Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Obama’s Financial Reforms and Rajan Committee

I wrote an article
in today’s Financial Express comparing
Obama’s proposals for financial regulatory reform in the United
States with the Rajan Committee proposals in India. Obama’s
speech is available here
and the full report is available here. The
Rajan Committee report is available here.

On Wednesday, US President Obama unveiled an 89 page blueprint for
reforming financial regulation in the US in response to the financial
crisis. The proposals have several striking similarities with the
recommendations of the Raghuram Rajan Committee in India a few months

Obama outlined the need for overhauling the regulatory structure
very succinctly. He said that where there were regulatory gaps,
regulators lacked the authority to take action and where there were
overlaps, regulators lacked accountability for their inaction. The US
and India face this problem of regulatory gaps and overlaps far more
acutely than many other countries (like the UK, Singapore or Germany)
which have a more streamlined regulatory architecture.

While recognising this problem, both the Obama and Rajan proposals
make only incremental changes to the existing architecture and eschew
more ambitious proposals to scrap the system altogether and start all
over again. The reality is that even these proposals might test the
limits of what is politically feasible.

Obama called for the creation of a Financial Services Oversight
Council (FSOC) which is very similar to Rajan’s Financial Sector
Oversight Agencies (FSOA) in terms of its composition and
structure. Both bodies consist of the heads of all regulatory agencies
and have a permanent secretariat. One difference is that the FSOC is
chaired by the Treasury Secretary.

The much bigger difference is that Rajan’s FSOA was also to
be the macro-prudential regulator for systemically important financial
conglomerates and organisations. Under Obama’s proposals, the
macro-prudential regulator for such conglomerates (unimaginatively
called Tier 1 Financial Holding Companies) is the Federal Reserve
Board. Arguments can be made in favour of both models. In the Indian
case, the critical concrete question would be whether the RBI should
be the macro-prudential regulator for the LIC or whether this role
should be performed by all sectoral regulators meeting together.

Obama calls for the creation of a Consumer Financial Protection
Agency (CFPA) whose role is very similar to that of the Office of the
Financial Ombudsman (OFO) proposed by the Rajan Committee. The key
difference is that the CFPA is vested with vast statutory powers while
the OFO was conceived of as having much of the characteristics of a
self-regulatory organisation. I believe that while there is merit in
starting out with less formal statutory powers, the OFO should also
move in the direction of the CFPA whose bite is as formidable as its

On the markets, the corner piece of the Rajan report was the merger
of the commodities derivatives regulator (FMC) into the securities
regulator (SEBI). In the US too there were high expectations about
merging the CFTC into the SEC, but Obama has stopped short of this.

Given the perception of the SEC today as a failed regulator (Bear
Stearns, Lehman and Madoff), it is perfectly understandable that the
President is reluctant to reward it with greater powers. The one
regulator whose failures were even more egregious than that of the SEC
– the OTS which regulated AIG – is proposed to be
disbanded. Another infamous regulator – the OFHEO which
regulated Fannie and Freddie – has already been replaced by the
FHFA. In this context, the SEC should count itself lucky that it has
been left largely intact.

In the long run, however, a merger of the CFTC into the SEC is
inevitable and if Mary Shapiro’s attempts to reform the SEC
succeed, we might not have to wait for the next crisis for this to
happen. In India, the arguments for folding the FMC into Sebi are very
strong and there is no need to wait at all.

Obama’s proposal (like the Rajan report) calls for moving
most Over The Counter (OTC) derivatives towards centralised clearing
and bringing them under the purview of the market regulators. This is
absolutely necessary. Obama’s blueprint also states that key
settlement and clearing agencies should have access to central bank
accounts and facilities to reduce their dependence on banks. This is
an extremely important issue in India as well where the dependence of
securities clearing agencies like NSCCL and CCIL on commercial banks
has become an unacceptable source of systemic risk.

Obama’s reforms recognise the importance of preserving
vibrant financial markets. Obama rightly states that the role of the
government is not to stifle the market, but to strengthen its ability
to unleash creativity and innovation. The goal is to restore markets
in which we reward hard work and responsibility and innovation, not
recklessness and greed. He also says that the purpose of regulation is
to allow markets to promote innovation while discouraging abuse, and
to allow markets to function freely and fairly, without the risk of
financial collapse.

These are important principles to keep in mind. The current global
crisis has discredited the existing regulatory regime for financial
markets; they have not discredited financial markets themselves.


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