Friday, March 20, 2009

Rethinking financial sector deregulation

Writing in BS, Jaimini Bhagwati observes:

Further, in the last few years some commentators have called upon policymakers and regulators in India to push for the following: (a) the central bank to adopt inflation targeting as its principal objective; (b) move speedily towards capital account convertibility; (c) raise foreign direct investment ceilings in the Indian banking sector; (d) move from defined benefit pensions schemes to defined contributions and favour larger investments in equity markets; and (e) establish Mumbai as an International Financial Centre (MIFC).

We need to pause and reconsider all of the above propositions

Readers of this blog will have no difficulty in appreciating that I share Bhagwati's scepticism about the proposals listed above. My guess is that the sub-prime crisis effectively ensure that a big chunk of the report on the MIFC and the Raghuram Rajan report on financial sector reforms will remain in limbo in the near future.

Bhagwati, now India's ambassador to the EU, Belgium and Luxembourg, was part of the liberalisation brigade earlier. So he surprises me when he says that, "....no amount of overhauling of the regulatory and credit rating processes can reduce systemic risk in the financial sector unless it is accompanied by a clipping of compensation packages to make these comparable to other sectors.".

I have highlighted here the link between top management pay and sytemic risk in the financial sector. But I have refrained from advocating absolute limits on pay. I am more concerned about the design of incentives. It could well be that once we accept the principle that variable pay must be based on return on risk-adjusted capital, levels of compensation in the financial sector will automatically fall from the present levels. But, I would not start out with the notion of caps on pay.

7 comments:

Apurv said...

even mumbai cannot be made the financial capital. we need to diversify the risk of one mumbai as recent attacks showed

K.R.Srivarahan said...

We tend to go overboard to the other extreme whenever a crisis occurs.Let us not attribute every aspect of ongoing financial tumult to capitalist greed. When the dust settles, which it certainly will, sooner than later, we need to take an objective view on what has happened and where we could have done better. We may however remind ourselves that crises will recur periodically though the causative factors will differ.

On making Mumbai the financial capital of India, we should look at "risk-adjusted" status of the city before crowning it.

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