Stick to the line of control

Financial Express, 27th May 2013

Just redefine foreign investments by whether or not they seek to control the company they are in

Indian capital controls are amongst the most complex in the world. In this area the Indian bureaucracy blindly marched on in the spirit of the licence permit raj of the 1970s. Today, the system has become so tangled that it is difficult to implement all the various conflicting rules in place. Simplifying the system requires implementing the UK Sinha working group on foreign investment through current initiatives such as the Sebi working group on QFI, and the Arvind Mayaram group on FDI definition.

The gentle reader is requested to read the next few tortuous paragraphs, in order to get a sense of the scale of complexity that has been constructed in the Indian capital controls. Foreign investment into India has been cut up into a maze of categories. Foreign investors are classified as: Foreign Institutional Investors (FIIs), Foreign Venture Capital Investors (FVCIs), Non-Resident Indians (NRIs), Qualified Foreign Investors (QFIs) and Foreign Direct Investors (FDI). FDI includes a sub-route involving issuing ADRs/GDRs or foreign currency convertible bonds. Sebi, RBI and the finance ministry make rules and regulations governing foreign investment. Investment by each subcategory of investors in each sector has to be continuously monitored.

The FDI framework consists of acts, regulations, press notes, press releases and clarifications, etc. The Department of Industrial Policy and Promotion (DIPP), ministry of commerce & industry, frames policy on FDI through press notes which are notified by RBI as amendments to the FEMA regulations. To bring some clarity, DIPP attempts to consolidate the various circulars on FDI in a consolidated policy statement (which has unclear legal authority). Often, it seems to get tangled in the issues with other routes of investment. While FDI is permitted up to 100% in most sectors under the automatic route, in other sectors there are sectoral investment caps.

In addition, the rules cross reference each other. For example, RBI regulations on FIIs state that an individual FII can purchase up to 10% of the equity of a company and all FIIs together can hold up to 24%. In addition, there are caps for NRIs and QFIs. The same regulations give an option to the company to raise the aggregate FII limit from 24% to the sectoral limit prescribed by the FDI policy. Similarly, when the DIPP issues press notes governing FDI limit, it states the FII investment limit should stay within the caps on foreign direct investment. In some cases, the consolidated FDI policy overrides the regulations made by RBI. In print media, the foreign investment limit is 26%, which includes the limit by NRIs/FIIs/PIOs. This means that if a company with an FDI of 20% lists on the exchanges, FIIs and other portfolio investors will be allowed to the extent of only 6%. This contradicts the RBI regulations which state that FIIs can purchase up to 24% of equity of a listed company.

Similarly, if a foreign investor invests in the same company through both the QFI route and the FDI route, the total holding of the person in such a company cannot exceed 5% of the paid up equity capital of the company, at any point of time irrespective of the sectoral cap, if any. In addition, regulations often restrict FII/NRI/QFI investments in a company at various arbitrary limits and cap their total limit to the FDI limit.

The regulatory framework is further complicated by the lack of clarity on the nature of instruments classified as FDI. As an example, if a company raises funds through the issue of ADRs/GDRs, the resultant foreign investment is considered to be part of FDI. ADRs/GDRs are largely equity instruments and investments through these do not qualify as 'control' by the foreign investors as these instruments do not give voting rights to the investors.

This tangled mess is typical of everything that India did wrong in economic policy in previous decades. Just as we have simplified industrial licensing (by eliminating it) or indirect taxation (by moving to a single rate GST), we need to drastically simplify capital controls so as to reduce transactions costs, and shift the focus of the field away from fixers to genuine investors.

In the Budget speech 2013, the finance minister announced that India will follow international best practices in defining FDI and FII. According to OECD and UNCTAD norms, a stake of less than 10% should be classified as FII. The government proposes to provide clear definitions to FDI and FII, with an aim to remove ambiguity over the two types of foreign investments.

The key step is that of clarifying the objective of the FDI/FII classification and regulations. If the objective of regulations is to prevent foreigners from taking control of an Indian company (due to national security, politics, infant industry arguments, etc) then the regulations should not take into consideration the amount of portfolio investments in the company, since such investments are not for the purpose of control of the Indian company. The regulator may choose to classify any single large investor (say, above 10) as one seeking control and bring him under the limit, but overall limits for portfolio investment do not serve this purpose.

