During the two decades prior to the global financial crisis, regulation in developed countries was characterised by progressive deregulation of various aspects of the functioning of the financial sector, premised on the efficiency of markets. The philosophy underlying ‘supervision’ prior to the crisis focused on the judgement of supervisors on the risk management and financial capacity of banking institutions. It is now clear that even when the build-up of risk in the system was quite apparent, the regulators and policy-makers were not prepared to intervene, on account of their belief that markets 'would somehow get it right'.
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In the post-crisis period, when all the traditional canons of good regulation are being challenged, I would propose five principles of good regulation.
The five principles
The first principle is that of the golden mean – the Asian concept of the middle path. This principle would imply that regulation should be able to restrain excesses – excessive leverage, excessive reliance on markets, excessive innovation, excessive growth of the financial sector in relation to the real sector, excessive remuneration, but also excessive controls and caution. For emerging markets it would mean taking the right lessons from the crisis and enabling the growth of markets with appropriate safeguards, rather than trying to prevent innovation.
The second principle is that of regulatory courage. This means having the nerve to take appropriate regulatory measures even when there is pressure from powerful industry and media groups not to do so.
The third principle is the need to encourage financial biodiversity. This means encouraging the presence of heterogeneous institutions and market participants having differing business models and risk appetites, thus leading to a better diversification of systemic risk.
The fourth principle is communication. Regulators need to enjoy public confidence and public understanding of their actions without diluting regulation. For this they need to communicate effectively.
The fifth principle is coordination and co-operation – both nationally and globally, across governments, central banks and regulators. Everyone in the finance industry must be mindful of the global implications of national policies.
India's example
Each of these principles can be illustrated in terms of the action taken by the Reserve Bank of India (RBI) recently. The best example of 'the principle of the golden mean' is the exchange rate policy that was followed by the RBI. The received wisdom in the early 1990s was that one could either have fixed exchange rates or flexible exchange rates. In India, there were no exchange rate targets, but nor were the rates completely left to markets. The policies ensured that the external account was balanced, exchange rates were by and large market determined, and undue volatility was avoided.
Even when the build-up of risk in the system was quite apparent, the regulators and policy-makers were not prepared to intervene
The second principle was demonstrated when the RBI acted with singular courage, in 2006 and 2007, in putting in place countercyclical prudential measures in the form of higher provisions and risk weights in certain asset classes which it was felt were beginning to overheat. This had the effect of cooling these sectors without hurting the flow of credit to the productive sectors. This was the time when there was huge pressure on the RBI to liberalise the markets, particularly the external sector.
The third principle of biodiversity is illustrated by the way prudential regulation is applied to the different categories of banks in the system, taking into account their complexity and systemic importance. The internationally active banks were encouraged to go for Basel II advanced approaches, while other commercial banks were permitted to continue with the standardised approach. Urban co-operative banks, which are analogous to credit unions, are on Basel I, while non-banking financial entities have much higher capital ratios at 15%. Rural banks are yet to move to the minimum capital adequacy ratios but have to maintain positive net worth and minimum liquidity ratios.
An example of an innovative form of communication to further financial inclusion is the outreach programme undertaken by the governor and the deputy governors of the RBI to remote unbanked villages to get a feel for grass-roots issues and also communicate the relevance of the central bank and the regulator to everyone’s lives.
The final principle is co-operation and coordination. In the formulation of policies relating to the capital account or the government borrowing programme, given the implications of twin deficits for financial stability, there is regular, formal and informal coordination between the central bank and the government.
Usha Thorat became director of the Centre for Advanced Financial Research and Learning in Mumbai in 2010, after working at the Reserve Bank of India for 38 years, most recently as deputy governor. The ideas in this article were first presented at the International Centre for Financial Regulation annual conference in October 2011.
