Indian Financial Code's Revised Draft

The Ministry of Finance released the “Revised Draft Indian Financial Code” (henceforth, Code) for public comments in July. Since its release, the Code’s proposal of a Monetary Policy Committee with a majority of government nominees, and the absence of veto for the Reserve Bank of India (RBI) Governor have attracted a lot of attention. However, the Code has some other critical proposals including the proposed Financial Stability and Development Council (that will act as the super-regulator and monitor systemic risk) that will radically alter the financial regulatory landscape of India. This commentary will critique two of its salient proposals. At the outset, I argue that the objectives and function of the proposed Financial Stability and Development Council (FSDC) appear to promote the familiar, “too big to fail” risk in the Indian financial system. I further argue that the constitution of its membership is such that it would create perverse incentives to resort to bailouts of financial institutions. Later, I analyse the “prompt corrective action” regime that is proposed for financial service providers who benefit from deposit insurance, and point out that it appears to have failed to account for one of the key lessons from the global financial crisis of 2008—asymmetric incentives created by the design of executive compensation were one of the principal causes of the crisis. I argue that prudential regulation of covered service providers can benefit from inclusion of power to regulate the design of bankers’ pay that it currently lacks.

The ‘Too Big to Fail’ Problem