory architecture consists of a Resolution Corporation which will manage the resolution of failing firms, while regulators (RBI and the proposed Unified Financial Agency (UFA)) will pursue consumer protection and microprudential regulation. RBI (as the central bank) will perform monetary policy functions.

Since the legislative mandate of regulators will define their perspective and information access, an individual regulator dealing with say, banking, is likely to focus its operations on banking alone, and not the entire financial system. Systemic risk analysis, in contrast, requires a bird's eye view of the entire financial system, especially to identify interconnections or trace interdependencies. The heart of systemic risk thinking is to look at the woods and not the trees, while the instinct of micro-prudential regulation is to look at trees.

Hence, FSLRC recommended that systemic risk oversight was best executed by a council of regulatory agencies - the FSDC - assisted by a technical secretariat. The board of the FSDC comprises the Minister of Finance (Chairman), the Chairman of RBI, the Chairman of the UFA, the Chairman of the Resolution Corporation, the Chief Executive of the FSDC and an Administrative Law Member of FSDC.

Responses to Dr. D. Subbarao

What are the relative roles of monetary policy and macroprudential policies?

While terms such as financial stability, macroprudential regulation and systemic risk oversight are often used synonymously, the most technically sound term is 'systemic risk'.

FSLRC views monetary policy and systemic oversight as distinct, to be employed by relevant agencies best suited for each. The draft Indian Financial Code (IFC) clearly lays out the process of defining monetary policy objectives alongside quantified medium-term targets (government's responsibility), as well as that of implementing the objectives (RBI's responsibility). This would create accountability in monetary policy, which can then make possible monetary policy independence.

Similarly, the IFC also clearly defines the scope and extent of systemic oversight which is the responsibility of the FSDC. The FSLRC recommendations specifically note that there ought to be strict separation between microprudential regulation (the domain of regulators alone) and systemic oversight.

Under what circumstances should one, rather than the other, be invoked? How do these policies interact with each other?

If institutional synergy between monetary policy and systemic risk is emphasised, this leads to a blurring of accountability. Instead of placing multiple objectives within the same institution, which could cause a conflict of interest, FSLRC has recommended that there be clear regulatory objectives assigned to separate institutions that best serve the issue at hand. There must be no impediment to holding a body accountable for lapses; multiple objectives only serve to reduce such accountability.

In furtherance of this, FSLRC has carefully carved out the contours of these two roles, with monetary policy implemented by RBI and systemic risk oversight carried out by FSDC. These agencies will invoke their enumerated powers when the situations call for it as specified by the IFC.

When these agencies follow their mandates as defined under the IFC, an overlap of these roles is unlikely. To the extent that decisions taken under the rubric of monetary policy may affect systemic risk and vice versa, RBI's presence on the FSDC table should ensure that open conversations about such intersections take place.

If they are handled by different agencies, is it possible that they can work at cross purposes? Is there an inevitable political dimension to macroprudential policies?

Within microprudential regulation, there is little need for any authority other than the regulator to exist. However, the presence of the political dimension takes on particular relevance in systemic risk. When there is a threat of an imminent systemic crisis, many actions that are required must have the authorisation of the political executive. Such actions cannot be taken by any technically ground and non-political and independent regulatory agency. The Finance Minister's leadership of the board of the FSDC reflects India's experience with the role of ministers such as P. Chidambaram and Yashwant Sinha -- and the role of finance ministers worldwide in the global crisis -- in dealing with systemic crises.

FSDC is a forum for regulatory bodies to discuss their concerns, especially if any one agency (including FSDC itself) appears to be working at cross-purposes with the mandate of any other agency. The possibility that such a concern may arise should not preclude the creation of a body to mitigate systemic risk.

If yes, how does one protect the autonomy of the institution responsible for macroprudential policy?

In an area such as monetary policy or micro-prudential regulation, there is a case for autonomy of the institution. With systemic risk, there is an inescapable role for the political authority in dealing with crises. No RBI Governor could have dealt with the 2008 crisis or the 2001 crisis. These required the authority and decision-making powers of the Minister of Finance.

In its submission to the Commission during the consultative stage, the Reserve Bank argued that the financial stability mandate that the Reserve Bank has been carrying out historically by virtue of its broad mandate should be clearly defined and formalized.

At present, the RBI has no mandate to carry out the function of systemic risk oversight, nor is there a work program of this nature.

In law: The words `systemic risk' or `financial stability' or `macroprudential regulation' do not occur in the RBI Act. That mandate, as well as powers to perform that mandate, are absolutely absent in the RBI Act.

In fact: RBI does not have a database about the overall Indian financial system, nor does it have executive authority over financial firms which are not banks. It has no meaningful way of assessing inter-connectedness or risk in sectors other than banking and payments. As an example, much of the complex dynamics of the crisis of late 2008 took place beyond the information set of the RBI. Further, the RBI does not have powers to do anything about the overall Indian financial system. In terms of financial regulation, RBI is only a sectoral regulator dealing with two sectors (banking and payments).

The Commission has acknowledged comments made by RBI and responded as follows (see FSLRC Report, Volume I, Chapter 9): In the consultative processes of the Commission, the RBI expressed the view that it should be charged with the overall systemic risk oversight function. This view was debated extensively within the meetings of the Commission, however, there were several constraints in pursuing this institutional arrangement. In the architecture proposed by the Commission, the RBI would perform consumer protection and micro-prudential regulation only for the banking and payments sector. This implied that the RBI would be able to generate knowledge in these sectors alone from the viewpoint of the safety and soundness of such financial firms and the protection of the consumer in relation to these firms. This is distinct from the nature of information and access that would be required from the entire financial system for the purpose of addressing systemic risk.

The FSLRC recommendation that the executive responsibility for safeguarding systemic risk should vest with the FSDC Board runs counter to the post-crisis trend around the world of giving the collegial bodies responsibility only for coordination and for making recommendations.

The international experience comprises some important examples which shaped the working of FSLRC.

Financial Stability Oversight Council (FSOC) in the United States: Created post-crisis, this body consists of the US Treasury Secretary and heads of all regulatory bodies. FSOC has powers similar to those envisaged for FSDC, including designating non-bank institutions as Significantly Important Financial Institutions (SIFIs), where designated institutions are subject to heightened prudential and supervisory provisions.

(See Section 113 of the US - Dodd-Frank Wall Street Reform and Consumer Protection Act, 2010. Further, See Section 295 (Functions of the FSDC) and Section 299 (Designation of Systemically Important Financial Institutions) of the IFC.)

The European Systemic Risk Board (ESRB) in the European Union: Consisting of the heads of the European Central Bank, the Governors of the national central banks of the EU member states and the regulatory heads of insurance, pensions and securities, the ESRB has the power to issue recommendations and warnings. These are issued with a specified timeline for the addressee to respond with a relevant policy response. It is crucial to note that addressees of such a recommendation are required to communicate to the ESRB and to the EU Council the actions undertaken in response to the recommendation or justify any inaction on a comply or explain basis.

To date the ESRB has published recommendations touching upon a wide range of issues, namely; lending in foreign currencies; the macro-prudential mandate of national authorities; US dollar denominated funding of credit institutions; money market funds and funding of credit institutions.

(See Regulation (EU) No 1092 /2010 of the European Parliament, para 17)

The Reserve Bank is also of the view that in a bank dominated financial sector like that of India, the synergy between the central bank's monetary policy and its role as a lender of last resort on the one hand, and policies for financial stability on the other, is much greater.

India is not a bank-dominated financial sector. As an example, the market capitalisation of all listed companies is over twice the size of non-food credit by banks to all companies. A perusal of the aggregative balance sheet of firms in India shows that bank financing is an important, but small, component. This is particularly the case if the balance sheet is re-expressed using market value of equity instead of book value.

The knowledge and expertise required to tackle systemic risk to the entire financial system is unlikely to be located within any one sectoral regulator. The knowledge about the Indian financial system will be dispersed across RBI, UFA, and Resolution Corporation. Hence, it would be inappropriate to place the systemic risk function in any one place.

RBI will only have expertise and information relating to the banking and payments industries. In equal measure, UFA will only have expertise in the non-banking non-payments financial sector, and the Resolution Corporation, will only have knowledge about handling failing firms. Each will be able to bring those respective nuances to the conversations on FSDC's board. Each of these agencies has synergies in its own right with the function of mitigating systemic risk.

The function of being a lender of last resort does not equate with performing systemic risk oversight. The IFC envisages that RBI will continue to provide funds to participants for which the RBI directly operates payment systems. Further, IFC establishes a mechanism through which RBI will also provide emergency liquidity for non-banking financial firms in times of severe or unusual stress in the financial system, on provision of collateral. There is no contradiction between a central bank that is a lender of last resort and a central bank that is not the systemic risk regulator.

We need to think through whether the responsibility of FSDC Board should be extended from being a coordination body to one having authority for executive decisions? What will that imply for the speed of decision making?

The FSLRC envisages two executive functions at FSDC: naming certain financial firms as Systemically Important Financial Institutions (SIFIs), and making decisions on system-wide counter-cyclical capital. Both these decisions will be taken by the board of FSDC, which will include the Chairman of RBI, the Chairman of UFA and the Chairman of the Resolution Corporation. FSDC is a council of regulators.

A loose coalition of regulators that does nothing more than meet has been tried in India. It was called the HLCCFM. It failed to solve problems such as the SEBI/IRDA dispute, and it played little role in the crisis management of 2008. The task ahead in designing sytemic risk regulation is one of understanding how to do things differently.

