Why should RBI immediately disband newly appointed Committee on Financial Inclusion?

Many of the past crisis situations can be linked to lax and laissez-faire regulatory and supervisory frameworks that had either been developed by industry insiders with commercial interests and/or been created with significant input from such insiders - both with a view to benefit the overall industry concerned!

Conflict of interest is an area of significant importance to regulatory ethics and this is something that the Reserve Bank of India (RBI) needs to note with urgency because there are significant conflicts of interest in the both the recently appointed financial inclusion committee as well as the banking selection advisory paneli. If not eliminated, they could spell disaster for the larger Indian financial sector. And this article is a means to record the above warning publicly!


First, let us look at what is meant by “conflict of interest”?


Conflict of interest is a scenario where a person or firm has an incentive to serve one’s (own) interest at the expense of another’s interest. This might mean serving the interest of the firm (institution) over that of a client and/or serving the interest of one set of institutions/clients over other set of institutions/clients.


Why attach so much importance to the same with regard to regulation in the financial sector? This is because if it is not entirely eliminated and/or at least properly reduced, the conflicts of interest can even threaten the entire financial system. At least, this is what past crises situations signifies. In fact, if there is a single most recurring theme in financial crises and scandals globally, it is the failure to manage conflicts of interest. And here are some examples:


Let us look this with regard to the financial sector in the United States, which provides very useful learning with regard to conflicts of interest and their relationship to crisis situations. They hold very important lessons for the RBI which seems to be embarking on a very dangerous journey in its effort to turbo charge financial inclusion as well as give out banking licenses in a tearing hurry!


As described by former SEC Chairman Arthur Levitt, “Bank involvement in the securities markets came under close scrutiny after the 1929 market crash. The Pecora hearings of 1933, which focused on the causes of the crash and the subsequent banking crisis, uncovered a wide range of abusive practices on the part of banks and bank affiliates. These included a variety of conflicts of interest; the underwriting of unsound securities in order to pay off bad bank loans; and "pool operations" to support the price of bank stocks.”


In fact, as Levitt has further argued, it is the significant revelations of ‘uncontrolled conflicts of interest’ (please note this carefully) that provided the basis and rationale for the passing of many subsequent regulations - the Securities Act (1933), the Securities Exchange Act (1934), and the Glass-Steagall Banking Act (1933). In fact, it appears that conflicts of interest were also the major reason for the enactment of the Investment Company Act (1940) and the Investment Advisor Act (1940).


Closer to the 1990s, when I lived in the United States for several years, I personally saw numerous examples of conflicts of interest leading to a crisis:

  • The insider trading scandals (such as, the Ivan Boesky and Dennis Levine scandals in the 1980s), the closure Drexel Burnham Lambert (the investment bank) and the associated (criminal) conviction of its famous employee (Michael Milken) are still fresh in my memory.
  • And then there were more financial scandals in the early 2000s – for example, the internet bubble in 2000/2001 exposed problems with dubious high flying research analysts (with very significant conflicts of interest) whose reports were in fact influenced by their own institutions’ investment banking interests. This, in fact, led to specific provisions in the Sarbanes-Oxley Act that dealt with conflicts of interest among research analysts.
  • And just about a decade ago, in 2003, SEC found that the use of brokerage commissions to facilitate the sales of fund shares [was] widespread among funds that relied on broker-dealers to sell fund shares. This led to the adoption of new rules to prohibit funds from this practiceii.


And then, we had the mother of all financial crises in the recent times—the global financial crisis of 2008, which was again based on significant conflicts of interest in many areas such as the production and sale of mortgage-backed securities, rating of these instruments and so on.


As noted in the 2007 report of the Financial Crisis Inquiry Commission (“FCIC”), conflicts of interest that existed among rating agencies in evaluating collateralized debt obligation (“CDO”) deals was investigated by the SEC which subsequently issued a report in June 2008 that stated that conflicts of interest at Moody’s was indeed a very, very major issue. And I quote from this report:


