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YH Malegam’s dissent note

Gautam Chikermane’s tweets


I regret I am unable to agree with my colleagues on the following proposals in the Report.

18.4.1. Capital Controls

1. The Report recommends (Chapter 8.3) that: “The rules on capital account transactions for all inward flows will be made by the Central Government in consultation with the regulators. The rules on capital account transactions for all outward flows will be made by the RBI in consultation with the Central Government”

2. I believe that rules should be made by the Central Government only in respect of FDI inward flows and rules in respect of all other flows, both inward and outward should be made by RBI. My reasons for this belief are as under.

3. The distinction made in the Report between inward and outward flows is not as relevant as a distinction between inward FDI flows and other inward flows. The latter distinction is necessary for the following reasons:

* Inward FDI flows result in the acquisition of assets by non-residents in India which can have policy implications e.g., retail, insurance etc.

* While inward FDI flows do carry the right of repatriation of capital, in actual fact very little repatriation takes place and in the short-term FDI flows are largely stable.

* On the other hand, non-FDI inward flows e.g., portfolio investment, external commercial borrowing, NRI deposits etc. are essentially short-term and volatile in nature.

* Even non-FDI inward flows, on repayment result in outward flows.

4. The Report states (See Chapter 8.1) that IMF “recommends that capital controls be implemented only on a temporary basis where other macro-economic policy responses have been exhausted”. While this is true, in a more recent Staff Paper (November 14, 2012) IMF has modified its stand and made the following statements:

* “Capital flow liberalisation is generally more beneficial and less risky if countries have reached certain levels of “thresholds” of financial and institutional development”

* “Rapid capital inflow surges or disruptive outflows can create policy challenges”

* “In certain circumstances, capital flow management measures can be useful”

These comments have to be viewed in the context of India’s persistent current account deficit which is financed largely by net non-FDI inward flows.

5. As the Report mentions (section 11.2) RBI “in order to perform its monetary policy functions and play the role as lender of the last resort needs certain powers “which include the power to” Act as custodian and manager of foreign exchange reserves”. There is strong linkage between capital controls and monetary policy. Capital flows have a natural tendency to affect monetary aggregates by increasing or decreasing the effective money supply and liquidity in the economy. Hence, in the Indian context, capital controls have been actively used as an additional monetary policy tool. To do this effectively, it is necessary that all capital flows, other than FDI inward flows should be monitored and controlled by RBI. Further as the IMF has pointed out, rapid capital inflow surges or disruptive outflows can destabilise the exchange and create volatility. For this reason also, capital controls need to be calibrated by RBI which has the responsibility for exchange rate management.

6. The present arrangement is that while the Central Government determines the policy for FDI, RBI, in consultation with the Central Government makes rules in relation to other capital flows. This arrangement has worked well and even the U.K. Sinha Working Group has not suggested any change to this basic arrangement. For the reasons enumerated above, this basic arrangement must be allowed to continue.

18.4.2. Financial Regulatory Architecture

1. The Report proposes (See Chapter 14.4) that: “the financial regulatory architecture suited for Indian conditions should consist of seven agencies” which will include:

* “Agency #1: A central bank that does monetary policy and enforces the consumer protection and micro-prudential provisions of draft Code in the fields of banking and payments”

* “Agency #2: UFA which enforces the consumer protection and micro-prudential provisions of the draft Code in all finance other than banking and payments”

The proposal therefore is that RBI will only regulate and supervise banks and payment system and that NBFCs and Housing Finance Companies (HFCs) will be regulated and supervised by UFA.

2. I believe that it is essential that NBFCs and HFCs should be regulated by the same regulator as regulates the banks i.e., RBI. My reasons are as under.

3. NBFCs are currently regulated and supervised by RBI. HFCs are currently regulated and supervised by National Housing Bank (NHB) which is a 100% subsidiary of RBI. Under the National Housing Bank (Amendment) Bill 2012 which is before the Standing Committee on Finance of the Parliament, it is proposed that the ownership of NHB will pass to Government and that regulation will pass to RBI with supervision remaining with NHB. The transfer of regulation is considered necessary since banks also do housing finance activity, the relative portfolio sizes being banks – 64% and HFCs – 36%. There are currently 54 HFCs with a total asset size of Rupees 335,000 crores which represents roughly 4.1% of the total asset size of all scheduled commercial banks.

4. NBFCs are also engaged in substantially the same activity as banks. They are asset finance companies, infrastructure finance companies, micro-finance companies and investment companies. They rely upon bank finance and are significant competitors of banks, particularly in the retail banking sector. Individually and collectively they are significant players in the financial system as shown below:

* There are 12,348 NBFCs registered with RBI of which only 265 accept public deposits.

* The total assets of NBFCs aggregate to Rupees 1,038,000 crores which represents roughly 12.7% of the total assets of all scheduled commercial banks.

* There are 376 systemically important NBFCs with assets which aggregate to Rupees 923,000 crores, representing roughly 11.3% of the total assets of all scheduled commercial banks.

* There are 42 NBFCs which have total assets in excess of the smallest scheduled commercial bank and 2 NBFCs which have total assets in excess of the smallest Public Sector bank.

5. As the Report points, (See Chapter 1.5.2) difficulties are created in addressing finance regulation on a holistic basis, when there is the rise of a rapidly growing shadow banking sector. As most knowledgeable commentators have pointed out, one of the major causes of the 2008 financial crisis was the fact that credit intermediation activities were conducted by non-banks outside the regulatory environment. This has raised serious concerns of regulatory arbitrage, requirements for similar regulation of entities performing similar activities and issues of commonality of risks and synergies of unified regulation.

6. The concern for “shadow banking” has also resulted in a number of international initiatives as under:

* At the November 2010 Seoul Summit, the G-20 leaders highlighted the fact that Basel III is strengthening the regulation and supervision of shadow banking and requested the Financial Stability Board (FSB) to make recommendations in the matter.

* FSB identified “shadow banking” as non-banks carrying on bank-like activities such as credit intermediation, maturity transformation and credit facilitation.

* Even before the crisis IMF has prescribed that similar risks and functions should be supervised similarly to minimise the risk of regulatory arbitrage.

* In many countries, HFCs are regulated by bank regulators e.g., MAS in Singapore, HKMA in Hong Kong. In the U.S. the Dodd Frank Act provides for regulatory and supervisory oversight of both systemically important banks and non-banks by the Fed.

7. All the above considerations support the view that:

* NBFCs and HFCs are engaged in activities which can be termed shadow banking.

* They are of a size individually and collectively which can pose a serious challenge to the efficient regulation of banks.

* All the considerations mentioned in the Report to support the need for a single unified regulation support a single unified regulation of banks, NBFCs and HFCs.

* The Commission having decided that there would be two micro-prudential regulators with a separate regulator for banking must recognise that NBFCs and HFCs have greater synergy with banks than with the activities regulated by UFA.

* Consequently it is imperative that NBFCs and HFCs be regulated and supervised by RBI.



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