In the spirit of FSLRC's overall recommendations, establishing FSDC as a statutory body endows it with legal process, transparency and accountability that ought to accompany a financial sector agency. This means that FSDC can be held accountable for lapses, and that the possibility of external influences affecting its functioning is significantly reduced.

The speed of decision-making is enshrined in process, the efficiency of which depends on the stakeholders involved. Acting decisively is of importance where a crisis is at hand, but in a world that seeks to uphold principles of rule of law, there is little value in hasty decisions made by a non-statutory body with no accountability for its actions. A statutory FSDC is more likely to ensure that decisions relating to crisis situations are taken responsibly, and with full disclosures.

During a crisis, we need the executive to lead the fight and stem the sources of systemic risk, and all regulatory bodies will have to work together with the Ministry of Finance. This is what happened everywhere in the world during the financial crisis is the best model for tackling a crisis. FSLRC recommendations have legislated this model to increase accountability for actions taken during a crisis.

Can we clearly define the boundaries between financial stability issues falling within the purview of the FSDC and regulatory issues falling exclusively within the domain of the regulators?

Systemic risk may arise due to various reasons, such as regulatory arbitrage, excessive leverage ratios, or procyclical fluctuations in the economy. None of these issues can be handled exclusively by any one regulator.

IFC has laid down the process of identifying and implementing measures to mitigate or eliminate systemic risk. One measure of counter-cyclical systemic risk regulation, i.e the countercyclical capital buffer to address pro-cyclical effects in the financial system, has been explicitly provided for in the law. The implementation of such measures may commence only at the instruction of FSDC.

Regarding the intersect between the roles of FSDC and the regulators, under the IFC, the FSDC cannot interfere with microprudential regulation or the monetary policy function of the RBI. Any concerns can always be raised at the FSDC table, and discussed in full view of the public and the markets.

The author is grateful to Sumathi Chandrashekaran, Bhavna Jaisingh, Radhika Pandey and Ankur Saxena for useful inputs.

The saga of criminalising and then decriminalising cheque bouncing

2013-06-15T18:43:00.001+05:30

by Shubho Roy.

The criminalisation of writing cheques without a sufficient balance was introduced in India in 1988. It was an addition to a much older British law called the Negotiable Instruments Act, made in 1881. The reason for the amendment was the endemic problem of cheques being dishonoured. This had made it difficult to do transactions where payment and delivery don't happen instantaneously. Mistrust of cheques was encouraging cash transactions, with consequent problems of counterfeiting, costs of storing and moving cash, and the law enforcement problems of an underground economy.

It has been estimated that about 30% of criminal cases in Indian courts are either cheque bouncing or traffic offences. The government has now proposed to amend the Negotiable Instruments Act (N.I. Act) to decriminalise the offence of bouncing cheques (called `138 N.I.' in legal circles) (See here). This move is aimed a decongesting the judicial system.

In 1988, when the amendment was brought in, no estimation was done of the additional burden on the criminal court system because of the law. This episode has taught all of us that every time legislation is enacted, careful calculations need to be made about the costs of enforcing the law and these costs should find their way into budgets.

The de-criminalisation of cheque bouncing is a good move. It will reduce the burden on criminal courts. However, the cheque bouncing cases are symptomatic of a deeper malaise: poor contract enforcement. While we may cheer the demise of a poorly thought out and draconian measure in 1988, there is a dark side to this as well.

Consequences for contract law

One of the best achievements of the World Bank is their `Doing business' database. India ranks poorly on many counts in the Doing Business 2013 report. Of the 10 indicators tracked by the report, India's rank is worst in Enforcing Contracts, where it is ranked 184th out of 185 countries:

It takes 1,420 days to resolve a contract dispute.
39.6 percent of the contract value is lost, of which 30% is paid out as fees to lawyers.
Even after getting a judgment in your favour, it takes 305 days to enforce the judgment.

Given the absence of good contract enforcement, after 1988, cheques were often used by the recipient of funds to create a deterrent against reneging. A common method of ensuring regular payment of rent is to use post-dated cheques. The landlord takes the entire year's rent in post-dated cheques. This allows the landlord to bypass the entire rent-controller and court system for evictions when rent is not paid on time. With the voucher from the bank (recording the dishonouring of the cheque), the landlord can file a criminal complaint against the tenant.

This is a bad system of contract enforcement! It is biased towards the party which expects payments and has no remedy to the party which is getting a service or good. As an example, if the tenant sets off some rent because of mandatory repairs which the landlord failed to carry out, the tenant is perfectly allowed to take a defence of `set-off' in a contractual relationship. However, underlying the NI act is a presumption of debt, which will let the criminal case continue till the tenant is able to establish that there had been a valid set-off.

On a similar note, while the existing Section 138 of the NI Act is a draconian idea and bad in many ways, it has interesting positive effects when placed in an environment of bad contract enforcement. Consider the penalties for bouncing a cheque:

Imprisonment for up to 2 years, or,
Fine up to twice the amount involved, or,
Both of the above.

This is draconian, but there is considerable legal certainty. In contrast, when a contract is violated, there is no statutory method for calculating the amount of damages that the violator has to pay. Given the delays in contract resolution, and the legal and administrative costs, which are usually not awarded, the net receipt is generally much lower than the amount owed. Indian courts are not bound by a strict statutory requirement of calculating litigation costs and interest accrued is rarely granted from the date of dispute. For this reason, there was some method in the madness of S.138 of the N.I. Act.

Consequences for courts

The proposed withdrawal of 138 N.I. has not adequately been thought through, in terms of the implications for the judiciary and the legal system. It is being argued that for many cases, arbitration will be done. However:

What about the increased civil court burden? As argued above, post-dated cheques were used as a substitute for contract enforcement services of civil courts. When this mechanism is no longer available, there will be a surge in contract disputes. This flow of cases will atleast partially counteract the de-bottlenecking of courts that will come from removing cases associated with S.138.
Where will we get the increased number of arbitrators? There are very few arbitrators in India, and there is no institutional system of providing arbitration services outside the larger cities.
Who will bear the costs? The costs of arbitration are very high in India. While it may be appropriate for large businesses to internalise their dispute resolution mechanisms, smaller businesses should have access to a court system.
Will arbitration be faster? There is no standardised procedure in the arbitration system in India for cheque bouncing cases. Evidentiary and procedural variety will lead to more challenges in appeal and increase the burden of the judiciary where every appeal will have to be checked for procedural propriety.
Does the judiciary have the bandwidth to cope with the case load that will appear for review? Orders of arbitrators will be appealed to the higher judiciary. In many cases the courts will have to intervene to appoint arbitrators.
Will people write more bad cheques? The authority of the arbitration system is based on the efficiency of the court system. The rational violator knows that the arbitral award will go to the same over-burdened judiciary where penal costs are rarely imposed, so there will be little incentive to honour arbitration awards.

Conclusion

S. 138 of the N. I. Act is a reminder to us of the complexity of public administration reforms. When liberal democracy works well, it is a Rube Goldberg machine with immense complexity of many moving parts. Simplistic reasoning will almost always lead us astray with unintended consequences. Hurried changes of law (such as those produced through weekend drafting projects) will almost always go wrong. Well done law will almost always require enormous effort, will require sophisticated thinking about incentives in envisioning legal effects, and will involve a certain element of complexity.

Faced with a problem like S.138 of the N. I. Act, what is a thinker of government to do? There is a real opportunity in thinking outside the box. The solution to making payments lies not in making cheques work better but in fundamental change in technology: by moving to electronic payments. All these problems go away if you pay me on an electronic system, and within one second, I know whether I got the money or not. Our job is to dematerialise money, just as we have dematerialised shares. This will also require consequent changes in the Payments and Settlement Systems Act, which has mistakenly copied S.138 of the N. I. Act. This requires new thinking in financial policy so that India can get to a sensible payments system.

Electronic payments is of course no substitute for the public goods of contract enforcement. India desperately needs a good legal system, which comprises laws, lawyers and courts. But in this specific case, the storm of complexity associated with cheques is actually something that can be completely side-stepped. Amidst the debate around S.138 of the N. I. Act is a failure of imagination on policies about the payments system.

FSLRC ki ABC

2013-06-13T07:52:00.000+05:30

We worked with CNBC Awaaz to make simple video content, in Hindi, about FSLRC. The overall 24 minutes of this video is composed of six self-contained capsules of 4 minutes each.

Fluctuations of the rupee

2013-06-11T07:38:00.000+05:30

I have a column in the Economic Times today titled Do not mourn rupee fluctuations.

The methodology for identifying dates of structural change in the exchange rate regime is from Zeileis, Shah, Patnaik, 2010.

You may find The rupee: Frequently asked questions, 1 December 2011, to be of interest.

The demise of Rupee Cooperative Bank: A malady

2013-06-10T17:32:00.001+05:30

by Radhika Pandey and Sumathi Chandrashekaran

The facts: A troubled decade for the Rupee Cooperative Bank (2002-2013)

It was a little over a decade ago when Rupee Cooperative Bank (RCB) began to show signs of distress. In 2002, the bank faced a liquidity crisis due to non-recovery of loans, prompting RBI to appoint an administrator for the bank. This involves the bank coming under the supervision of the administrator, and is usually accompanied with the bank losing the freedom to carry on certain basic functions, such as accepting deposits or giving out loans.

