The Indian Financial Code Draft II: Catalyzing “Too Big to Fail” In India?

[The following post is contributed by Mandar Kagade, who is a Policy Analyst at the Bharti Institute of
Public Policy, Indian School of Business]
The Indian
Financial Code
has proposed to constitute the Financial Stability &
Development Council (“FSDC”)
pursuant to Chapter 76 of the Code with the objective of fostering the
stability and resilience of the financial system by identifying and monitoring
systemic risk and taking all required action to eliminate it. I submit that
despite the otherwise laudable objectives, the existence and the functions of
the FSDC in its current form create a significant risk of “Too Big To Fail”
moral hazard in the Indian financial markets.
First, the FSDC through its
Executive Committee is tasked to designate certain financial service providers
(“FSP”) as “Systemically Important
Financial Institution” (“SIFI”).
While such identification is important as it alerts the markets about the
location of concentrated risk, the identification itself creates implicit moral
hazard among the market constituents and potential counterparties because it
sends a strong signal that the given FSP is irreplaceable in the financial
ecosystem. Once investors and potential counterparties know that a particular
FSP is a SIFI, they have a strong incentive to not monitor its financial health themselves because they
will rationally discount the risk that the SIFI will be allowed to fail. Put
differently, the cost of capital required by investors and counterparties for
doing business with the SIFI concerned will be at a discount to its real cost
of capital. This lack of market discipline is likely to induce a further moral
hazard among the shareholders and the management of the SIFI concerned as they
will be motivated to take “heads, I win,
tails, you lose” risks as they
will internalize all the profits from taking the extra risks and will
“socialize” the losses among the taxpayers and the counterparties, if the bets
go wrong.
Second, it is arguable that the
FSDC and the regulator concerned will themselves monitor a designated SIFI
pursuant to its mandate under the Code. However, I submit that since the FSDC
and the other regulators are situated outside the SIFI, any monitoring, however
rigorous, will only happen with a time lag. As the great financial crisis of
2008 (“GFC”) teaches us, the
downward spiral from a merely illiquid FSP to an insolvent FSP can take place
rapidly.  As such, monitoring from the
outside leaves the SIFI (and consequently) the financial system at large,
exposed to failure.
The FSDC is modeled on the
lines of the Financial Stability and Oversight Council (“FSOC”) constituted by
the Wall Street Reform & Consumer Protection Act, 2010 (“Dodd-Frank Act”).
Like the FSDC, the FSOC too has the mandate to identify a SIFI. However, in
contrast to the Indian Financial Code, the Dodd-Frank Act also mandates that
the FSOC act to promote market discipline by eliminating moral hazard. The
Indian Financial Code fails to provide any explicit mandate to the FSDC for
elimination of moral hazard. Of course, not to say that the Dodd-Frank Act
eliminates moral hazard altogether; as discussed, the very act of
identification of a SIFI itself leads to implicit moral hazard. However, if we
are to retain a super-regulator at all, then we are better off curtailing
its  discretion to resort to bailouts by
explicitly prescribing that it balance its systemic risk concerns  against the competing objective of moral
hazard mitigation. I propose to submit comments on the same lines to the
Ministry of Finance. It is to be hoped that the lawmakers implement the
proposal.
– Mandar Kagade


[Update – November 2, 2015: A more detailed analysis of the issues discussed in this post is available in an article by the author in the Economic and Political Weekly (EPW)] 

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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