By Mandar Kagade, Analyst, Bharti Institute of Public Policy

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 “headsI wintailsyou 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.

This post was first published in IndiaCorpLaw on August 3, 2015.