In the case of RCB, after five years under the 'supervision' of administrators, fresh elections were held and a new board of directors was elected. The task at hand for the new board was to recover overdue loans of Rs 360 crore. As things turned out, they could not recover the full amount. Over the years, RBI's watchful eye on the bank did not wane. In 2011, RBI imposed a fine of Rs 5 lakh on RCB for violating its directives regarding the limits and scope of business permitted to be carried out by cooperative banks. The violations included discounting a cheque for an amount higher than Rs 25,000; and releasing a loan of over Rs 25 lakh for land purchase which exceeded the general limits set by RBI for cooperative banks. In 2012, another similar fine was imposed because RCB had unauthorisedly sanctioned cash credit facility exceeding Rs 1 lakh to four customers.

Anyone looking at the dateline of events would expect trouble to be looming large ahead. Earlier this year, with effect from close of business on 22 February 2013, RBI placed RCB under harsh restrictions, under the Banking Regulation Act, 1949. There were also restrictions on banking activities - RCB would not be able to grant or renew loans and advances, make investment, incur liability (i.e., borrow funds or accept fresh deposits), disburse or agree to disburse payments, enter into compromise or arrangement and sell, transfer or otherwise dispose of any of its properties or assets, and so on. RCB has not as yet lost its license, according to the RBI, which issued a clarification that the directions should not be construed as cancellation of banking licence.

Before the directions were issued, six directors of RCB had resigned in early February 2013 "over differences on loan recovery". A day after the directions were issued, on February 24, the six directors withdrew their resignation "to work in the interest of the bank". RBI would not have any of it, and dissolved the Board of Directors on 26 February. In its place, it appointed a two-member administrative board, chaired by a career bureaucrat, and an experienced administrator, who had earlier handled the merger of another bank with a public sector entity.

Why is this a malady?

These events have been bad for the depositors. They are now allowed to withdraw only upto Rs 1000 per account. Effectively, they have lost their money (other than what is protected under deposit insurance).

What is the source of this malady?

Cooperative banks, being cooperative societies that offer banking services, have a peculiar status in India because of how the two subjects are treated in the Constitution of India: 'cooperative societies' are a subject of state governance; whereas 'banking' is a subject of central interest.

There are legal arrangements that permit RBI to partially handle cooperative banks, but managing the failure of cooperative banks has problems:

Long delays before RBI takes serious action: The administration of a bank is given multiple opportunities to salvage its position. RCB, for instance, showed early signs of distress in 2002, but was permitted to stay alive for over a decade before final directions were issued. The position of cooperative banks is perhaps more problematic because of the political stake involved: some of the more prominent cooperative banks failing in the recent past died a slow death because high-ranking politicians were associated with them.
Long delays to close down the failed bank: The process of managing the failure of a bank is slow, and the tools available to RBI are limited. This problem, in theory, is shared by all failing banks. In practice, however, most failing banks have been only cooperative banks, which are therefore at the receiving end of procedural and administrative delays.
Long delays for claim settlement: Due to the frequent failure of cooperative banks, combined with fixed deposit insurance premiums, the DICGC invariably has to pay out claims of an order far higher than premiums collected from these banks. This hits the ordinary depositors the most, who, in the case of cooperative banks, are more likely to be small depositors, from the unorganised sector, farmers, or small traders.

The Centre is not entirely powerless when it comes to cooperative banks. Under Part V of the Banking Regulation Act, RBI has some micro-prudential powers with respect to cooperative banks, similar to but significantly weaker than those it has with respect to commercial banks. But the application of these powers is made difficult, particularly in the context of winding up of cooperative banks, because of the centre-state arrangement.

Additionally, the Deposit Insurance and Credit Guarantee Corporation (DICGC), the RBI subsidiary that pays out to depositors of failed insured banks, covers ''eligible cooperative banks'' under its deposit insurance scheme. Eligible cooperative banks, according to the DICGC Act, are those functioning in such states/union territories that have amended their Co-operative Societies Act to incorporate two features: first, that RBI may order the concerned Registrar of Cooperative Societies to wind up a cooperative bank or to supersede its committee of management; and second, that the Registrar may not take any action of its own accord for winding up, amalgamation or reconstruction of a cooperative bank without prior sanction from RBI.

The IFC solution

The Financial Sector Legislative Reforms Commission (FSLRC), through the draft Indian Financial Code (IFC) offers a solution to this malady. While other solutions are possible, the present centre-state governance arrangement allows only limited room for maneuver with regard to the resolvability of cooperative banks.

The IFC creates a Resolution Corporation, which will resolve financial service providers that show signs of financial distress. This would include those who offer banking services. The Resolution Corporation will detect financial trouble at an early stage and will be empowered with a significantly more robust set of tools to close down a failing financial service provider than the RBI is presently empowered with.

The IFC recognises that the process of resolving failed financial institutions is closely intertwined with micro-prudential regulation. Therefore, the IFC provides for a structured framework of regulatory intervention and information-sharing between the micro-prudential regulator and the Resolution Corporation. The Resolution Corporation will have a wider mandate than the present DICGC. It will be responsible for prompt resolution of trouble financial service providers and for paying compensation to the consumers of failed financial service providers.

Under the IFC, the Resolution Corporation has the duty to insure (Section 260):

(a) each consumer of a specified category of covered obligations with a covered service provider to the extent of a specified limit; and
(b) each covered service provider to the extent of a specified limit.

The IFC permits the Resolution Corporation to manage the failure of only eligible financial service providers who fall within the ambit of micro-prudential regulation. This narrower class of financial service providers are referred to as ''Covered Service Providers'' i.e. those who make covered obligations. How is this determined?

The ultimate goal of resolution is consumer protection. Keeping this goal in mind, the specified categories of covered obligations, who will fall within the ambit of the Resolution Corporation, will be determined by the Regulator, in consultation with the Resolution Corporation. The determination will be based on the following principles Ssection 260(4)) :

(a) the detriment that may be caused to consumers if obligations owed to them are not fulfilled by a covered service provider;
(b) the lack of ability of consumers to access and process information relating to the safety and soundness of the covered service provider; and
(c) the inherent difficulties that may arise for financial service providers in fulfilling those obligations.

In addition to the financial service providers who make covered obligations based on the above principles, the class of covered service providers will also include systemically important financial institutions (SIFIs).

These principles are in consonance with the test for the intensity of micro-prudential regulation that is followed in the IFC. Applying these tests on the activities of cooperative banks shows that similar obligations are made by such banks to their consumers, and they would logically be covered by the Resolution Corporation. By extension, cooperative banks that make such obligations will have to apply for Corporation insurance, and in order to do so, will have to first submit to the micro-prudential regulatory conditions set by the regulator.

Therefore, for cooperative banks, it will no longer be sufficient for RBI to be empowered to order the State Registrar of Cooperative Societies to liquidate, amalgamate or reconstruct a cooperative bank, or to supersede management. Instead, in order to be eligible for insurance from the Resolution Corporation), State governments will have to co-opt RBI as the banking regulator of cooperative banks in that state under law. Upon becoming eligible for Corporation insurance, cooperative banks would be charged premia according to their risk position. This is contrary to the present practice of collecting fixed deposit insurance premia from all eligible banks.

If the State governments do not co-opt RBI as the banking regulator under law, then banks such as RCB would not be eligible for insurance cover from the Resolution Corporation, and by corollary, may not be permitted to carry on certain types of activities that need Corporation protection (refer to the discussion earlier on specified obligations).

Cooperative banks that are regulated poorly, or not at all, because of the present dual regulatory arrangement, will continue to pose considerable risks to the soundness of the financial system until some drastic changes occur. The IFC, being a central legislation, comes with its challenges, because it is not able to directly impinge on what is otherwise a subject of state supervision under the Constitution of India. But through structural design, it is possible to compel the State governments to embrace the well-defined regulatory and supervisory expertise of an RBI and a Resolution Corporation as laid out in the IFC.

The authors are grateful to Smriti Parsheera for useful inputs.

Author: Suyash Rai

2013-06-10T07:26:00.003+05:30

Identifying each individual in financial firms that performs customer-facing functions, 8 June 2013.
Regulatory strategy for savings/investment schemes, that would address ponzi schemes, 30 April 2013.
Correctly defining the scope of financial regulation so as to block ponzi schemes, 30 April 2013.
RBI vision document on payments: An evaluation, 5 July 2012.

Identifying each individual in financial firms that performs customer-facing functions

2013-06-08T22:11:00.001+05:30

by Suyash Rai.

The growth of the Indian financial system has generated opportunities for individuals to get jobs in sales and distribution roles. It is easy for individuals to switch jobs, and with that it has become easier to indulge in abusive practices, enjoy the financial benefits that accrue, and leave the firm before the consequences become visible. There is ample anecdotal evidence about sales persons and agents who have got away scot free after doing the wrong things. These individual stories add up to the overall evidence at the level of the financial system of an upsurge of difficulty in consumer protection.

This problem is greatest with agents, who can switch between firms more than employees can. Similarly, sales persons switch easily from a field such as banking to another such as insurance.
For many in this field, the prevailing notion is that some individuals in sales and distribution are bad eggs and must be stopped. While there is some value in this perspective, it is important to not blame the entire failure of consumer protection in India upon individuals. Deeper reform of the system is required, as is envisaged in the consumer protection framework of the draft Indian Financial Code.

