HT PAREKH FINANCE COLUMN
Post-Crisis Regulation:
A Contrarian Perspective
T T Ram Mohan
There have been a number of
commissions and committees
on the financial crisis over the
past year, which have largely
covered the same ground in their
analysis and recommendations
for reform of the financial sector.
The Warwick Commission on
International Financial Reform,
constituted by the University of
Warwick in the United Kingdom,
however, strikes out on a different
path. It raises a number of
issues in a way that many other
reports have not. And it also
differs sharply in some of the
recommendations it makes. This
article highlights four themes
that figure in the report: macro-
prudential regulation, rightsizing
the financial sector, regulatory
capture and home country versus
host country regulation.
The Reserve Bank of India’s approach has been
in line with much of the Warwick
Commission’s recommendation and the latter,
in turn, are quite different from what the Percy
Mistry and Raghuram Rajan Committees put
out for India.
T T Ram Mohan (ttr@iimahd.ernet.in) is with
the Indian Institute of Management,
Ahmedabad.
8 JANUARY 16, 2010  vol xlv no 3  EPW   Economic & Political Weekly
T
here is no dearth of committee
reports on the sub-prime crisis. To
mention a few: the Turner report in
the United Kingdom (UK), the UK Treasury’s
report, the United States (US) Treasury’s
report, the Financial Stability Forum report,
the report of the Stiglitz Commission con-
stituted by the United Nations (UN) and
the UNCTAD report. With the exception of
the Stiglitz Commission (whose range of
concerns is wider), these reports largely
cover the same ground and their diagnosis
and prescriptions have much in common.
So, I approached the November 2009
report of the Warwick Commission on Inter-
national Financial Reform, constituted by the
University of Warwick, with a certain lack of
enthusiasm. Almost everything that needed
to be said has been said. What more could
they say? True, the commission had more
academics and representatives of think tanks
on board than many other committees. But
one was not sure this was necessarily a virtue
in an area in which application is everything.
I am happy to say that my misgivings
turned out to be misplaced. The Warwick
Commission does have fresh perspectives
to offer. It raises a number of issues in a
way that many other reports have not.
And it also differs sharply in some of the
recommendations it makes. In this article,
I propose to highlight some of the themes
that figure in the report: macro-prudential
regulation, rightsizing the financial sec-
tor, regulatory capture and home country
versus host country regulation.
Macro-Prudential Regulation
There is general agreement now that it is not
enough to get the rules for banks and other
financial institutions right. Even if this is
done, the system could be exposed to risk.
Worse, systemic risk could be high precisely
on account of micro-prudential regulation.
This arises because of h­omogeneity in the
financial system. Homogeneity, in turn, is
the result of several factors: the use of
market prices as a measure of risk, failure
to take into account funding and leverage
in setting rules for capital, and not distin-
guishing between various types of risk.
Take the problem with the use of market
prices as measures of risk, a problem with
which we have become only too familiar in
the present crisis. If all players are required
to use mark-to-market accounting, then
all will want to sell when the price of par-
ticular assets fall. This sets in motion a
downward spiral in asset prices and leads
to a huge erosion in capital in the financial
system during a crisis. Similarly, the use of
market measures of risk leads to herd
behaviour in good times as all participants
want to hold assets that were regarded as
safe in the past. Such herd behaviour then
makes the assets overvalued, risky and
correlated with other assets of investors.
How do we tackle this problem? We have
heard much about making regulations
counter-cyclical. This would put the brakes
on herd behaviour in financial institutions.
The novel proposal that the Warwick
Commission makes is to have different rules
for different players in the financial system.
Banks use short-term funding and may be
subjected to mark-to-market accounting.
Others, such as insurance firms, use longer-
term funding and should be allowed to
judge whether it makes sense for them to
buy assets that banks want to get rid of.
Using the same accounting rules for
both types of players does not help in a
crisis situation. Rather, the commission
urges, regulations must move particular
risks to institutions best capable of hold-
ing them. This is indeed a bold departure
from the conventional wisdom which is to
set store by a “level playing field” for all
players. More on this later.
