Give them credit

Indian Express, 9 February 2008

The RBI and the Government are expected to release a report later this month which finds that the Indian financial system is essentailly sound and resilient. Depsite being 2,600 pages long and weighing 15 kilograms, the report will not carry with it the weight of internationally accepted, independent, expert opinion. Even if these conclusions were correct, the fact that the government prevented independent experts from international bodies and members of standard-setting bodies from participating in the assessment exercise undermines the work, and sends out the wrong signals.

As reported by Hindu Business Line (02 February 2009) the report by the Committee on Financial Sector Assessment is the result of an exercise the Indian government chose to undertake on its own instead of agreeing to an assessment under the Financial Sector Assessment Programme (FSAP) by the IMF and World Bank done for member countries. The self assessment committee, which includes top officials from the RBI and Ministry of Finance, is reported to have found that "the financial system is essentially sound and resilient, and that systemic stability is robust. Compliance with international standards and codes is generally satisfactory, and India is broadly compliant with most of the standards and codes."

Why did the government and RBI choose to do a "self assessment" when more than two thirds of IMF / World Bank member countries chose independent expert assessments through FSAPs? India's actions raise a number of questions. How are these actions consistent with our position that there should be greater international supervision of financial systems in countries whose regulators and governments did not alert the world to the problems in their financial systems? If countries with sophisticated regulatory systems need independent assessments, why not India?

Though the `Financial Sector Assessment Program' (FSAP), a joint IMF and World Bank exercise, aims to be an effort to increase the effectiveness of efforts to promote the soundness of financial sytems in member countries, it plays an important role of providing an independent assessment about a country. This role is being emphasised by many countries, including India, at the G20 forum especially after the regulatory failures in the US in the current finanacial crisis.

This consideration is part of the history of FSAP. Prior to the East Asian crisis, global financial markets believed a lot of what East Asian governments were saying about their domestic financial systems. The governments steadily put out reports claiming that their financial system was sound. Then came the crisis and the reality turned out to be very different.

Global financial firms reacted in an extreme fashion. They went from trusting almost anything in East Asia to trusting nothing in East Asia. Prior to the crisis, global financial firms believed the government propaganda and money poured into East Asia. When the crisis broke, global financial firms disbelieved everything that these governments said and just took money out. This contributed to the severity of the crisis.

In response to these events, the World Bank and the IMF jointly came up with a proposal on how developing countries could better engage with the global financial system. In an FSAP, a team of well-respected international experts would write a report about the strengths and weaknesses of the financial system of a country. This would be an independent review and not propaganda: it would not be like speeches given by civil servants or reports released by central banks.

The FSAP process has been running for roughly a decade now, and roughly two-thirds of countries have done an FSAP. Many countries choose to release these reports so as to feed them back into the information system of the global financial system. These reports can be found on the website of the IMF.

Let us remember the benefits India gets by undertaking such an exercise. For a foreigner, Indian finance is difficult to comprehend. On one hand are some world-class elements, such as the index derivatives trading at NSE. Side by side with this are problems such the malfunctioning Bond-Currency-Derivatives Nexus, or the political influences in Indian finance, with features such as SEBI being prevented from questioning Raju. Global finance has to struggle in making decisions on investing in India. The reduction of asymmetric information through FSAP would help. The FSAP gains legitimacy through three instruments: independence from the government, the use of internationally respected experts, and the stamp of the World Bank and the IMF. A `self-assessment', done by civil servants and their friends, by definition has none of these.

This is evident when we look at what the report has to say about accounting standards. "The International Auditing Standards (ISAs) are widely accepted in India. Some gaps need to be addressed in areas relating to convergence with ISAs, implementation of auditing standards, strengthening the peer review, access to working papers and independence of auditors." Given the state of auditing and accounting standards in India, especially after the Satyam scandal, the government would only undermine its own credibility were it to release a report that points to access to working papers as one of the major gaps.

The right thing for the Government of India is to immediately request an FSAP. Anything less, especially a self assessment that paints a rosy picture, sounds too much like propaganda and sends out the wrong signals. The FSAP report should then be publicly released. It would give an independent expert perspective on what is right and what is wrong in Indian finance. It would reduce the asymmetric information between global finance and the realities of India, and thus help stabilise foreign capital in India by giving out realistic expectations about what is right and what is wrong in Indian finance.

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