While we strive to build systems that generate better financial health for consumers, even in the most pro-consumer system, it will be possible for individuals to indulge in abusive practices, and leave before the consequences show up. This is because of certain inherent features of financial products and services:

For many products (eg. pensions), the consequences take years to be realised.
Much of the discussion between a salesperson/advisor is verbal, and, even if a written advice is insisted on, it is possible to lie or mislead an unsuspecting consumer.
Internal control systems usually work with random checks, and do not catch everybody, but consumer abuse must be comprehensively prevented or redressed.

Logically, this potential for harm goes with the potential for doing good - outliers will be on both sides. Ex-post action on consumer abuse must involve understanding what happened, compensating consumers, and punishing those responsible. This has a deterrent effect as well. In the present system, if the individual has moved on, little can be done against him. The firm has to take responsibility, and it has no recourse to the individual.

This is a malady, and a system must be developed, at least within the financial system, to keep track of individuals. This is important not just for punishment, but also for research on how different profiles, trainings and experiences lead to different consumer outcomes.

A recent initiative pushes in this direction. Association of Mutual Funds of India (AMFI), under direction from SEBI, has now notified regulations that speak to this concern. Every individual (employee or agent) dealing with the consumer is now required to be assigned an Employee Unique Identification Number (EUIN), which will be a permanent number. EUIN can be used to keep track of the individuals even as they switch jobs. This is a good step, but, given the generic nature of the sales/advise skills, this will work well only if all sub-sectors in finance adopt this approach.

The registration requirement in the Indian Financial Code

When something needs to be done by everybody, it is a good idea to put it in the law in some form. The draft Indian Financial Code (IFC) encodes this idea of identifying the individuals who deal with consumers. Section 104 of the IFC mandates every financial service provider to ensure that any individual dealing with consumers in connection with the provision of a financial product or financial service is registered with the Regulator. The provision also empowers the regulators to specify pre-conditions for registration in respect of different financial products or financial services.

Registering individuals with regulators will be expensive. Nothing in the IFC prevents the regulators from allowing self regulatory organisations or product manufacturers to implement the process and send a batch file to the regulators, who would just supervise the integrity of the process. The draft Code does not interfere with such efficiency.

If this provision is enacted, over time, the database of registered individuals will develop. It will start showing interesting patterns, and firms and regulators will be able take preventive measures, as well as strict action against abusers. The idea is necessary and will go a long way in solving this malady.

Conclusion

SEBI and AMFI are doing an interesting thing. In the short term, it will have a limited effect as IRDA and RBI and FMC and PFRDA are not part of this initiative. In addition, we should see consumer protection as a much bigger question, of which pinning responsibility upon employees is only one component. When the Indian Financial Code is enacted as law, the capacity building that would have taken place at SEBI and AMFI in building the EUIN will be a useful building block.

Iran may have developed offensive cyberwar capabilities

2013-06-07T23:15:00.002+05:30

After Stuxnet, Iran seems to have developed offensive cyberwar capabilities, possibly with Russian help.

Catnip, organised by me in chronological order. First, the Stuxnet story:

Israeli test on worm called crucial in Iran nuclear delay, by William J. Broad, John Markoff, David E. Sanger, in the New York Times, 15 January 2011.
A declaration of cyber war, by Michael Joseph Gross in Vanity Fair, April 2011.
Obama order sped up wave of cyberattacks against Iran, David E. Sanger, New York Times, 1 June 2012.
Confront and conceal by David E. Sanger, 5 June 2012.
Stuxnet: Leaks or lies, Steven Cherry interviewed Larry Constantine, IEEE Spectrum, 4 September 2012.

And then, the recent developments:

Cyberattacks against US corporations are on the rise, by David E. Sanger and Nicole Perlroth in the New York Times, 12 May 2013.
New computer attacks traced to Iran, officials say, by Nicole Perlroth and David E. Sanger, in the New York Times, 24 May 2013.
Silent War, by Michael Joseph Gross in Vanity Fair, July 2013.

Interesting readings

2013-06-06T23:31:00.001+05:30

Indian historical linguistics in the Economist.

A lecture by Lant Pritchett titled Folk and the formula - Pathways to capable states.

Anil Padmanabhan on Myanmar in Mint.

A great travel story from Nagaland.

Trampling on the individual in India: Saurav Datta in the EPW, and Spicy IP, on the attack on a blogger by the Times of India.

I was in Los Angeles when the Rodney King incident took place, and I thought to myself that when video cameras become ubiquitous in India, it will really make a difference to the behaviour of the police. One is seeing some examples of this, and the exponential rise of video-capable phones will help. In Canada, some are carrying this further: mounting a camera on every policeman. Also see Tarun Wadhwa in Forbes.

Who will audit the RBI? by K. P. Krishnan.

N. Sundaresha Subramanian in the Business Standard about what the independent directors of Ranbaxy were thinking and doing in 2004.

Regulation that is attacking something that is not a market failure: Tarun Shukla in Mint on forced hiring of domestic pilots.

Somasekhar Sundaresan on what SEBI should do on its 25th birthday.

Ila Patnaik on the messy issues of defining FDI, portfolio investment and foreign control.

Ellen Barry in the New York Times tells the story of the flight of a key figure in Russian economics: Sergei Guriev. A country that cannot keep its intellectuals safe has no future. Also see.

Mohammed Hanif has a great piece in the Guardian looking back at the elections in Pakistan.

China's economic empire by Heriberto Araujo and Juan Pablo Cardenal in the New York Times.

A group of musicians in Lahore have an original take on Everybody hurts by R.E.M. Video.

A true war story by Simone Gorrindo.

The role of the board

2013-06-05T08:12:00.001+05:30

The board is a critical ingredient of well functioning public bodies. The board must:

Have a big picture of the objectives of the organisation;
Get pushed, through accountability mechanisms, when these objectives are not being achieved;
Lead the top level thinking about the organisation chart and resource allocation, so that the organisation is constantly reshaped so as to fit its purpose;
Exert direct influence on key policy choices so as to push the management team towards delivering results.

In India, we lack experience with boards that perform these functions. All too often, organisations are little dictatorships where the chief executive holds all power and jealously resists any other influences upon decision making. I have been in situations where a chief executive stoutly claims that a policy discussion is not an appropriate matter for discussion in the board.

The draft Indian Financial Code works hard on establishing high quality boards, on establishing a sound work process for the board including powers of the board, and on setting up accountability mechanisms through which failures of the organisation would feed back to the board. This kind of establishment of the board is a critical component of the governance process.

In the Indian Express yesterday, Ila Patnaik and Shubho Roy reflect on the irrelevance of the RBI board. The Cobrapost expose showed a huge supervisory failure of the RBI. The entire board meeting of the RBI should have been devoted to identifying why this failure took place, and coming out with a list of actions through which things would change in the future. Instead, the board meeting dealt with things like skills development for horticulture.

SEBI does better than RBI on the role and functioning of the board, reflecting the fact that the RBI Act is ancient and these provisions in the SEBI Act are only around 20 years old. But with SEBI also, there is a lot to be desired about the working of the board.

Bureaucrats are not stakeholders

2013-06-04T06:48:00.001+05:30

Indian democracy has become quite focused on bringing views of all stakeholders into the policy debate on any question. That is a good thing.

I have an article in the Economic Times today, where I argue that while we do this, we should be careful to not treat officials as stakeholders. When the merger of Indian Airlines and Air India is being evaluated, all viewpoints should be brought to bear on the decision but one -- the views of existing employees of Indian Airlines or Air India.

Should policy makers favour home ownership?

2013-06-03T21:42:00.006+05:30

The argument in favour of home ownership

Many people believe that more home ownership is a good thing. It is felt that people who own homes have a greater incentive to get involved in local politics as they have a stake in higher house prices. In contrast, people who rent lack this commitment device. Indeed, in a short run sense, a person who is renting benefits when the neighbourhood goes bad : his rent goes down.

From the viewpoint of the individual, renting is always better as it preserves flexibility. Owning a house imposes limitations on the locations where one could live and work, as the frictions of moving home are substantial. This biases individuals in favour of renting.

In the four-part classification scheme of market failures (monopoly power, asymmetric information, externalities, errors by consumers), this falls under the heading of externalities. If home owners become better citizens and better voters and induce better urban governance, this induces positive externalities upon all residents of cities. To the extent that this is the case, some elements of State policy should favour home ownership, so as to counteract the market failure.

This argument has limited value in India today, given that urban governance is organised in a terrible way. We have just not established the feedback loops of accountability from voters to the city mayor. Even if a voter wanted to get involved in more political action, and wanted to nudge his city administration forward, he does not have the levers to do so. If one only looked at the India of the present, we would reject this externality argument and say that there should be a pure level playing field between owning and renting.

Or, one could be an optimist and think that in the future, as the political system is reformed, these feedback loops will fall into place. One could then argue that large scale home ownership sets up interest groups today that have a stake in cities doing well in the future, as their portfolio value is bound to the quality of the city. The presence of such interest groups may help increase the probability of political system reform, when households get worried about potential damage to their portfolios as a consequence of urban mis-governance.

