Rethink financial intermediation
The financial markets and intermediaries that we see around us have evolved over a few centuries. Hence, many features of markets and intermediaries that we observe around us, today, owe more to historical problems rather than the needs and opportunities of the present.
An area where this problem is eminently visible is financial intermediation. The three major classes of intermediaries which exist today are banks, mutual funds and brokers. All of us have well-defined mental notions of what a bank does, what a mutual fund does and what a broker does. These notions, which are enshrined in law and regulation in many ways, are largely obsolete. Using contemporary technology, it is easy to visualise a high degree of overlap between the functions of banks, mutual funds and brokers:
- Banks are already fund managers in the sense of deploying funds which investors place with them.
- When brokers offer discretionary portfolio management accounts, they become fund managers.
- There is no reason why mutual funds cannot allow access to their investors through cheque books and ATM cards. Similarly, the investor funds which temporarily lie with a broker could easily be made mobile using cheque books and ATM cards.
- It increasingly makes sense for a mutual fund or a bank to directly have an exchange membership and do securities trades directly; the forced use of an external stock broker can't be justified in a world where exchanges are no longer clubs of brokers who meet on one trading floor.
- A bank branch could be highly successful in offering brokerage services. Banks are already depository participants, and the depository can easily hold custody of both equity and debt instruments. It would be efficient and convenient for banks to offer trading services.
- Securities trading could take place on ATMs. Investors could have the power to move money between alternative fund managers using an ATM.
All these illustrate the convergence in financial intermediation which is taking place all over the world. Many of the ideas listed above, about what is possible using contemporary technology, are already turning into reality in other countries, thus breaking down the walls which traditionally separated banking, mutual funds, and brokerage.
To make sense of financial intermediation, today, the appropriate starting point is a focus upon the functions which an intermediary performs for households and firms in the economy. Conventional debates about intermediation commence by placing (say) banks at the centre of the debate. From an economic perspective, it is useful to place what banks do at the centre of the debate and ask how these functions can be performed better.
Convergence also shows up with financial markets, especially with derivatives. One of the three major categories of derivatives usage -- arbitrage -- is almost purely a fixed income activity, where the best-placed players are today's banks. How would this fit into conventional banking regulation? Similarly, a dollar-rupee futures market is a superior form of market organisation compared with the existing dollar-rupee forward market. When this comes about, would the RBI regulate futures brokerage firms, who would be trading a wide variety of exchange-traded derivatives in equities, interest rates, and commodities, in addition to currency futures?
The recent report of the Ficci task force on capital markets (chaired by Ashok Desai) is perhaps the first document in India which reflects a unified vision of intermediation. It introduces the novel idea of individuals having two important accounts: one with the share depository and one with a new "cash depository". Access to individuals for both these depositories would be through the conventional "distribution channels" of branch offices, ATMs, phone banking and the Internet.
The cash depository would be solely concerned with holding custody of money with zero interest, and providing low-cost movement of funds through cheques, ATMs and real-time electronic transfers. Interest would be earned when individuals place their funds with fund managers. Fund managers would offer heterogeneous risk/return/liquidity choices.
For example, an individual who expects to write a cheque on his entire balance within a few days would be well-advised to place all his money with a money market mutual fund. Conventional banks would compete in this universe in two different ways --either by setting up money market mutual funds or by offering relatively illiquid fund management alternatives which involve deploying assets to corporate working capital requirements, etc.
One major advantage of this approach is that in such a world, there would be no illusion of 100 per cent safe bank deposits (except the zero-interest balances kept with the cash depository). Further, this approach accurately places banks and competing fund managers on an equal footing in terms of regulation and policy.
In such a world, reserve requirements are an unfair tax on one kind of intermediation (banking). Reserve requirements should be replaced by a unified framework for prudential regulation which (a) spans brokers/mutual funds/banks, (b) deals with both credit risk and market risk, and (c) reflects the fact that the securities operations of intermediaries are already adequately addressed by the initial margin that is charged by the clearing corporation.
The functional approach towards financial markets and intermediaries suggests that the walls which separate Sebi, RBI, the Forward Markets Commission (FMC) and sundry government agencies are out of place. Even though wheat trading may fall under the ministry of civil supplies or the ministry of agriculture, spot and futures markets for wheat are really secondary financial markets. Similarly, even though provident funds at present come under the ministry of labour, the knowledge involved in the regulation of fund managers is the same, whether it is for provident funds or conventional mutual funds.
One possible structure for regulation and policy consists of having exactly two agencies.
RBI: The RBI should be concerned with monetary policy and the balance of payments.
FMA: The "financial markets authority" should be a new agency which regulates (a) spot and derivative secondary markets, (b) financial intermediaries and (c) primary markets. It would combine functions at present in the RBI (banking, fixed income and forex markets), Sebi (Securities exchanges, mutual funds, primary market), and the FMC (commodities tradings). It would include financial aspects of saving for old age (which at present come under the ministry of labour), and the insurance sector (which comes under the ministry of finance).
Such regulatory unification would harness economies of scale in regulation and supervision, for the regulators and the regulated. It would improve financial market outcomes by avoiding turf conflicts and by speeding up the process of learning how financial markets work and how best they can be regulated.
For example, the anonymous, electronic, exchange-centric trading which has worked so well on the equity market is the logical choice of a trading mechanism for currencies and bonds; a single regulator would be faster in converting success stories in one area into improved market practice in other areas. A unified regulator would result in a financial system where economic agents devote less effort towards regulatory arbitrage, resulting in a greater focus upon solving problems of firms and households.
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