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Raghuram Rajan on why regulators need common sense

Raghuram Rajan on why regulators need common sense Anthony Harrington

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On 17 June, delegates to the First State Bank "Banking and Economic Conclave" in Mumbai heard a speech by the charismatic governor of the Reserve Bank of India, Dr. Raghuram Rajan. The ostensible subject of Rajan's speech was the Financial Sector Legislative Reforms Commission (FLSRC) report, which he calls "one of the most important, well researched and well publicized reports in Indian financial history".

However, Rajan's real interest, it seems, was to use the occasion to set out in a practical way how < href="">regulators should think about their tasks and what intervention in the markets should actually look like. The launch point for his comments was what he called a slightly schizophrenic approach taken by the FSLRC to the "uber" task of how exactly one should go about regulating the regulators.

The FSLRC, rightly in Rajan's view, favors laws that do not set out to micro-manage the regulators but that give them the freedom to, as Rajan puts it, "fill in the details in consonance with the changing needs of the economy". However, the FSLRC, concerned that regulators might end up being given too much flexibility, wants to impose judicial oversight over the regulators as a system of checks and balances. Rajan sees this as likely to deteriorate into a rigidly prescriptive approach that vitiates the flexibility India is trying to build into its regulatory system.

Usually regulation is thought about as the need to impose additional controls and oversight over risk. Rajan switches it around to look at regulation as a way of controlling the risk of "bad behavior". When banks start building products that are "overly complex" they may start from the position of trying to be innovative to address a perceived market need, but that can quickly deteriorate into mis-selling.

Problems arise when the behavior of the regulated entity cannot be completely specified in contracts (where the contract could be adequately overseen by the judicial system), because the outcomes are too difficult to observe or verify in real time, or can only be gauged by looking across multiple instances of those contracts.

This is where the regulator comes in. A large number of complaints over a product can prompt the regulator to recognize a problem and to act, even though no single customer feels it worth taking the bank to court over the product. Where the regulator feels that a particular product - Rajan cites the examples of CDO squared and CDO cubed from the financial crisis - poses a systemic risk it can ban the product altogether.

"The broader point is that a lot of regulatory action stems from the regulator exercising sound judgement based on years of experience. In so doing, it fills in the gaps in laws, contracts and even regulations."

He emphasizes that there are a range of regulatory decisions where those who are tasked with formulating the regulatory regime should not fall into the trap of trying to prescriptively second guess regulatory judgments. This, he argues, is where India's FSLRC report into regulation goes astray. It seems to want to make everything the regulator does subject to legal appeal, which would, in effect, turn the courts into a super regulator - a role for which the courts are manifestly unsuited, since the inability of the courts to act on a range of regulatory issues is precisely why one needs a regulator in the first place. Legal judgement cannot replace regulatory judgement, he argues.

The other problem is that the easier you make it for banks to appeal against the regulator, the more the banks will game the system - and preventing "gaming" is exactly what the regulatory process should be all about as it seeks to control systemic risk. As always, Rajan's thinking is worth following. His tenure as governor of the RBI continues to be a fascinating spectacle.

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Tags: Financial Sector Legislative Reforms Committee , FLSRC , India , Raghuram Rajan , regulation , Reserve Bank of India , systemic risk
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