Today we're highly distorted in favour of owning

If one started out at a undistorted market, one could have a reasonable discussion about whether there is something intrinsically good about owning as opposed to renting, and possibly envision whether levers of policy might be applied to favour home ownership, and the scale of intervention that is justified. In India today, unfortunately, the game is highly stacked against renting:

Tax policy favours owning in the divergent treatment of interest payments as deductible versus deductibility of rent.
Rent control laws inhibit renting.
High inflation disrupts rental contracts by forcing repeated renegotiation.
House owners that are corporations have not yet emerged. It is, hence, hard to find professional contracting in this field. Search costs are high, and there are often restrictions such as owners that won't rent to single women or muslims out of social conservatism. Our failures on property as a fundamental right, and on achieving a capable judiciary, have led to the risk of expropriation when the renter is elderly, a journalist or a lawyer. This has the perverse effect of diminishing access to rented houses for such persons.
Contracts are frequently disrupted, which induces costs of moving and frictions such as fees to brokers.
Less than professional owners imply that many practical issues such as smoothly functioning utilities don't work out properly. Under home ownership, a person has the incentive to make sure that utilities work correctly. With renting, this falls between the cracks and the service level is often poor.

The game is thus highly stacked in favour of owning. We need to level the playing field in favour of more renting.

The problems of home ownership

From first principles, the ownership of an illiquid asset (a home) diminishes flexibility. A person who lives in a home is much less likely to move.

In India, we need to achieve massive migration flows. Large scale migration will generate better matching between the requirements of the labour market at various locations all over India, and the requirements of production. Large scale migration will break down tribal and ethnic loyalties.

A country where people easily up and move is one in which the labour market is more flexible. This is a blessing and has consequences such as milder business cycle fluctuations. That's a different kind of market failure. The State should favour renting as this gives a more flexible labour market which yields milder business cycle fluctuations, which induces gains for all. Every person who owns a house imposes a negative externality upon everyone else in the form of a more inflexible labour market.

On this theme, here is a fascinating new NBER WP by Blanchflower and Oswald. The abstract says: We explore the hypothesis that high home-ownership damages the labor market. Our results are relevant to, and may be worrying for, a range of policy-makers and researchers. We find that rises in the home- ownership rate in a U.S. state are a precursor to eventual sharp rises in unemployment in that state. The elasticity exceeds unity: a doubling of the rate of home-ownership in a U.S. state is followed in the long-run by more than a doubling of the later unemployment rate. What mechanism might explain this? We show that rises in home-ownership lead to three problems: (i) lower levels of labor mobility, (ii) greater commuting times, and (iii) fewer new businesses. Our argument is not that owners themselves are disproportionately unemployed. The evidence suggests, instead, that the housing market can produce negative ‘externalities’ upon the labor market. The time lags are long. That gradualness may explain why these important patterns are so little-known.

Turning to international finance, the objective of international risk sharing is to remove home bias. In the real estate context, what works best is for a person in Bombay to rent a flat owned by Japanese investors and for a person in Tokyo to rent a flat owned by Indian investors. This achieves risk sharing: each party avoids the risk of real estate fluctuations that are correlated with the main portfolio which includes human capital. Capital controls that interfere with such investments are an obvious mistake that need to be removed. But as in trade integration, once overt restrictions are removed, an array of institutional factors that impede cross-border interaction come to prominence.

For the risk-sharing outcome (homes in Tokyo owned by investors in Bombay and vice versa), we need real estate to be owned by professional companies that rent it out. The shares of these professional companies, or securitisation instruments that generate cashflows out of rental streams, can then be purchased by foreign investors. As long as real estate ownership is in the hands of individuals in India, we will suffer from home bias with too much of the portfolio of residents being invested in local instruments. This is another dimension of owning versus renting that we need to keep in mind; we are better off when there is less home ownership.

Conclusion

Most people assume that home ownership is a good thing, that a country is better off if more people own homes. Like most interesting questions in public policy, the story is more complex than meets the eye. There are two different externality-based market failures running in different directions.

At present, in India, the first externality (more home ownership makes people better citizens) is absent since urban governance is unresponsive to voters. The only externality at work is running in the opposite direction (more home ownership gives a less flexible labour market). In the short term, policy should work on pushing towards more renting.

In the long run, urban governance in India might improve, and then we would need to understand the magnitude of these two opposing effects, and then one could choose whether it's worth pushing in one or the other direction. If one can't quantitatively estimate these things, then a cost benefit analysis is not feasible. The best thing is then to do nothing.

In either event, the mainstream view -- that policy makers should push in favour of more home ownership -- needs to be questioned.

SEBI at 25

2013-05-24T06:17:00.001+05:30

In a column in the Economic Times today, I look back at SEBI's journey of the last 25 years. In success and in failure, SEBI was the laboratory where we learned how to do financial economic policy.

You may find it interesting to look at my note about RBI at age 75 (in 2010).

Structural transformation and stylised business cycle facts

2013-05-18T11:43:00.001+05:30

The first step in the economics of business cycles is to establish `stylised facts' about the characteristics of business cycle fluctuations. Once these are know, alternative models can be judged on the extent they are able to predict these stylised facts. This is routine in mainstream macroeconomics, which is largely about the United States economy.

When we think about India, however, there is the question of structural transformation of the economy. There was an old Indian macroeconomics which worried about different things. In recent decades, the economy has changed in fundamental ways: the economy has become mostly open, the role of agriculture has subsided, a financial system has come about and private decisions of firms that are shaped by financial markets now dominate fluctuations of investment. On these themes, you may like to see my article New issues in Indian macro policy.

This raises the question: Does structural transformation change the stylised facts of the business cycle? It appears obvious that when we go from an agriculture-dominated economy to one where agriculture is 12% of GDP, the role of monsoon shocks in GDP should fade away, which should matter for the spectral properties of business cycle fluctuations. Other kinds of structural transformation may not change stylised facts too much. As an example, the IT revolution did not change the business cycle facts in the US. In some respects, things could go in reverse. Some researchers have found that going from a closed to a more open economy yields more consumption volatility, not less, which violates the neoclassical prediction that capital account openness enables better risk sharing.

A recent paper explores these questions: Has India emerged? Business cycle stylised facts from a transitioning economy, by Chetan Ghate, Radhika Pandey and Ila Patnaik, Structural Change and Economic Dynamics, volume 24, page 157--172, March 2013.

The findings of this paper are quite fascinating. Prior to 1991, the stylised facts of the Indian business cycle are quite different from those seen for advanced economies. A sharp change is visible after 1991, and the Indian business cycle becomes more like that of advanced economies. But in the post-1991 period, consumption volatility went up in both absolute and relative terms.

Why did these changes take place? The authors explore a few hypotheses. Was India just lucky in the post-1991 period -- with lower volatility of productivity or monsoon shocks? No, that was not the case.

Did India figure out how to do business cycle stabilisation? No.

The three components which seem to have kicked in are: (a) The decline in the share of agriculture; (b) Investment / inventory cycles rooted in the behaviour of private firms and financial markets and (c) Capital account integration. The fading away of agriculture gave a reduction in the volatility of GDP. Investment and output are now positively correlated thanks to the new investment/inventory cycle that is rooted in the private sector. Pro-cyclicality of capital flows helps explain higher consumption volatility.

A great deal of knowledge in Indian economics was rendered obsolete when India changed from being a closed and poor country to being an open and middle-income economy. We now need to construct a new edifice of empirically grounded knowledge that will help us think about where we now are. This paper will be a key component of this reconstruction.

Autonomy for the CBI: Desirable but non-trivial

2013-05-16T12:00:00.000+05:30

I wrote an article in the Economic Times today about autonomy for bodies such as the CBI.

There are five areas where there is a role for autonomy. But this is a difficult puzzle in public administration and we should be wary of simplistic solutions. We know a bit about how to do autonomy correctly in three areas (monetary policy, financial regulation, infrastructure regulation). Comparable cogitation is required for the other two problems (criminal investigation, tax administration).

The arrogance of power

2013-05-12T17:38:00.001+05:30

Yu Hua has a great piece in the New York Times titled In China, Power is Arrogant where he says:

Several of these rules have since been revoked, but their wacky and arbitrary nature demonstrates the arrogance of power in China. One can imagine all too easily their creators — sitting in comfortable armchairs, drinking high-grade tea and smoking fine cigarettes — discussing the issues at hand as if they were purely intellectual abstractions, never considering how ordinary people might react. That people will be unhappy is no cause for concern because, for so long, the power of the state has trampled on individual rights. Only when rules are so onerous that they stir actual protest do higher-ups take notice: “You guys are just making a mess of things,” they’ll tell their bureaucrat underlings.

This is in China, where the law is a bit of a joke; they do not have a Constitution, an independent judiciary, and the rule of law. Sadly, I often feel similarly about regulation-making in India, where we have much more rule of law, and the law matters much more!

It is rare and unusual, in liberal democracy, for Parliament to contract-out the power to make law. We do this, with regulators. Regulators are bodies created by Parliament and given the power to issue law. The agencies, and unelected bureaucrats, that issue law should be possessed with thought and care in wielding this power. All too often, they are not. Regulation-making in finance, all too often, is devoid of reason.

The draft Indian Financial Code, drafted by FSLRC, features an elaborate regulation-making process -- with details encoded into the law -- that will check such abuses and help bring more sanity to the outcome. It requires that regulators walk through the following steps:

What is the market failure that I have identified? Can I demonstrate that this is a market failure?
Is solving this market failure within my objectives as stated in the law?
What intervention am I proposing?
Is this intervention within my powers?
Will the proposed intervention hit at the claimed market failure? (All too often, financial regulators in India talk about a certain stated malady and then propose an intervention which does something unrelated).
What costs will this proposed intervention impose upon society? Will these costs be larger than the benefits?

