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

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.

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

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 href="http://finmin.nic.in/fslrc/fslrc_report_vol2.pdf">draft
Code and the underlying href="http://finmin.nic.in/fslrc/fslrc_report_vol1.pdf">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.

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

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 href="http://rbidocs.rbi.org.in/rdocs/Speeches/PDFs/IMCCON05062013.pdf">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.

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The saga of criminalising and then decriminalising cheque bouncing

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:

1. It takes 1,420 days to resolve a contract dispute.
   
   


2. 39.6 percent of the contract value is lost, of which 30% is paid out as fees to lawyers.
   
   


3. 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:

1. Imprisonment for up to 2 years, or,


2. Fine up to twice the amount involved, or,


3. 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:

1. 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.


2. 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.


3. 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.


4. 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.


5. 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.


6. 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.

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FSLRC ki ABC

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.

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Fluctuations of the rupee

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.

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The demise of Rupee Cooperative Bank: A malady

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:

1. 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.
   


2. 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.
   


3. 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
HREF="http://www.dicgc.org.in/English/FD_A-GuideToDepositInsurance.html#q1">''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.

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