Homogeneity in the financial system
today also arises from the failure to take
into account differences in funding and lev-
erage. An institution that is heavily depend-
ent on short-term funds from the capital
markets has the same capital requirements
as another that relies on deposits. The com-
mission proposes capital requirements that
are linked to mismatches in maturities
between assets and liabilities. This, how-
ever, is not something that has thus far
found favour with the Basel Committee.

There is one aspect of homogeneity that
does not seem to have got the attention it
deserves: homogeneity in ownership. Or,
to put it differently, the potential benefits
in terms of managing systemic risk of hav-
ing different kinds of ownership in the
financial sector. India and China both have
this sort of heterogeneity, more so India.
We have a public sector-dominated bank-
ing sector, a fairly large room for the domes-
tic private sector and lesser scope for the
foreign sector. Their respective shares will,
of course, change over time and it is possi-
ble to debate how fast this should happen.
The crucial point is that the system seems
to gain from having a diverse mix of owner-
ship probably because the attitudes towards
risk differ among the different owners.
Public sector banks are relatively risk-
averse; foreign banks, perhaps, come in at
the opposite end of the spectrum. The system
as a whole avoids either extreme. In risk
management, there is the regulatory issue
of ensuring that all players do not use the
same models because this makes for identi-
cal responses in a crisis. Can we extrapo-
late from this and say that the same argu-
ment holds with the pattern of ownership
in banking? The Warwick Commission
might have addressed this issue.
There is one significant aspect of ma­cro-
prudential regulation that the report does
not touch upon: the role of monetary policy
in dealing with asset bubbles. Should central
banks respond to signs of asset bubbles? Is
there a range for asset prices that central
banks should target? These are issues that
have figured in public discourse on the
financial crisis.
Rightsizing the Financial Sector
I turn now to another important issue
flagged in the report, namely, the size of
the financial sector in relation to the real
economy. The financial crisis has thrown
the spotlight on how bloated the financial
sector had become in economies such as
the US and the UK and how certain
m­arkets, such as foreign exchange, bore
no relationship to the real economy.
The Warwick Commission sees a clear
need to rightsize finance. It also raises an
important research issue that needs to be
pursued: is there an optimal size for the
financial sector? Finance should not be so
small that it constrains the real economy; it
Economic & Political Weekly  EPW   JANUARY 16, 2010  vol xlv no 3
HT PAREKH FINANCE COLUMN
should not be so large that an inevitable
shrinkage at a later point has an adverse
impact on the real economy.
What caused the financial sectors in the
advanced economies to become so bloated?
The report mentions several factors. One,
the belief that the financial sector is the
most efficient allocator of resources and
hence the more developed the financial
sector, the better for the economy. Two, the
growth of investment banks and brokers
who, it was thought, performed the role of
resource allocation without putting the
ordinary depositor at risk. Three, the view
that market participants had developed
sophisticated models that helped them
monitor and manage risk effectively.
How to prevent the financial sector from
being bloated? The report mentions means
that have been proposed by others as well:
counter-cyclical provisioning norms, man-
dating a ceiling on the leverage ratio for
financial institutions, higher capital
requirements for systemically important
institutions, and a Tobin tax to limit short-
term activity in the financial markets. The
fifth idea is the commission’s own: segre-
gating different categories of finance,
based on risk capacity, and moving away
from a level playing field for all institu-
tions. Former US Federal Reserve Chair-
man Paul Volcker, Bank of England gover-
nor Mervyn King and former US Treasury
Secretary Nicholas Brady are among those
who have urged restrictions on the scope
of activities of financial institutions. They
would like to see a clear separation of
banking from investment banking ac­tivities
in order to prevent a recurrence of finan-
cial crises. Others have argued for restric-
tions on the size of financial institutions.
The commission believes that a better
way to handle the problem is not to have
the same regulations across various types
of institutions. Having an un-level playing
field, they contend, will in itself prevent the
emergence of financial supermarkets and
the too-big-to-fail problem. This is an idea
that is worth exploring because, if feasible,
it could be an alternative to blunt instru-
ments such as restrictions on scope and size.
Regulatory Capture
The Warwick Commission is forthright in
laying the blame for the financial crisis where
it belongs. It says, “Regulatory capture
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substantially contributed to regulatory
failure”. It makes the point that regulatory
capture was not just a matter of market
players coming to exercise influence.
