Tuesday 2 October 2012

Towards better financial regulation

Financial Express, 2nd October 2012

The Financial Sector Legislative Reforms Commission was set up to review, simplify and rewrite the legislations affecting financial markets in India. It has been asked to make legislations to bring them in tune with the changing financial landscape in India and the world. The commission, headed by former Supreme Court Judge Justice Srikrishna, has been deliberating since April 2011, and consulting with a spectrum of experts and stakeholders in the financial sector and regulators.

The commission has just released an approach paper available on its website. The paper outlines its strategy and the recommendations it is thinking of making in its report to be submitted by end March 2013. The approach emphasises the objectives of regulation, the rule-making process, and discusses a change in India’s financial regulatory architecture.

In the 2000s, through a number of government committee reports such as the Raghuram Rajan and the Percy Mistry reports which highlighted problems in the Indian financial sector, a slow consensus was seen to be developing in support of reforms. As India grows, the needs of the economy for finance increases. Households and firms, especially small firms, do not have access to finance. Until now, the approach in Indian finance has been to give permissions for some products or markets. The rest of the financial products and markets for which no explicit permission is given, are banned. This approach has restricted innovation in financial markets.

The modern approach to financial regulation, in many advanced economies such as Australia and Canada, which have undertaken financial sector reform in recent decades and which were resilient during the crisis, is one which allows greater innovation, and yet addresses issues of market failure in finance, emphasises the objectives of regulation. It emphasises that the objective of regulation is to protect consumers. Protecting consumers can be achieved by creating a system in which it is difficult to cheat them, indulge in unfair practices, or sell them unsuitable products. If this is the objective of the regulator, and he is empowered with instruments to ensure it, he does not prevent innovation as long as the financial firm is not engaged in such practices which violate these objectives. This envisages that the regulator’s objectives are clearly defined, his powers are clearly enumerated and that his decisions are appealable.

With the objective of protecting consumers, the financial regulator must reduce the probability of failure of financial firms. Here, the regulator must not prevent failure completely. Weak firms should fail, so that labour and capital is freed up. However, firm failure must be done with a minimum cost to consumers or to the taxpayer. It should be the shareholder who pays since he took the risks. The FSLRC envisages creation of a new resolution agency for smooth firm resolution, before a firm goes bankrupt. Such agencies, in other countries, try to sell off weak firms before they fail.

With a view to protecting consumers and improving microprudential regulation of financial firms, the FSLRC has discussed a consumer protection law and a microprudential law which would outline the basic principles on the basis of which regulators would write regulations. Laws may be separated from agencies that enforce these laws. A law can be administered by one agency or many agencies. The same law, such as a consumer protection law, can be enforced by a number of agencies, each in its field. The question of regulatory architecture—a separate banking regulator, or one banking and one non-banking regulator, or indeed one consumer protection agency (as in Australia) and one unified non-sectoral regulator—can be decided by a separate regulatory architecture law.

A crucial element of the FSLRC approach is an emphasis on the governance of regulation. Regulators will be given independence under the law through the selection process, and mechanisms that determine the relationship between government and regulators. But they will be accountable. Accountability will be ensured through clear, well-defined objectives, avoiding conflicting objectives, a well-structured rule-making process involving a clear reference to the objective of the regulation being in sync with that of the law and to the appeals mechanism (through a newly created non-sectoral Financial Sector Appellate Tribunal that subsumes the present Securities Appellate Tribunal).

Questions of policy such as public sector ownership are left to politicians. But the law will require regulation to be ownership neutral: public, private, cooperative or foreign financial institutions, once registered and regulated in India, will face the same laws and regulation. The path to capital account convertibility is, of course, not a matter of law. It is policy. But law will ensure that regulations made under the capital controls law are subject to the same rule of law, procedures and appeals as all other financial sector law.

The commission has invited comments on its approach paper. These comments will be inputs into further discussions and decisions that are to be made.

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