Monday, June 09, 2008

What broad lessons can India draw from the subprime crisis?

o In a very well written piece, the Chairman of the CFSR (Committee on Financial Sector Reforms) of the Planning Commission, Dr. Raghuram Rajan writes about the lessons that our country can learn from the subprime debacle and also offers solutions.

o Perhaps the most important lesson is that a narrow focus on rules can lead regulators to miss the bigger picture, and can encourage regulatory arbitrage, to the detriment of the system. Regulators were overly fixated on seeing that rules on capital norms were being met, without seeing the larger picture – that many banks were going to the riskiest structures consistent with the rules. To achieve this, a statutory body, the Financial Sector Oversight Agency (FSOA) composed of key regulators, which will replace the current informal High-Level Coordination Committee (HLCC) is recommended to be set up. The FSOA will conduct a principles-based supervisory dialogue with top management of key financial conglomerates, look out for an overall build up of risks in the system, and undertake coordinated action to mitigate those risks. The senior-most regulator – typically the RBI governor – would be the head of the FSOA. In many ways, the FSOA would have the powers in India that the US Treasury’s reform plan seeks to give the Fed.

o Second, some regulators resort to boxchecking when they simply do not understand what they are dealing with. We need to constantly upgrade regulatory skills. Investments in better regulatory pay and conditions, as well as in training, can offer tremendous national return.

o Third, there are fewer limits on regulatory action when regulators can go beyond the letter of regulations. To balance this power, the CFSR recommends regulatory actions should be subject to appeal to a Financial Sector Appellate Tribunal. More freedom for regulators will therefore be combined with checks to ensure the freedom is not misused.