This six-step procedure will have to be followed by regulatory agencies, when the Indian Financial Code is enacted as law. This will force staff of regulators to think more and speak in the public domain about what they are thinking. Documentation answering these six questions will have to be released into the public domain. This will achieve two things: Market participants will not be caught by surprise, and criticism (if any) will be voiced by independent observers and stakeholders. The regulatory agency will then have to respond to criticism, also in the public domain. The board of the agency (no less) will take in all this documentation and decide whether to issue the regulation and in what form. The documentation tabled in Parliament will also reflect this full process; it will not merely be the text of the regulation.

Compare this idealised process against a recent episode: RBI regulation on Indian entities owning overseas trading facilities that trade on Indian underlyings. Here is the full text of the RBI `regulation':

2. It has been observed that eligible Indian parties are using overseas direct investments (ODI) automatic route to set up certain structures facilitating trading in currencies, securities and commodities. It has come to the notice of the Reserve Bank that such structures having equity participation of Indian parties have also started offering financial products linked to Indian Rupee (e.g. non-deliverable trades involving foreign currency, rupee exchange rates, stock indices linked to Indian market, etc.). It is clarified that any overseas entity having equity participation directly / indirectly shall not offer such products without the specific approval of the Reserve Bank of India given that currently Indian Rupee is not fully convertible and such products could have implications for the exchange rate management of the country. Any incidence of such product facilitation would be treated as a contravention of the extant FEMA regulations and would consequently attract action under the relevant provisions of FEMA, 1999.

and here is an opinion piece by Ila Patnaik about it.

RBI is perfectly within its powers in issuing this -- and that is the problem with the existing laws. However, this behaviour of RBI is riddled with problems:

Regulation making should be the power of the board and not of officials. It should go through a full formal regulation-making process. This one has not.
The announcement by RBI came out with zero notice. It suddenly imposes negative consequences on MCX and Financial Technologies. This is not fair.
The regulation really makes no sense. What is the economic objective that is being pursued? What is the cost that is being imposed? What do we gain as society from it? The document says nothing. It is a statement of arrogant power, that reminds me of the stories about China at the outset.

Suppose the economic objective was blocking FEMA violations that might take place through such structures. If so, the intervention proposed should directly address these. Suppose the economic objective was blocking PMLA violations that might take place through such structures. If so, the intervention proposed should directly address these. In either event, it is important for RBI to fully articulate what is the problem they're trying to solve; under the present law they have no obligation to say what they are trying. The present law creates arrogance of the regulator.

This is just an example. I see this all the time with RBI, SEBI, FMC, etc. Regulations are issued in much the same mode as the Chinese story: `One can imagine all too easily their creators — sitting in comfortable armchairs, drinking high-grade tea and smoking fine cigarettes — discussing the issues at hand...'.

Under the rule of law, the power to write law is a sacred one, and should be exercised with commensurate care. The present structure of financial law in India is riddled with bad laws that feature inappropriate delegation of powers to semi-autonomous agencies that are not sufficiently careful about using this power, that are arrogant in their use of this power. The regulation-making process of the Indian Financial Code will put regulation-making on a sound foundation, and prevent episodes like this one.

What ails the police?

2013-05-12T14:25:00.001+05:30

by Pradnya Saravade and Renuka Sane.

The recent incidents of rape in Delhi have led to public outrage and calls for resignation of the Delhi Police Commissioner. The problems in police functioning and the unmet expectations of the people are not restricted to Delhi alone. There is a sense of distrust and dissatisfaction with police organisation and operations across the country. In a survey by Transparency International and the Centre for Media Studies, the police topped the list on both perception of corruption and actual experience with corruption. The challenge of police reforms looms large, and an inadequate response may prove to be very costly to not just economic growth, but overall social stability of the country.

It is important to think of three aspects of police operations:

Manpower
Competence
Accountability

Manpower

The number of policemen per 100,000 people in India in 2011 was 137. This compares to about 217 in Australia, 393 in Hong Kong, 370 in Malaysia, 195 in South Korea, 307 in the UK and 256 in the USA.

The overall average masks remarkable variation within states in India. The first column (1) in the Table below on the four most populous states from the four regions in India sourced from the National Crime Records Bureau, shows that Bihar and Uttar Pradesh have only 65 and 94 policemen per 100,000 population, a very low number even by Indian standards. These statistics reflect a very low presence of police personnel on the streets and consequently a high work-load on those on duty.

	(1)	(2)
State	Per 100,000 population (2011)	Police expenditure (% of total expenditure) (2012-13)
Uttar Pradesh	94	5.2
Bihar	65	4.5
Maharashtra	163	4.8
Andhra Pradesh	106	3.1

Competence

The State may increase recruitment into the police force over the next few years. For policing to be effective, however, the policemen need to be competent to serve the population on local crimes: from murder and rape to kidnapping and burglary, handling mass agitations of an aggrieved public against the State in a sensitive manner, and also getting into action during terrorist strikes utilising a completely different skill set. The increasing demands on all of the above require that the police undergo continuous training and upgradation of skills, and be well equipped with the latest technology and weaponry. It is, then, not just a matter of hiring more policemen but also a matter of devoting top management time to organising the police force well, and ensuring adequate inputs of equipment and training.

The second column (2) in the Table above, sourced from States of India, CMIE, shows that the expenditure on police in the four states is about 3-5% of total expenditure. A large part of this expenditure is on the maintenance of the existing police machinery. There is little scope for the police to invest in training and upgradation of skills. This expenditure on policing is not enough to even cater to the basic needs of staff and equipment.

Accountability

The efficiency with which spending is converted into public goods outcomes depends on accountability mechanisms. Ultimately, the test of the effectiveness of the increase in police strength and expenditures is the resolution of crime, and satisfaction of the public on the service provided by the police machinery. There has been dissatisfaction on the evaluation system of police organisations, and a Supreme Court judgement required the setting up of state security commissions in every state. One of the mandates of these commissions is to develop a framework that measures performance through crime victimisation and police perception surveys. As yet, no state has done this. There was one randomised experiment which included a crime victimisation survey in Rajasthan. However, it has not been institutionalised as part of police policy to be followed up at regular intervals. Unless a well conceived survey based feedback loop is established, and becomes a periodic feature of the policy on policing, accountability on the desired outcomes cannot really be expected.

Conclusion

The personal safety of citizens is a public good. It satisfies the two tests for a public good: it is non-rival (your consumption of safety does not diminish my safety) and non-excludable (we cannot exclude a new born child from the blanket of safety).

The desire for safety is the most basic human impulse. To some extent, sectarian impulses amongst common people in India may be driven by the unmet requirement for safety in individuals who then resort to embracing kith and kin in the quest for safety. Without safety, the project of building prosperity through a market economy will stall, as the operations of complex firms break down when faced with criminality and the threat of expropriation dulls the incentive to work.

The republic needs to do more in terms of building a world class criminal justice system, and achieving safety for all. This requires improvements in laws, courts and police. For the police, this requires getting more policemen, transforming their training, equipment and management, and establishing accountability mechanisms.

Interesting readings

2013-05-11T17:10:00.001+05:30

In continuation of Capacity constraints in public policy, India will double the size of its diplomatic staff. And, see Milan Vaishnav in Foreign Affairs.

India is Asia's dharamshala -- why not learn to love it? by R. Jagannathan on Firstpost.

The crisis in our community by Nilanjana S. Roy in the Hindu.

How to tell if your neighbour is a bombmaker by Scott Stewart of Stratfor.

K. P. Krishnan, Smriti Parsheera and Suyash Rai in the Economic Times on Saradha and the IFC.

Shanu Athiparambath in the Business Standard on the objective of monetary policy in India.

An unusual commission by Ashok V. Desai in the Telegraph. Hurdles to new financial code by Monika Halan in Mint.

Monika Halan in Mint on lazy banking that costs the poor money.

T. B. Kapali in the Hindu Business Line worries about accountability of financial regulators.

T. K. Arun in the Economic Times on the root cause of the Saradha scandal. Editorial in the Indian Express about ponzi schemes raging in Indian finance.

Smriti Parsheera on mylaw.net about FSLRC.

Anuradha Guru and Prachi Misra in the Financial Express on systemic risk in the Code.

An interview with Justice Srikrishna on barandbench.com.

In continuation of Real estate - an asset class?, see Why property is the biggest con-job on investors by R. Jagannathan on Firstpost.

SEBI takes a good first step in reviewing risk management by Mobis Philipose in Mint.

India's poor crisis resolution regime by Radhika Pandey and Sumathi Chandrashekaran in the Business Standard.

Windows: it's over by Steven J. Vaughan-Nichols wonders about what will happen to Microsoft Windows, now that both Windows and the PC are in a slump.

Ashlee Vance in BusinessWeek tells a story about `Eve' that I found rather remarkable.

Seven traits of highly creative people.

Real estate in India is not a great asset class

2013-05-11T17:03:00.000+05:30

Most people in India are convinced that investing in real estate is a great idea. In the Economic Times today, I have an article titled Real estate in India is not a great asset class.

Economic Times had carried this as a `poke me' feature, where reader comments are invited. There are 186 comments there as I write this, and they are broadly hostile to what I have written. I would get nervous about the price of any asset where a strong majority of market participants think there are great returns in store.