A simple solution of redefining the different foreign investment routes is by dividing investment into two categories: investment which is related to foreign control of the Indian companies and investment which does not lead to control of an Indian company. Under this system, the FII or, say, QFI investment will not be considered for FDI limits. It will simplify both the calculation of limits for FDI and the monitoring costs. The investments which do not lead to control of the Indian company should then be subject to a uniform registration requirement with emphasis on robust KYC norms.

(Co-authored with Radhika Pandey of NIPFP)

How do you prevent rupee trades?

Financial Express, 10th May 2013

Even if Indian firms stop offering such overseas trades, the market will continue to thrive

In a recent circular, the Reserve Bank of India (RBI) prohibited Indian entities owning foreign entities that facilitate trading in offshore rupee derivatives. Since the rupee is not a convertible currency, it cannot be traded outside India. Trading in rupees derivatives, even when it is in non-deliverable products, which may not technically be trading the rupee, constitutes a violation of the Foreign Exchange Management Act (FEMA). RBI feels that such trading makes the job of managing the rupee harder.

While RBI does not have regulatory jurisdiction over foreign exchanges that offer platforms for such trades, FEMA gives it jurisdiction over entities even those outside India if they are owned or controlled by a person residing in India. Indian entities facilitating offshore markets require its permission. According to the present law, those entities which, fully or partly, own businesses that offer such products need to take permission from RBI. Today, such firms have three choices. Either those derivative products must not be sold any more, or the businesses have to exit their participation in the ownership of those exchanges, or they must receive RBI's permission to continue the facilitation of offshore rupee derivative products. While at one level this appears is an attempt to curb the growth of the rupee market for hedging and speculation, the real issue lies in the legal framework of capital controls.

The first is the question of the path to capital account convertibility. As long as the rupee is not convertible, i.e cannot be bought and sold in foreign markets, and as long as RBI is required to administer FEMA, issuing and enforcing such regulation is part of RBI's responsibilities. While the usual arguments can be made about the need for RBI to encourage growth of the market, their usefulness in today's context are limited. Unless there is move towards convertibility, and unless the present FEMA is repealed, RBI, with the responsibility to see that it is not violated, will have to enforce it. Within the present framework of non-convertibility and the present regime of capital controls, a violation of FEMA is an offence under the law. If the law is changed to make the rupee fully convertible and RBI is required to administer that law, such a regulation would not be feasible. For the time being, Indian companies participating in such activities are required to operate within the legal boundaries of FEMA.

Today, the arguments for making the rupee convertible are stronger than before. As India integrates both on account of trade and financial flows with the rest of the world, it needs to move to allowing the currency to trade abroad. This can be done in limited ways and in a slow and cautious manner. China has already started pushing ahead on making the remnimbi international. In a recent agreement with Australia, China will allow Australia to hold 5% of its reserves in remnimbi. India can start the same with neighbouring countries that have a large share of trade with India. Countries in the neighbourhood that peg to the Indian rupee and which are holding convertible currencies as reserves should be able to hold Indian rupees. Such a move can be done by agreements and treaties until India ultimately repeals FEMA.

But let us say India chooses to keep the legal framework for capital controls in place. Then, there is a need to address the manner in which financial sector laws are administered. Under the present FEMA, RBI is not required to carry out consultations with stakeholders or show a cost-benefit analysis of why a regulation should be issued. In the recently-drafted Indian Financial Code (IFC) proposed by the Financial Sector Legislative Reforms Commission (FSLRC), the regulator would be required to show what will be achieved by the regulation. In this case, for example, it is well known that there exists a large offshore market for Indian rupee derivatives. Offshore markets for the rupee exist in Singapore, Hong Kong, London, Dubai and Bahrain. A report by the City of London on NDF markets for BRICS currencies shows that in London the rupee NDF market is the fastest growing among BRICS currencies. Between April 2008 to April 2012, NDF trading volume in the Indian rupee has increased from $1.5 billion to $5.2 billion, an increase of almost 250%.

RBI should adopt the practices of reasoned order for issuing regulation and showing a cost-benefit analysis at its own initiative even before the IFC becomes law. In a cost-benefit analysis, RBI will need to show the impact of the regulation. It will have to show by how much it will be able to reduce the size of the NDF market, thereby making its job of rupee management easier.

At first blush, greater benefits from the present regulation are not obvious. Even if Indian companies withdraw from equity participation in the exchanges on which NDF trades take place, the market will continue to thrive, keeping rupee management difficult. Also, since RBI has moved to a flexible exchange rate, the benefits from curbing the size of the market are limited.