“We introduce some of the most arcane subjects in our report: securitization, structured finance, and derivatives—words that entered the national vocabulary as the financial markets unravelled through 2007 and 2008. Put simply and most pertinently, structured finance was the mechanism by which subprime and other mortgages were turned into complex investments often accorded triple-A ratings by credit rating agencies whose own motives were conflicted. This entire market depended on finely honed computer models—which turned out to be divorced from reality—and on ever-rising housing prices. When that bubble burst, the complexity bubble also burst: the securities almost no one understood, backed by mortgages no lender would have signed 20 years earlier, were the first dominoes to fall in the financial sector.” (Page 28)


Just as an aside, I would like to state there are huge problems with securitisation in the Indian micro-finance sector as well and hope the RBI takes note of the same. Getting back to the FCIC report, it cited several other conflicts underlying the crisis such as: a) underwriters assisting CDO managers in selecting collateral; and b) hedge fund managers selecting collateral from their funds to place in CDOs that they offered to other investors. The FCIC report notes in the above connection that:


“The SEC investigated the rating agencies’ ratings of mortgage-backed securities and CDOs in 2007, reporting its findings to Moody’s in July 2008. The SEC criticized Moody’s for, among other things, failing to verify the accuracy of mortgage information, leaving that work to due diligence firms and other parties; failing to retain documentation about how most deals were rated; allowing ratings quality to be compromised by the complexity of CDO deals; not hiring sufficient staff to rate CDOs; pushing ratings out the door with insufficient review; failing to adequately disclose its rating process for mortgage-backed securities and CDOs; and allowing conflicts of interest to affect rating decisions.” (Page 212)


Yet another conflict cited in the report was about Citigroup offering “liquidity puts” that gave it significant fees in the short term but placed significant financial risk on it in the long term. And I quote the following on Citigroup from the report –


“There is a potential conflict of interest in pricing the liquidity put cheep [sic] so that more CDO equities can be sold and more structuring fee to be generated.” The result would be losses so severe that they would help bring the huge financial conglomerate to the brink of failure, as we will see.” (Page 139)


Another high profile example of conflict of interest in the recent years is the settlement that the SEC reached with Goldman Sachs, in which that firm paid $550 million to settle charges filed by the Commission, and acknowledged that disclosures made in marketing a subprime mortgage product contained incomplete information as they did not disclose the role of a hedge fund client who was taking the opposite side of the trade in the selection of the CDO. And I quote


“2. Goldman acknowledges that the marketing materials for the ABACUS 2007-ACI transaction contained incomplete information. In particular, it was a mistake for the Goldman marketing materials to state that the reference portfolio was "selected by" ACA Management LLC without disclosing the role of Paulson & Co. Inc. in the portfolio selection process and that Paulson's economic interests were adverse to CDO investors. Goldman regrets that the marketing materials did not contain that disclosure. (http://www.sec.gov/litigation/litreleases/2010/consent-pr2010-123.pdf , Page 2, point 3)”


After the 2008 financial crisis, there are a couple of examples of problems that arose from poorly controlled conflicts of interest. One is the famous case of Barclays Bank, which acknowledged misconduct related to ‘possible collusion’ to artificially set LIBOR (the London Interbank Offered Rate). As all of us know, LIBOR is a very significant benchmark that is used to set short-term interest rates on different financial instruments including derivates.


Second is the 2010 AP micro-finance crisis which is again a classic example of the conflict of interest problem! In the 2010 AP crisis, the lax regulation and laissez-faire supervision of the NBFC MFIs (done at the behest of the micro-finance industry at large and NBFCs in particular and RBI’s own misplaced trust in NBFC MFIs as Dr Y V Reddy, former Governor has admitted) led to the eventual crisis on the ground.


Like all of the above, the conflicts of interests prevalent in the recently appointed RBI financial inclusion committee are indeed very serious (as shown in Table 1 below) as the committee has many members representing companies (institutions) that have significant commercial interest in the broad area of financial inclusion including micro-finance. Across the board, these members and the institutions will therefore stand to benefit from the recommendations, regulatory or otherwise made by this committee. This needs to be carefully noted!