Mis-selling: from impressions to evidence

2013-04-30T18:48:00.001+05:30

by Renuka Sane.

Retail finance in India is once again in the news for reasons of fraud, this time in the form of the Saradha Group in West Bengal. There is a general sense that such schemes proliferate because of the failure of financial inclusion, and that better supervision by current regulators will bring us back on track. The problems of mis-selling however, are not confined to the unregulated chit-fund industry. For many years now, problems of consumer protection have been gathering prominence. While there is concern about the collision between hard-driving financial firms and the average unsophisticated investor, it has been over-ridden with the argument that the problems are minor, sporadic and over-stated by a sensationalist media.

Evidence on mis-selling

There may not be consensus in policy circles on the pervasiveness of mis-selling, but the incipient academic literature on the problems of consumer protection in household financial choice in India reflects otherwise. The following papers are of note:

Anagol and Kim (2010) study a 22 month period in which closed-end mutual funds were allowed to charge an arguably shrouded amortized fee whereas open-end funds were forced to charge standard entry loads. They find that inflows into the more expensive funds were much higher, and that investors paid approximately 500 million dollars in extra fees in this period.
Sane and Thomas (2013) discuss the failure of consumer protection in the micro-finance crisis in Andhra Pradesh in 2010.
Anagol, Cole and Sarkar (2013) conduct audit studies of insurance agents. They find that insurance agents overwhelmingly recommend products which provide high commissions to the agent and are unsuitable for the customers. This is exacerbated for customers who appear to be less financially literate.
Halan, Sane and Thomas (2013) study the lapsation in insurance policies after the introduction of unit-linked insurance plans (ULIPs) and find that investors lost more than a trillion rupees from mis-selling over the 2005-2012 period. This shows us that while chit funds are a problem in India, (regulated) ULIPs have imposed bigger losses upon households than (unregulated) chit funds.

These papers offer hard evidence about the problems of consumer protection across products and income-groups and establish that the magnitudes of money involved are substantial. It is not easy to now argue that the problems are sporadic and small and of second-order importance.

Weak regulation

These problems have not taken place in an environment of unregulated finance. The regulation in India is product oriented, focuses on form and not function, and places great emphasis on prudential regulation. While protection of customer interests is a key part of the mandate of all regulators, there is no framework on how to bring this about. Each regulator has its own procedures for licensing and registration of intermediaries, expected code of conduct, caps on commissions, grievance redress procedures. The focus is on inputs, and checking the correct boxes, and not on outcomes. This often leads to instances of regulatory arbitrage, or leaves open the possibility that several entities slip through the cracks and get regulated by no one regulator. The system does not clearly identify the rights of the customer, or place responsibility of outcomes on the distributor. There is no basic definition of whether a product is suitable for a specific customer and no standard to which distributors can be held responsible for what they sell. Once investors get duped into signing consent forms, redress seems unlikely. The evidence that the current redress systems are effective in providing relief to customers is also very weak.

Early regulatory responses

The response from Indian regulators has been in the form of policy changes that should prevent mis-selling that has been seen in the past decade. The key milestones are:

Ban on entry loads on mutual funds , SEBI, August 2009
Cap on ULIP commissions, IRDA, October 2009
Order on regulation of ULIPs, pointing out that ULIPs are inherently fund management products, SEBI, April 2010
Changes in ULIP product rules, including surrender charges, IRDA, September 2010
New rules for NBFC-MFIs for lending in micro-finance, RBI, July 2012.
Regulations on investment advice, SEBI, January 2013.

Each of these initiatives is an incremental response by a regulatory agency that became uncomfortable with the status quo. However, they do not add up to a comprehensive and internally consistent strategy for consumer protection, and they are not adequately rooted in law. One regulator has banned commissions for a product, while similar products are permitted to charge commissions under a different regulator. Various distributors such as banks come under far less scrutiny on distribution because they fall under a different banking regulator. SEBI regulations on investment advisors do not apply to agents who provide advice solely on one financial product. This implies that the existing network of agents, including banks, can continue to function in the current framework which does not require agents to act in a fiduciary capacity towards their clients.

Considering the low financial literacy and low access to finance in India, perhaps it is also not advisable to require each agent to have a fiduciary responsibility. There is a strong case to be made for simple products that may be sold without the imposition of high suitability standards. However, no such provision exists in the current regulations. The micro-finance regulations focus predominantly on prudential regulation, even when the problems in the sector arose on issues of customer protection. There is also no understanding of whether the measures imposed have brought about the desired change. A framework for evaluation of the costs and benefits of various regulatory interventions is completely missing from the current regulatory discourse in India, and the response so far has continued to ignore its importance.

The Indian Financial Code will yield transformative change

The Indian Financial Code (IFC) is an important landmark in financial regulation in that it identifies customer protection as a central goal of regulation. The draft law enshrines the customer with rights to prevent mis-selling at the time of sale, and provides for a redress system after an event has occurred. In the IFC, the consumer has a right to get fair disclosure and suitable advice from financial service providers. This recognises that the market for financial products is an uneven playing ground with customers not being in a position to evaluate financial products, especially over long horizons. The code also requires the regulator to undertake measures to promote financial awareness.

The IFC has appreciated the possibility that excessive regulation may have its costs which ultimately get borne by the customer. It has put in place several checks to ensure that regulation is not stifling the market, including that of continuous evaluation of outcomes brought about by policy. Section 54, of Chapter 13 specifies that the financial agency is required to measures the costs and benefits of regulations by using the best available data and the best scientific method when such data is available. There are important connections between the incipient literature on household finance in India, and the requirements for analysis that are embedded in the IFC.

Addressing ponzi schemes: the three parts of the solution strategy

2013-04-30T08:06:00.003+05:30

There is a great deal of moral outrage about ponzi schemes. Parliament is being asked to "do something!". We have seen this movie in India before. Laws are enacted as a knee-jerk response to an event. Quick and dirty responses are poorly thought through, which perpetuates the cycle of underperformance in public administration [example: IRDA/SEBI ordinance, example: MFI bill; example: Lok Pal Bill;].

Laws are the DNA of government, and the drafting of laws should be done with extreme care. The drafting of law should:

Be rooted in adequate technical expertise from four fields: in the subject matter, in public administration, in law and in public economics.
Reflect diverse viewpoints and interests
Be rooted in a consultative process
Reflect an understanding of international experience
Be forged out of a sophisticated debate about alternative design choices.

All too often, in India, we rush in to offer a legislative response while cutting corners on these six requirements.

In the field of finance, the process of policy reform began with a committee process from 2005 to 2011 which mapped out the big ideas for policy reform through a series of expert committee reports. This led up to the establishment of the Financial Sector Legislative Reforms Commission (FSLRC) which worked for two years. A cast of 146 participated in the work of FSLRC, which has drafted the Indian Financial Code. In addition, hundreds of people participated in the committee process that led up to FSLRC. If this full process of policy analysis, from 2005 to 2013, had not been undertaken, the solutions at hand would be a lot inferior.

With this knowledge in hand, it is possible to isolate the three elements of dealing with ponzi schemes, which are in the three blog posts that I just put up on this blog:

The first issue is the question of jurisdiction: Is X a regulated activity and who is the regulator in charge? (By Smriti Parsheera and Suyash Rai).
The second issue is about regulatory strategy, and the Indian Financial Code has three elements that would impinge on ponzi schemes: micro-prudential regulation, resolution and consumer protection. (By Suyash Rai and Smriti Parsheera). The approach is, of course, more general and applies to all savings/investment schemes. But it's interesting and important to understand how this approach addresses the immediate problem that we face today.
The third issue is that of the investigation and enforcement process, where certain maladies have afflicted existing approaches. (By Shubho Roy).

Also see The law that can kill ponzis, once and for all by K. P. Krishnan, Smriti Parsheera and Suyash Rai in the Economic Times.

Investigating ponzi schemes: A malady

2013-04-30T07:44:00.003+05:30

by Shubho Roy.

What has happened?

SEBI was investigating Saradha for more than 3 years before the deposit schemes of the company collapsed (See here). Saradha seems to have used two methods to delay the investigation:

When SEBI asserted its authority to stop Saradha group from collecting money, Saradha challenged the jurisdiction of SEBI in district courts. It quickly got orders to prevent SEBI interfering in its businesses. These orders were eventually overturned by the High Court.
When SEBI requested information from Saradha about their schemes and investors, Saradha responded by providing large volumes of documentation without specifically answering SEBI's questions. This slowed down the entire investigation.

Why is this a problem?

In those three years Saradha took on new depositors and collected money from existing ones. All this money is now lost. Two years of investigation were required to stop what seems to be a run of the mill ponzi scheme. The tactics employed by Saradha are not new. They are similar to those employed by Sahara in delaying investigations in the OFCD schemes and in many other white collar crime investigations. The disturbing fact is that they seem to succeed time and again. While SEBI has wide powers of entities registered with it, if someone does not register with SEBI, the system of enforcement of laws changes completely. The current system requires SEBI to approach the local courts for prosecuting violations of the SEBI Act which constitute an offence. Moreover, SEBI cannot directly appoint lawyers for prosecuting the offences and must rely on the state government prosecution machinery to get criminal prosecution started.