If the cost-benefit analysis does not show greater costs but, say, RBI has other concerns, such as those of money laundering, it should not be able to issue regulations under the powers given to it under FEMA. It should then have to issue them under the Prevention of Money Laundering Act. At the same time, it would need to develop the supervisory capacity to examine the books of financial firms to uncover how the money laundering was undertaken. Today, such supervisory capacity is lacking, and given that regulators do not have to give the rationale and cost-benefit analysis of their regulations, they may have the incentive to use a nuclear option of banning such activities rather than carefully supervising them.

Further, RBI should engage with the entities to indicate to them not to participate in businesses that result in a violation of the law. This would offer greater business certainty and lower risks in case of those arising from difficulties in the interpretation of the law.

Some chit chat

Indian Express, 08th May 2013

To protect investors, make the formal financial system more accessible and attractive

News of investors losing their life savings in Ponzi schemes like Saradha has become recurrent in recent times. It seems that as long as the real estate sector was booming, these schemes were able to survive as new money kept coming in. But with employment and incomes growing slowly, finding new investors to pay off old ones might have become more difficult. It should not be surprising if many more such schemes collapse in coming days.

Chit funds alone attract millions of investors. It is estimated that registered chit funds have collected Rs 300 billion worth of deposits. The real story apparently lies in unregistered funds, who, it is estimated, have collected Rs 30 trillion. This is nearly half of the Rs 64.8 trillion held in commercial banks (in February 2013). But while all chit funds may not be fraudulent, the danger of some being so, given the weaknesses in regulation, is very high.

The origins of India's unregulated financial system lie in the poor and outdated financial regulatory system that India has clung on to. The banking regulator is proud of the fact that there have been no bank failures, no complex derivatives and the banking system survived the global crisis - a system, it claims, that offers an example for the world to learn from. The sad reality is, however, that as much as half the Indian population does not have access to this banking system. Even those who have access often find it unattractive. Interest rates paid to depositors have been pushed down through years of policies of administered interest rates and lack of competition in banking. Regulatory requirements for priority sector lending and holding of government bonds have further resulted in lower returns. The result is low or negative real interest rates for depositors.

This is fertile ground for unscrupulous individuals. A Ponzi scheme like Saradha can be set up. The law does not require all financial service providers to register with any single regulator. If a firm says it is a collective investment scheme, it is required to register with SEBI and be regulated by it. If it claims to be a chit fund, it is regulated by state governments. If it says it is a private company taking deposits for its business, it must be regulated by the registrar of companies as Sahara has claimed it should be. If it takes public deposits, it should register as a non-banking financial company and be regulated by the RBI. It may actually register with no one, as Saradha didn't.

If any one regulator finds out a company is guilty of fraudulent practices and tries to stop its activities, it has to approach other regulators. The financial firm, in the meanwhile, can go to court, claiming the regulator has no jurisdiction over it, as in the case of Sahara. It can continue to collect money. The regulator has to prove in a court of law that the firm was indulging in activity that is under its jurisdiction, and then, during the long delays in courts, watch helplessly as thousands more get duped by the firm. Section 11AA of the SEBI Act, under which SEBI has been acting, defines "collective investment schemes" in terms of principles that identify such schemes. It, however, includes exemptions for institutions such as chit funds, nidhis and cooperative societies.

Will passing a more stringent law, as the West Bengal legislature has done, solve the problem? Do state governments have the capacity to regulate financial firms? Even if some well-governed state governments are able to regulate chit funds, the regulatory capacity of other state governments can be quite limited. Perhaps the way forward should be that state governments with weak regulatory capacity choose to hand over powers of such regulation to the Centre.

But even after that is done, institution-based regulation would continue to provide legal cracks in the system for unscrupulous firms to slip through. To address this issue, the Indian Financial Code (IFC), proposed by the Financial Sector Legislative Reforms Commission, suggests that the definitions of financial products and services be broad and principle-based, with no statutory exemptions. All kinds of deposit-taking and investment schemes, including chit funds, are covered by the proposed definitions. For example, a deposit, in the draft law, is defined as a contribution of money, made other than for the purpose of acquiring a security, which may be repayable at the demand of the contributor. As a consequence, anyone in the business of accepting deposits or managing investment schemes would need to get authorisation from the regulator. The IFC proposes two regulators. Under the proposed law, either a financial firm must obtain a bank licence from the RBI, or it must register with the Unified Financial Agency (UFA), the regulator of all financial firms and activities other than banking. This would eliminate the legal tussles over jurisdiction seen today. In addition, the IFC proposes powers of investigation and prosecution for the financial regulators to prevent further fraud.