Regulatory capture was also intellec-
tual. There was a universal acceptance of
notions of market efficiency and the con-
sequent need for regulation with a light
touch. There is also the in-built reluctance
of politicians to cut off a boom – who
wants to put an end to the good times?
The report draws attention to an insidious
trend that we in India also need to be alert to:
a growing role for the private sector in policy
formulation. There is a line to be drawn
always between taking inputs from the
private sector – and both the Reserve Bank
of India (RBI) and the Securities Exchange
Board of India (SEBI) do a good job of this –
and giving them a role in formulating policy.
The report makes three concrete sugges-
tions for containing regulatory capture. One,
regulatory policy should be more rule-based.
Two, the financial sector and financial insti-
tutions should be rightsized so that they do
not wield disproportionate clout when it
comes to making policy. Three, we should
emphasise host-country rather than home-
country regulation. This is especially neces-
sary for emerging market economies to
have room to deal with cross-border flows.
Home Country versus Host
Country Regulation
Perhaps the most contrarian recommenda-
tion of the report is that the locus of regula-
tion should be host-country regulation and
not home-country regulation. The conven-
tional wisdom underpinning the various
Basel agreements tends to stress global
rules in the name of creating a level playing
field for players and preventing regulatory
arbitrage. The commission makes the tell-
ing point that the present system, with its
global orientation, could not ultimately
prevent regulatory arbitrage.
The reality is that national regulators
may sign up to global agreements but will
ultimately do their best to favour their own
institutions – witness the expansion of US
investment banks into Asia after the east
Asian crisis, “light touch” regulation in
Britain, etc. Besides, global rules just
cannot meet the requirements of individual
countries because countries differ in their
financial structure. They also differ in their
10
political priorities. In India, the focus on
financial inclusion is appropriate. Trans-
plant this to the US and you may end up
having lax regulation for the section of
society that needs it most, as we saw in the
sub-prime crisis.
The report states its alternative proposal
in emphatic terms:
The idea is that all institutions carrying on
financial activities nationally, raising funds
from residents or investing in national assets
or markets, must be regulated locally. An
I­celandic bank could no longer operate in the
UK as a branch, regulated in most party by the
authorities in Iceland but must be regulated
in the UK as a stand-alone bank with sufficient
capital for its activities in the UK and be able
to withstand the failure of its parent.
Does this imply that a subsidiary of a for-
eign bank will be subject to the same treat-
ment as a domestic bank? The report sug-
gests this would indeed be the case. Such a
prescription, however, is open to question.
In India, the RBI permits foreign banks to
operate either as branches or as subsidiaries.
But subsidiaries of foreign banks do not
qualify for the same treatment as domestic
banks. This is because a host of issues related
to the regulation of foreign banks do not go
away just because they operate through sub-
sidiaries. The report mentions the stability of
the Indian banking sector as highlighting
the advantages of host country regulation, so
JANUARY 16, 2010  vol xlv no 3  EPW   Economic & Political Weekly
it would have been appropriate for the
commission to have taken note of the
nuances to foreign bank regulation in India.
I would argue that it may not suffice to
stop at having foreign banks operate as sub-
sidiaries. To ensure a better convergence
with host country interests, it may be neces-
sary to require subsidiaries to list on exchan­
ges with a requirement that, say, 40% of
capital be offered to host country investors.
To sum up, we in India will not have diffi-
culty in going along with the thrust of this
report and indeed will be pleased with what
it says because on issues such as macro-pru-
dential regulation and host country regula-
tion, the RBI has turned out to be ahead of
the regulatory curve and in line with what
the report r­ecommends.
The Percy Mistry report on Mumbai as an
international financial centre viewed a
span­king financial district as central to
powe­ring economic growth. India’s growth
record in 2004-08 has helped debunk this
view. The Warwick Commission’s emphasis
on rightsizing finance should help place the
issue in better perspective. The Raghuram
Rajan Committee report found fault with
the absence of a level playing field amongst
different financial intermediaries in the
Indian system. The Warwick Commission
report should prompt some serious rethink-
ing on this issue as well.