The source of these difficulties

The present system suffers from a number of weaknesses, two of the most important are:

The normal court systems do not have the time or expertise to enforce violations of investment and securities laws. This leads to confusing orders which sometimes exceed the jurisdiction of the courts. Even in the case of Saradha, the High Court set aside the orders preventing SEBI from exercising its powers over Saradha, noting that the courts were out of jurisdiction when they prohibited SEBI. However, High Court orders take time, and in this time period the operator of the ponzi scheme can continue to collect money or misappropriate the money already deposited. Expertise in deciding jurisdiction and applicability of SEBI laws is also not available in most normal district courts. It will be extremely expensive and wasteful to train all district judges in securities laws for the once-in-a-decade case in financial laws.
The use of state public prosecutors for violations of financial laws is problematic for two reasons. First, the normal public prosecutors office is flooded with normal criminal cases like theft, murder, etc. A complex financial law case will never be the priority of the normal public prosecutors office. Second, the average public prosecutor who is extremely busy with the daily load of run of the mill criminal cases is not trained investment and securities laws. Just like district judges, it is not cost effective to train all public prosecutors in securities laws.

How would this work under the IFC?

The Indian Financial Code, drafted by the Financial Sector Legislative Commission, addresses these issues in the following ways:

The whole system of investigation is formalised under an investigator appointed by the regulator. The terms of reference for the investigator, the system of investigation and the time for investigation has to be written down at the onset. Since all incomplete investigations will require extensions, there will be system of raising alarms for an unusually long investigation. See draft clause 394 of the IFC.
The code allows the investigator to apply for a warrant for the search and seizure of documents. The investigator does not have to go to the area where the scheme is operating. He can apply for a warrant with the magistrate where the head office of the regulator is situated. This allows the government to create a special magistrate's office. This magistrate can be trained in issues of finance and fraud and be a proper judicial check for warrants. See draft clause 396 of the IFC.
The code also allows the financial agency to make an order preventing transfer of any money or assets pending an investigation if there is a reasonable fear that the assets of clients are at risk. Any violation of such orders is also punishable by imprisonment up to five years. See draft clause 398 of the IFC.
The code empowers the central government to set up special courts to try cases involving the violation of investment laws. This allows for far quicker and more efficient disposal of cases. These courts will be district courts and follow all due process of law required under the Evidence Act and the Criminal Procedure Code. However, unlike general criminal courts, judges in these courts can be experts in securities and investment laws. See draft clause 417 of the IFC.
Finally the code envisages that the financial sector regulator appoints its own lawyers to prosecute cases of criminal offences. These lawyers will have the same powers as a prosecuting lawyer under the criminal procedure law. Since most financial regulators have legal officers on staff today, this allows specialised expertise to head the prosecution of these crimes rather than a generalist public prosecutor.

The strategy used in the IFC is similar to that used in securities laws in the U.S., where dedicated federal court benches are used to prosecute securities frauds. Even in India, special courts and prosecutors have been created for the CBI and for prosecution of offences under the Prevention of Corruption Act. The longer a ponzi scheme lingers the more victims it accumulates. The Indian Financial Code provides a system to effectively shut down schemes like these and a specialised criminal law system to prosecute violators.

The loss of critical savings by many have raised demands for retribution. A hurried response to such demands can bring in laws which dilutes the principle of `innocent until proved guilty' or reduce the procedural and evidentiary standards. The Code scrupulously avoids this by placing the power of issuing warrants and convicting offences on the same standards as envisaged in the laws of evidence and criminal procedure. However, it addresses the problems of a slow judicial system and dedicated expertise in resolving financial crimes.

Regulatory strategy for savings/investment schemes, that would address ponzi schemes

2013-04-30T07:44:00.001+05:30

by Suyash Rai and Smriti Parsheera

The first task in dealing with ponzi schemes is correctly defining the scope of financial regulation. Once a firm is classified as a financial service provider, the appropriate regulator must choose a regulatory strategy for it. Assuming SEBI had clear jurisdiction with Sahara or MMM, what would SEBI do?

Safety and soundness regulation (also called micro-prudential regulation) is an expensive form of regulation, which includes requirements relating to maintenance of capital, investment restrictions, corporate governance, risk management systems, etc. This type of regulation can not apply equally to every financial institution. For example, the regulator should be able to distinguish between small member-controlled chit funds and larger chit funds.

Differences also need to be drawn based on the nature of the activity being carried out. Micro-prudential regulation should be less stringent for investment schemes as compared to deposit-takers, given the difference in the nature of promises being made to consumers. However, at the very least, the scheme would require authorisation from the regulator. In the MMM India example, had the scheme sought such approval, its promoters would have to satisfy basic fit and proper person requirements. Given that the scheme has been floated by Sergey Mavrodi, a convicted fraudster and the man behind Russia's largest Ponzi scheme, it is likely that the scheme would have failed on this count.

This points to the need for a sophisticated approach to ensure optimal regulation. The law should allow the regulators to apply safety and soundness regulation wherever required, but the decision can't be left to the regulators unconditionally. The law must provide some guidance to them, to make them accountable. What could be the form of this guidance?

Consider the following examples:

A bank with Rs. 10,000 crores of deposits from 1 crore depositors.
A local chit fund with Rs. 10,000 from 20 members.
A chit fund with Rs. 1000 crores from 1 crore members.
A hedge fund investing Rs. 1,000 crores, from 50 investors.
A mutual fund investing 10,000 crores, from 1 crore investors.

Where should safety and soundness regulation apply, and what should be the intensity of the regulation? A closer look reveals a few distinctions on four dimensions.

The bank and the large chit fund are more opaque than the others - most of the important information about their asset quality is not visible. That is why we are often taken aback when they fail. In small chit funds, people have reasonable visibility, since the money is with one of the members and is distributed regularly. Hedge funds and mutual funds are also quite easy to monitor, as long as they report fairly, because they invest in securities that visible in the market on a real time basis.

Bank and the chit funds make promises that are inherently more difficult to fulfill - they must return money, irrespective of their financial position. Banks more so, because the deposits are callable at par. Hedge funds and mutual funds invest on behalf of investors, with no guaranteed rate of return and so the market risk stays with the investors. Institutions making promises inherently more difficult to fulfill are at a greater risk of failing to keep the promises.

There is a difference in the influence the consumers can wield over the institution. In a small chit fund, members have significant influence over each other. In game theory terms, they are in a repeated game over a long horizon - small amounts are saved over short periods, and this is repeated. When a few people become managers of funds for a large number of people, the moral hazard problem increases exponentially, and the consumers' ability to influence the institution drops. Similar difference can be seen in the hedge fund (small number of high value investors), and the mutual fund (large number of small value investors).

The institutions differ in terms of consequences of their failure. If a bank or a chit fund fails, many poor and middle class people lose their savings and many suffer significant hardships. We are seeing this in Saradha's case.

Each of these four distinctions is relevant for deciding where safety and soundness regulation should apply. They can be stated in terms of principles, but do not translate into a set of ex-ante rules in terms of institution-types. If the law states them in terms of rules, it may be gamed. The principles, therefore, must be in the law.

Section 151(1) of the Indian Financial Code provides four principles-based tests, based on the four distinctions discussed above, that will help the regulators decide where and to what extent safety and soundness regulation should apply. The regulators will use a combination of these principles to take the decision. For example, it is not enough that the promise is inherently more difficult to fulfill, the institution should score high on some other tests as well. From the five examples listed earlier, the bank and the large chit fund will be intensely regulated for safety and soundness, and the mutual fund would attract some regulation to ensure that it is acting prudently and reporting fairly. The small chit fund and the hedge fund may be largely exempt.

Handling failure

Even among the licensed and regulated deposit-taking institutions, some will become weak. In such situations, there are ways of stemming the decline, and if the institution fails, minimising the loss to depositors. Dealing with failure requires a sound resolution and deposit insurance system. Deposit insurance covers deposits, upto a limit, against the risk of failure of the institution.

At present, banks in India are covered by a deposit insurance system, which, as demonstrated by the experience of many urban cooperative banks, often takes a long time to settle claims. Bank-like institutions, such as deposit-taking NBFCs, are not covered by deposit insurance. Countries like US and Canada have elaborate systems of resolution, which may include sale of the firm, management through a bridge institution, and temporary public ownership. The agencies responsible for resolution are also empowered to take corrective action if a firm's soundness declines. In India, there is no system for resolving failing firms, and no structured framework for corrective action.

Part VII of the IFC provides for a resolution corporation, which will provide deposit insurance to certain institutions, take corrective actions on firms becoming weak and resolve institutions before they become insolvent, by arranging a sale of the firm, managing it through a bridge institution, or facilitating temporary public ownership. Section 260 enables extension of deposit insurance to institutions taking deposits. The regulators, in consultation with the resolution corporation, will decide which institutions will be covered by deposit insurance. This decision will be taken based on tests like the ones proposed for deciding where safety and soundness regulation will apply.

Enhanced consumer protection

The operators of the MMM scheme claim to make full disclosures to their members about the uncertainty of returns and the risk to their funds. But is mere disclosure sufficient to absolve Ponzi scheme operators from all liability? Certainly not. While disclosure and transparency requirements are integral components of an effective consumer protection regime, research shows that when faced with complex financial decisions, consumers often suffer from cognitive biases which can result in sub-optimal decision making.

It is for this reason that IFC contains additional protections when retail consumers are advised on financial products. This is in the form of suitability assessment requirements that compel the managers and distributors of financial products to assess the relevant personal circumstances of individual scheme members and the suitability of the product for their purposes before advising them to join such schemes.