But it is not sufficient to give regulators the powers to catch criminals. The origin of the problem, that is, the inaccessible and unattractive formal financial system, also needs to be addressed. Today, regulators have an incentive to ensure there is no failure of the financial firms they regulate, leading to over-regulation. Saradha depositors may be paid by a West Bengal tax on cigarettes, and SEBI may be given additional powers to prosecute. But beyond this legal patchwork, India needs a comprehensive legal framework for financial regulation if it is to protect investors and reduce such fraud in future.

Growth pick-up still a mirage

Financial Express, 30th April 2013

Even if all projects were to get clearances tomorrow, we may see actual activity in less than half

The Prime Minister's Economic Advisory Council (PMEAC) report suggests that higher GDP growth next year is achievable if government policies and administrative actions support investment. Primarily, if the government clears stalled projects, and environment and other clearance are given for projects through the Cabinet Committee on Investments (CCI), Indian GDP growth can rise to 6.7% next year.

The problem of stalled projects has seen some progress in recent weeks as the CCI gave clearances to oil and gas projects. The mandate of the CCI is to give clearances to large projects. While this is a step in the right direction, and would lift investment and growth even if only a few large projects get kick-started, there are additional difficulties that would need to be addressed before growth can pick up to 6.7% next year.

First, some of the projects that are stalled today were bid before the 2008 crisis. Remember the pre-crisis years? Growth in India was in double digits, the world economy was booming and almost every investment project looked attractive. The pegging of the rupee to the dollar led to a high growth of forex reserves and consequently bank credit. Some of the bids by the private sector were quite aggressive based on its over-optimism. In today's far more sober environment, it is not clear that even if given clearances, all of those projects would be attractive. At least a third of them might appear to be unattractive.

Second, the projects that are stuck in mid-way for many years have had financial implications for the balance sheets of the companies and banks involved. Long delays in completion of projects has meant that companies have not been able to pay back loans taken for the projects. Banks that had given loans have seen these loans get into trouble. Many banks are reluctant to call these non-performing loans. Many loans have been re-structured. RBI data shows that the growth of restructured advances has been much faster than credit growth of banks. Between March 2009 and March 2012, while total gross advances of the banking system grew at a growth rate of less than 20%, restructured standard advances grew by over 40%. Public sector banks account for a disproportionately large part of this. Restructured accounts have grown at a rate of 47.86% in public sector banks as against a growth rate of credit of 19.57%. Loans to industry, especially large industry, have seen the most restructuring. Public sector banks, especially after the recent corruption scandals, may be reluctant to lend to companies in distress even when they can.

The above suggests that even if a project bid by a large company obtains a clearance, the company may no longer be in a position to undertake fresh borrowing to undertake the project. Or banks may no longer lend to it for new projects beyond the lending they are doing to recover old loans. This may account for another one third of the stalled projects not being revived even if given clearances.

Further, the terms of restructuring loans to companies in distress usually assume that in a couple of years the economy will recover and the company will be able to pay back the loan. Figure 1 shows the sharp decline in GDP growth, down to 4.5% in the quarter ending December 2012 as one of the sharpest downswings in growth in recent years. The seasonally-adjusted quarter-on-quarter growth was 3.5%.

Nor have we seen investment pick up. Figure 2 shows the seasonally-adjusted quarter-on-quarter growth of investment by the private corporate sector. It was 0% in the January to December quarter. When investment is 0% and GDP growth is 3.5%, it will take a strong change in the business environment and sentiment for them to pick up.

Figure 3 shows that those signs of change in business perceptions are not to be seen yet. It shows new project announcements per quarter by all sectors and all categories of investors. Project announcements as a share of GDP have been declining quite steadily since 2010. When sentiments improve, this is the first place where we expect to see the optimism. Even if projects are not finally implemented, they must at least be announced for the investment to kick off.

What we might see in the next few months may be a pick up due to some projects being revived. Once investment activity starts, it may induce optimism. Yet one must be aware that even if all projects were to get clearances tomorrow, we may see actual activity in less than half. We will be fortunate if growth does not fall below that of the 5% we appear to have achieved in 2012-13.

