I read Mr. Someshwar Sundaresan’s article in ‘Business Standard’ on the structural changes that the government should enforce, post-demonetisation. The article left me confused and concerned. The latter reaction prompted this blog post.
Demonetisation had the potential to be a politically (for the BJP) and personally (for the PM) costly move. Hence, it required risk-taking. Some of the measures that the author advocates are not going to stir popular imagination. Hence, there is no natural, logical sequence in putting them up now for consideration, in the wake of demonetisation. In other words, they are independent. They stand or fail in terms of merits of the case, regardless of demonetisation.
One of his first proposals – that is to decouple the banking regulation function from the monetary policy role of the RBI – is not new. It was proposed by the Financial Sector Legislative Reforms Commission in 2012. That Commission had several dissenting notes and one or two dropouts too. So, what exactly did the commission represent and how widely-held those views were within the Commission are important considerations. That said, we can comment on the author’s proposal without going into the credibility of FSLRC recommendations.
Monetary policy decisions are transmitted to the real economy through financial markets and through the financial system – banks and non-bank financial corporations. In India, as in several countries even in an economically advanced region like Europe, the banking system is the far more important channel than financial markets.
Therefore, banking regulation and monetary policy are two sides of the same coin. There is information flow between the two functions that is critical for the effectiveness of the central bank in monetary policy conduct and conversely, there is information in monetary policy decisions that affect regulation. Separating the two would impede this information flow and play into the silo-mentality that is pervasive in bureaucracy and officialdom in general. Indeed, creating structures and an enabling environment that breaks down the silo mindset in official authorities is a crucial structural reform that has to happen now. It is part of the reforms in State capacity building. That is the broader and more urgent task. State incapacity was evident in some form or the other in the execution of demonetisation.
As for separating the regulatory function from the monetary policy role of a central bank, those who tried it have rolled it back. England is an example.
Whether intended or not, the proposed change would undermine soundness of financial regulation. Financial economy and real economy are two different animals. Principles that govern the latter – mainly, laissez faire – are not readily and automatically applicable to the former. There is both solid conceptual and empirical evidence against such a mindless application of so-called ‘free market’ and ‘laissez faire’ principles to the financial sector.
Therefore, the call to separate the banking regulatory function from the central bank that is responsible for monetary policy is best unheeded.