Table 1 : Conflict of Interest Origins in The 13 Member RBI Financial Inclusion Committee

Conflict of Interest Origins in 13 Member RBI Financial Inclusion Committee

(Based on Facts Available with Writer and Best Available Judgement of the Writer)

Number of Members of the RBI Financial Inclusion Committee Who have This Conflict of Interest

Number of Members in RBI Financial Inclusion Committee with Specific Conflict of Interest as a proportion of Total Committee Members

  1. Commercial Interest in Financial Inclusion/Micro-Finance area



  1. Members Whose Institutions Could Benefit from Recommendation of Committee



  1. Banking License Applicants



  1. Related to Banking License Applicant (Excluding the two Banking license applicants themselves)



  1. Direct/Indirect Relationship of Committee Member with Major Institutions That were Involved in the 2010 MF Crisis



  1. On-Going Relationship with RBI/Related Institutions as part of Other Responsibilities (One member has six separate such relationships with RBI as on date. So, total members adjusted to reflect this) 



  1. Lender/lending institutions/equivalent



  1. Close Working Relationship Between Members



  1. Members Who Could Gain from Suitable Regulatory Recommendation or Favourable Regulatory Framework



Note: Conflict of interest in points 3 and 4 arise because the chair of the RBI financial inclusion committee is also a member of the RBI banking selection advisory panel, which is to meet roughly at the same time.


What needs to be emphasized here is the fact that the ‘broad industry of financial inclusion’ which needs to be regulated surely cannot decide on its own regulation. In fact, many of the past crisis situations given earlier, can be linked to lax and laissez-faire regulatory/supervisory frameworks that had either been developed by industry insiders with commercial interests and/or been created with significant input from such insiders - both with a view to benefit the overall industry concerned!


Thus, the financial inclusion committee under Dr Nachiket Mor needs to be disbanded forthwith and immediately. Also because the MFIDR Bill (2013) is under the consideration of the Parliamentary Standing Committee of Finance (PSCF), it would be advisable for the RBI to wait for the recommendations of PSCF before taking any steps towards the development of regulatory architecture in the area of financial inclusion/micro-finance! This is especially necessary because in the past, the RBI has had lots of committees comprising of micro-finance industry insiders who decided on how to regulate and supervise themselves and the results are there for all of us to see – the Krishna district AP 2006 micro-finance crisis, the Kolar 2009 localised micro-finance crisis and the state wide 2010 AP micro-finance crisis to name a few


Protecting independent committees that are looking into regulation/supervision in the financial sector - from the influence of the companies (institutions) operating in the same financial markets - is a strong prerequisite to ensure effectiveness of the regulatory architecture being developed. Otherwise, the threat arises that, instead of being guided by public and larger client interests, such committees (like the RBI financial inclusion committee) will promote the interests of the companies and institutions whose activities are supposed to be regulated and supervised. And the RBI can ignore this important fact concerning its own financial inclusion committee at its own peril!

i The conflicts of interest in the banking selection advisory panel are similarly analysed in a separate article

ii Please see http://www.sec.gov/rules/final/ic-26591.pdf - Prohibition on the Use of Brokerage Commissions to Finance Distribution, Investment Company Act Release 26591 (Sept. 2, 2004), 69 Fed. Register 54728, 54728 (Sept. 9, 2004).


(Ramesh S Arunachalam has over two decades of strong grass-roots and institutional experience in rural finance, MSME development, agriculture and rural livelihood systems, rural and urban development and urban poverty alleviation across Asia, Africa, North America and Europe. He has worked with national and state governments and multilateral agencies. His book—Indian Microfinance, The Way Forward—is the first authentic compendium on the history of microfinance in India and its possible future.)


Ramesh S Arunachalam
1 decade ago
Please see this associated article

jaideep shirali
1 decade ago
Ironically, the government keeps on showing the "conflict of interest" flag to citizens, but when it comes to its own activities, this does not apply. A noteworthy example is Pay Commissions, where babus involve almost no common citizens and decide their own salaries & perks. This, when the citizen pays the bill. A similar case is the Railways recruitment policies, which have attracted criticism. The point is, somehow conflict of interest does not apply to netas & babus, just to the citizen. This article reinforces the point.
samir k barua
1 decade ago
Well argued article. Even if one has confidence in the professionalism and integrity of individuls concerned, good governance is all about eliminating the possibility where there could be even a hint of doubt that self interest may dictate the dcisions or recommendations. Samir K Barua
Ramesh S Arunachalam
Replied to samir k barua comment 1 decade ago
Thanks sir. You have put it so well. Conflict of interest is not an accusation - it is a situation that often erodes trust and should be avoided preferably. Thanks again sir!
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