China's rebalancing act

Indian Express, 30th April 2013

Its tilt to consumption-led growth is good news for India and the global economy

Unlike in India, the slowdown in Chinese growth appears to be not merely a cyclical downturn, but lower trend growth rate that Chinese policymakers see as desirable. It forms part of China's strategy to rebalance the domestic macroeconomy towards a slower growth rate of employment, lower investment and higher consumption. This is good news for global rebalancing as China's exchange rate policy should now become more flexible, Chinese current account surpluses should come down and accumulation of Chinese forex reserves should slow down or stop. For India, a relatively more consumption-oriented China could mean higher exports, both to China and the rest of the world, lower commodity prices and less of a pressure from exporters for exchange rate intervention.

After growth at double digits for many years, China grew at a much slower 7.7 per cent in the first quarter of the year. At a recent conference in Beijing, I heard Chinese policymakers sounding fairly comfortable with this lower growth. Indeed, they argued lower growth in China was desirable. It almost seemed that it was planned.

The main arguments in favour of lower growth - an average of 8 per cent in the next 10 years and 7 per cent thereafter - was mainly China's demographics. As the Chinese working-age population starts shrinking due to the replacement of the current working population by those born after the one-child policy was put in place, there is less need for high job growth. The last few decades were ones in which China was trying to meet two objectives: earn foreign exchange and create jobs. The high growth rate of job creation was necessary to absorb the large number of people joining the labour force. If the same growth rate continues, China will have labour shortages. With a slower growth of the working population and labour force, wage growth rather than employment growth will be the focus.

Second, China has undertaken significant infrastructure investment in recent decades. In coastal areas, China has met its targets for infrastructure investment. It now needs to utilise better the infrastructure that it has created. Some estimates even show that China's infrastructure investment has been excessive. The need for additional investment in infrastructure is lower, and so the investment strategy will be modified accordingly.

A shift towards domestic consumption-led growth will make the Chinese growth model less dependent on exports. In episodes of global slowdown like the recent one, the Chinese economy can then continue to grow more steadily. The decline in the Chinese trade surplus and slower exports after the crisis have made it evident that, even if desirable, the policy of export-led growth was unlikely to be sustainable.

At the recent IMF-World Bank meetings in Washington DC, China has indicated that it will allow the renminbi to move in a wider band than it has hitherto. This effectively means that it will allow the yuan to appreciate. This will make Chinese exports more expensive and imports into China cheaper. Such an exchange rate regime will be more suitable for a domestic consumption-led, rather than an export-led growth strategy.

An appreciation of the yuan will also allow other emerging economies to permit their currencies to be more flexible. Today when China sustains a policy of an undervalued exchange rate through its intervention and sterilisation, other central banks often come under pressure to do the same. The context in which China has been able to financially repress the system and pay low or negative real interest rates to households is unlikely to work in more market-oriented and democratic countries. It will be a relief for other EM (emerging market) central bankers not to have the kind of pressure they face thanks to China today.

One of the origins of the global crisis was diagnosed to be the cheap funding available in the US economy owing to Chinese purchase of US treasury bills. The high level of liquidity, asset price bubbles and, finally, the meltdown were said to be caused by the Chinese policy of keeping consumption low, savings high and then pushing those savings into the US, where households consumed too much and did not save. This arrangement was facilitated by the Chinese exchange rate policy. A change in the Chinese policy is expected to lead to a global rebalancing.

For India, which has had an economy much more based on domestic consumption, where the domestic savings to GDP ratio is closer to 30 per cent, in contrast to China's 50 per cent, a rebalancing in China is good news. Not only is a more rebalanced world a better and more sustainable business environment, with less vulnerable risks, but India could gain directly as it is often seen as a competitor to China. In areas where India can compete with Chinese products for a share of the market, its exports can benefit. In addition, if India is able to enter the market in certain products, it stands to gain. As China focuses more on growth in services, as it has seen recently, as well as high-end products, away from the low-end manufacturing that dominated its growth model, Indian exports stand a better chance.

Lower investment in China is likely to lead to a softening of global commodity prices. As a large commodity importer, India stands to benefit from softer prices. Though it may be argued that global growth may slow down if China slows down, as the Chinese policymakers argue, if the growth can be higher quality growth, protecting the environment and reducing pollution, with higher wage growth, more innovation and less distortions, the world stands to gain.

Economic stability is not the only issue at stake. Political stability in China is a challenge as inequality has grown. If China does not follow a wider consumption-based growth model, the bigger challenge may be political rather than economic stability. It seems that the Chinese government has set the forces for domestic rebalancing in place, it remains to be seen how successful the policy will be.

