Recently, the independence of the United States Federal Reserve came under scrutiny with the much publicised letter sent from Patrick McHenry to Janet Yellen, criticising the participation of the Federal Reserve (and therefore, indirectly by Yellen) in ‘international forums on financial regulation’. Two questions for thought-one, do we need regulation in the first place and two, if yes, how independent should the regulator be?
Do we need financial regulation?
The first module in my International Banking Law course dealt with the decades-old debate on a lassiez-faire financial system, ardently propounded by economist Kevin Dowd and effective bank regulation within a financial lassiez-faire system by economist duo Benston-Kauffman.
Does our financial system need regulation? Or does Kevin Dowd’s proposition hold, that if free trade is a good thing, why shouldn’t financial markets be?
The US Fed Reserve and the RBI function in different ways, as can be seen with the way they have dealt with the sub-prime mortgage crisis and the NPA issue respectively. The sub-prime crisis was, in short, a result of lack of effective regulation in a laissez-faire system, thereby giving a strong example to back Benston-Kauffman’s hypothesis. Closer home, the RBI recognised the problem of non-performing assets at a time when it can be substantially addressed, albeit criticism that the RBI could have stepped in at a much earlier stage. But substantial reform and subsequent regulation have been formulated, not just to address and ease the problem of non-performing assets, but also take relevant measures to develop India’s stagnant corporate bond market, and in the larger sense the debt capital market. At this stage, I’m compelled to confirm with the Benston-Kauffman proposition. Since its existence, the RBI has more or less made effective regulation for the Indian banking and financial system and the Benston-Kauffman model seems to work for the Indian economy (and not just because I’m a finance lawyer and finance regulation is part of my bread and butter). At the outset, we do need effective regulation, to develop our financial markets and attain efficiency. In doing so, the central bank of a country can function as an invaluable resource in advising the nation as well as provide financial, technical and legal expertise. On an international level, central banks may come together to formulate better practices for banking supervision (such as the Basel Guidelines) based on individual nation experiences.
Independence of Central Banks
Alright, so we need some regulation. But how is this regulation to be carried out? The argument is that central banks must be isolated from the government because political influences may affect the regulator in regulating effectively. For instance, in India, if the central government were to exercise more control or direct what the RBI should or should not do, say, direct them the RBI to mandate banks to lend more to farmers and thereby carry more risk, it would undermine effective regulation. Further, the major role played by central banks is formulation of monetary policy and control of inflation, and the central bank may not be able to do this effectively in the presence of political influence. This is a common argument put forward by those who favour an independent central bank. This may be supported by the argument that the central bank as a regulator is an economic institution, not a political one, with economic aims and objectives.
Yet, on the other hand, the relationship between economics and politics is not a straightforward one. Every government will have economic objectives, and will require to work with the central bank and other financial regulators to achieve these aims. Thus, while the central bank and the government are independent of each other, it is imperative that they work in harmony to achieve social, economic and socio-economic objectives of the economy.