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Submitted by Nachiket Mor on
My personal experience is entirely limited to India and its States and therefore may be incomplete but I find the logic of the post from Professor Allen not at all appealing for several reasons: 1. The presence of the public sector in financial services changes the incentive structure of regulators and the government almost entirely, to the point it blurs the separation between these entities and instead of overall development of the sector the principal objective becomes protection of the public sector. 2. Tax bailouts of one form of another become the norm and not the exception and are often hidden deep inside the balance sheets of public financial institutions. For example, the reason the banking license is such a highly desired commodity in India is principally due to the repressed interest rates on current and savings accounts (representing between 30 to 40% of bank balance sheets) which virtually guarantees profits for even the most risk-averse and inactive banks. Loan waivers for large farmers, large scale bailouts of failed cooperative banks and regional rural banks are a matter of course and do not even figure in discussions of crises -- which is why several of us in India feel that we have "escaped" the sub-prime crisis entirely. 4. The most significant problem is that even a small public sector and the need to protect it, constantly forces the system to operate with a low benchmark of performance and risk management, gradually setting a standard for the entire system, even the private sector. Conscious of this the Regulator seeks to compensate with more and more detailed regulation and rules further weakening the internal capacities of the financial institutions. Bank failure is then correctly seen as the failure of regulation forcing the Regulator to take steps to ensure that it never happens. This leads to enormous Moral Hazard as shareholders, management and depositors all transfer their respective supervisory roles also to the Regulator. The Regulator then constantly cites the limits to its regulatory capacity as the most significant barrier to allowing an increase in the number of players thus moving the system towards a strong pro-incumbent-bias who in turn gradually become too big to fail thus further reinforcing this trend. 5. As the two Andhra Pradesh MFI crises so graphically demonstrate (both in 2006 and more recently in 2010) the "official" sector fights back with all the power at its disposal when the private sector threatens its primacy. When the vocal middle classes are involved the restrictions have to be much more subtle (introduction of licensing for ATMs) but when the loss of control over the vote banks of the poor are involved the political interest also becomes fully aligned and the wholesale destruction of the private sector becomes a feasible option. There is no question that financial systems need strong regulation and in my view for that reason there is need for a Regulator that is completely independent and without the confusing mandate that the presence of public sector financial institutions implies. The need to balance systemic stability with the need for evolution of the financial system, in my view needs a Regulator and a systemic design that is fault-tolerant but not error-free. It allows for failure of financial institutions without threatening the stability of the entire system. On this blog post (http://bit.ly/DesignChoices) Bindu Ananth and I explore some alternative designs that have this character.