Selling it right

Indian Express, 11th April 2013

Consumer protection should be at the heart of the financial regulatory framework

Does India need a new law for consumer protection in finance? One lesson from the global financial crisis is that unsuitable housing loans sold to poor, uneducated consumers could pull down the world's financial system. Very few people would have believed that sub-prime loans, which constituted a very small part of housing loans and that too only in one country, could trigger a crisis that led to banks failing, money markets crashing, governments falling, countries going bankrupt, millions becoming unemployed and the GDP of many nations going down. This is not to argue that the sale of unsuitable housing loans was the only regulatory failure that led to the global crisis, but an important lesson is that a regulatory system that does not prevent the sale of unsuitable financial products to consumers could be putting the financial system and the entire economy at risk. Not only is consumer protection an important end in itself, if it lies at the heart of financial regulation, bad practices that result in the failure of firms and markets can be checked.

Today in India, there is very little reference to consumer protection in primary legislation in the financial sector. Not surprisingly, none of the financial laws on which regulation is based, and which were written long before there was clear thinking about the need for consumer protection, provides consumers with basic rights or protections. Nor do they give regulators a specific set of relevant powers to pursue the objective of consumer protection. It is not treated as a core pillar of financial regulation. Many countries are rewriting laws to bring this perspective into financial sector regulation.

Some regulators have issued regulations based on the general rule-making powers given to them in their respective laws. For example, SEBI issued Disclosure and Investor Protection Guidelines in 2000. Various guidelines have been issued by the RBI and IRDA to protect consumers in banking and insurance. However, consumer protection regulation remains weak and varies across different sectors and services.

The approach adopted by the Financial Sector Legislative Reforms Commission (FSLRC) is that consumer protection needs to be treated as a core part of the legal and regulatory framework. So the first step towards ensuring consumer protection is to have good primary legislation that provides for it and makes it a priority for regulators, empowering them adequately. The primary law should require all regulators to formulate regulations that ensure consumers are protected from unfair practices. If, in a contract, there is a term that permits one party (often the financial firm) but not the other party (often the customer) to avoid or limit the performance of the contract, or to vary the terms of the contract or the services provided, the contract is unfair. If the conduct of the financial service provider, who often has greater market power, is misleading or abusive or coercive, such conduct is unfair.

Similarly, consumers should have a right to financial privacy, data ownership and data security. The laws were written before it was easy for an employee to sell a CD containing the digital records of his firm's customers for a small price. So the laws, unsurprisingly, were not geared to handle this eventuality. Today, we can argue that consumers should have the legal right to own their financial data. Consumers dealing with financial institutions must have the right to expect that their financial activities will have a reasonable amount of privacy. They must have the assurance that the data is secure.

Additional rights and protection need to be given to retail customers, who may be individuals or businesses, carrying out small value transactions. They are often at an even bigger disadvantage. Retail consumers should not be sold unsuitable products. The suitability of a financial service or product depends on the profile and needs of the specific consumer. The lack of knowledge often makes it difficult for the consumer to decide what will work best for her. The law should make it a right for the consumer to be given sufficient time, relevant information and, if possible, sound advice to help her decide on the suitability of the financial product she is buying.

For example, if a consumer is considering buying life insurance, in most cases, simple information disclosure is inadequate. There should be an assessment of the consumer's need. Proper advice would be necessary to ensure that the consumer purchases the right kind of insurance, with the optimal level of coverage. For certain services, the regulator may mandate advice. Providers of such services would then not be allowed to approach the potential consumer without some kind of a basic process of needs assessment and advice. For example, regulations could mandate that before a financial institution makes a recommendation to a consumer regarding a specific financial service, it gathers sufficient information from the customer to ensure that the service is likely to meet her needs and capacity.

Under the draft Indian Financial Code (IFC), advice would typically be accompanied by increased responsibility for the financial service provider, making it accountable for consumer outcomes, leading up to compensation for consumers if they have been poorly advised. Most services should come with a high level of responsibility for the providers, especially if the providers approach the consumer.

Consumers should also be given reasonable time to take the decision. For example, consumers going in for certain financial services with long-term implications could be allowed a cooling-off period, during which they may cancel the contract or decide not to enter it.

Consumer protection regulation is ineffective if consumers do not have an effective ex-post grievance redressal mechanism. At present, this is highly inadequate and varies across sectors. The draft IFC proposes to set up a fast and efficient non-sectoral, widely accessible consumer redressal mechanism.

It seems fairly obvious that consumers should have protection against unfair conduct and terms. But we need to put that in the law, because unless it says so, regulators cannot write regulations that ensure such protection or penalise firms that violate these principles. The draft IFC proposes to enshrine these principles in law.

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.