Tuesday, 26 March 2013

Turf war in the offing

Financial Express, 26th March 2013

FSLRC recommendations would be challenged by the financial regulators

Two of the most important committees on financial sector reform in India in recent years-the Raghuram Rajan Committee and the Percy Mistry Committee-have recommended a change in the regulatory architecture. The problems of regulatory gaps, overlaps, turf wars, and tension with the government have only increased since these committees submitted their reports. While the Percy Mistry report recommended a single unified regulator, Raghuram Rajan recommended a more conservative approach-a banking and non-banking regulator, keeping RBI as the banking regulator. The Financial Sector Legislative Reforms Commission (FSLRC) has taken the more conservative approach of two reports, keeping banking with RBI while proposing a merger of other regulatory bodies into one regulator.

In almost every country where regulators have been unified as the financial system has become more complex and as regulatory walls have become hurdles to better regulation, existing regulators have fought back. The past and present staff of various regulatory bodies are amongst the biggest opponents of regulatory institutional change. No doubt, in India too, turf war will take place. The commission, in recommending a non-sectoral law, will no doubt make regulators and many regulated entities, happy in the present set up, quite unhappy. The debate on the draft law in public discourse will need to go beyond who will administer the law and beyond the unhappiness of regulators who find their turf encroached upon to the contents of the law. In many ways, who administers the law is the least important part of the recommendations of the commission.

Financial sector reform in India has been a slow process of responding to the needs of a growing economy. Other than the initiatives in the equity market, most changes in the framework of financial regulation in India have been made in response to the need of the hour. This has meant piecemeal changes to the various laws that give powers to regulators to regulate finance. In addition to the many amendments to the laws, there have been many committees looking into the difficulties of finance. A slow consensus has grown which recommends changes in the regulatory framework. However, many of these changes were not possible since the basic structure of the law did not allow it. The FSLRC was set up to review, rethink and redraft the basic laws so that Indian finance can be reformed to prepare India as a growing modern economy, without having to constantly amend existing laws to incorporate changes in technology or other innovation.

This commission, which submitted its report to the finance minister on March 22, 2013, was not a quick and dirty response to political pressure in a crisis situation. It was a serious, consultative, well-researched effort at rethinking the objectives of regulation, of regulatory governance, and of the independence and accountability of regulators in India. The job of the commission, which began two years ago, was not to simply tweak and fix the things that were not working, but to question the fundamental arrangements between regulators, the government, the regulated and the consumer for whose protection regulation is ultimately being done. The commission involved more than a 100 people doing research, learning lessons from the global crisis and consulting regulators, market participants and various stakeholders.

What is the most important element of the new draft law-the Indian Financial Code. This law puts consumer protection at the centre of all regulation. Whether we have to reduce the risk of failure of banks or an insurance company, so that depositors and policy holders are protected, whether we have to find ways of rescuing failing entities with minimum cost to the taxpayer, whether we have to find ways to ensure that a household is not sold unsuitable products, or whether we wish to prevent a disruption of financial services on the scale of the system as a whole, the objective of the regulation is to protect the consumer without putting the burden on the taxpayer.

The need for regulation arises because of the asymmetric power and information that customers of financial services have, in contrast to the providers, and they must be protected from unfair practices, or from the provider taking very high risks to earn high returns. In this framework, the objective of micro-prudential regulation, i.e. regulation of entities in the financial sector, is to protect customers. If regulation entails a higher burden on owners and shareholders, in proportion to the risks they take and the commitments they make, in order to protect customers, the burden may be justified. After the global financial crisis, whose origins lay first in the sale of unsuitable financial products to consumers, and then in the lax regulation of financial firms that were holding those assets, the commission has focused on the extremely important role that good regulation can play in making the financial system resilient.

A major theme of many of the recommendations of previous committee reports in India has been the opposite problem of those that led to the global financial crisis. Instead of suffering from too much innovation as the US is supposed to have witnessed in the run up to the financial crisis, Indian regulators have often been found to do excessive regulation and strangle of innovation. This issue can be addressed by giving regulators clear objectives, through enumerated powers. If the regulator simply wishes to ban something so that he does not have to witness any risk on his clock, the law will not give him the power to do so. He needs to demonstrate that the regulation is required to meet the objectives assigned to him, and is within his powers to do so, and that a cost benefit analysis of the regulation shows that the additional cost, monetary or otherwise, of complying to this regulation is going to bring clear benefits to the economy. The regulator would be hopefully restricted by the proposed accountability mechanisms not to prevent all innovation. Further, even if he does go ahead and issues regulations that do not meet the objectives that are given to him, the regulation can be challenged in a newly set up Financial Sector Appellate Tribunal.

Once the draft code becomes law, regulators would be required to write regulations in line with the powers and role given to them by the new law. The process may take time, but the framework provided by the FSLRC would lay the foundations of a well regulated modern financial system in India.

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