By Dr. Nachiket Mor

These are some of my observations from a conference that I attended recently organised by the National Community Investment Fund (NCIF) for a specific class of US institutions: CDFI (Community Development Financial Institutions) Banks. The regulators present at the conference were deeply appreciative of the critical role that these banks had played over the last few years and reported that several of these small banks had weathered the entire crisis well and overall, unlike in the case of larger banks, had even seen a small increase in their overall lending portfolio.

CDFI Banks are typically:

1. Full service banks.
2. Have FDIC insurance and offer checking and savings bank accounts.
3. They are for-profit institutions.
4. Of the over 7,500 banks in the US, 6,700 have less than $1 billion (Rs.5,000 crore) in assets and 4,400 have less than $250 million (Rs.1250 crore) in assets. Of these 6,700 small banks / community banks about 85 are certified by the CDFI Fund as CDFI Banks which gives them access to several financial benefits from the US government.
5. CDFI Banks are about 10% of the total CDFIs in the country but they control/manage over 50% of the total CDFI assets.
6. NCIF estimates that there are another 400-500 institutions that have not yet been certified or don’t want to be certified despite their mission of serving low- and moderate-income communities. NCIF uses the term “Community Development Banking Institutions or CDBIs” to describe them.

The opening speech at the conference was given by Sandra Thompson, Director, Division of Risk Management Supervision, FDIC. It was an unusual speech coming from a regulator in its warmth and appreciation of the strong role that community banks like CDFI Banks were playing in the economy. This warmth was also displayed by other regulators that spoke at the conference and was perhaps due to that the fact that, unlike in India where there is a sense that the government owned financial institutions need to be protected and the private sector is viewed with suspicion, here there is no such predisposition. Several issues were raised by her that suggested that these institutions needed special consideration:

• CDFI Banks were working in very difficult parts of the economy, ones that larger banks were unwilling or unable to serve. This meant that even though the overall economy, in her words, was “experiencing a fragile recovery”, the areas being served by the CDFI Banks were still in deep trouble.
• The TARP programme was really designed for the larger banks and such funds were not made available to the smaller community banks. During 2010 the Treasury created a special Community Development Capital Initiative to support CDFI Banks and Credit Unions.
• The new compliance requirements (over 2300 pages of them) imposed on Banks by the Dodd-Frank Act were proving to be very expensive for several of the smaller banks.

These comments of hers were related to the big issues that kept coming up during the entire day of discussions:

1. If CDFI Banks wishes to be banks and collect deposits should they be treated any differently from a prudential perspective from other, larger banks. If they wished to serve higher risk communities should they not be required to provide additional capital against that higher level of risk? Should there be a special category for CDFI Banks to support their mission focus? A number of CDFI Banks seem to not be able to articulate their overall competitive strategy in a sharp way or even that of their customers (there were several notable exceptions though). Several of these CDFI Banks seem to be more focussed on “picking up pieces” and helping people “survive” rather than supporting the growth and development of a community that had some real growth prospects. Such banks (that are unable to articulate their strategy) accordingly have:

a. Limited cost advantages allowing them to drive profitability.
b. Have given up on their superior knowledge of their customers allowing them to contain default.
c. Are unable to charge appropriate rates.
d. Have lower profitability that was low to negative despite being for-profit banks.

2. This brought up the whole issue of social return that could be added to the often times low or negative financial returns. While there was a great deal of enthusiasm from the CDFI Banks about this idea the investors that were at a panel (from CITI, Bank of America, TIAA-CREF, and Prudential Financial) were not as enthusiastic. They had the following comments:

a. Social performance was seen as a screen – the financial performance was the quantitative measure and was used to guide actual investment decision making and not social returns.

b. The more sharply the CDFI Bank could distinguish itself from a mainstream bank the more attractive it would be to investors – if it presented itself as just a “better” or more “socially conscious” bank that “works harder” for its clients, it would not be as attractive.

c. More investors preferred debt / deposit instruments that had a guaranteed (even if low) return of both principal and interest to equity investments since exits were few and far between.

Despite all these concerns there was a great deal of enthusiasm about the very high level of importance of the 6,700 community banks (CDFI and non-CDFI) and the role that they were playing in the economy. The NCIF itself is working hard to quantify social returns of CDFI Banks and find other ways to preserve the unique value proposition of these banks, even while diversifying income sources and reducing costs through shared platforms and so on.

There was a presentation from John Hale III, Deputy Associate Administrator of the Office of Capital Access, Small Business Administration (SBA). He was working hard to make the SBA guarantee programme much more attractive to the small banks. There was also a discussion of Treasury guaranteed loan sale / bond sale programme by CDFIs which sounded very much like a securitisation effort.

Within the CDFI community there was much interest in:

1. Better use of technology both in the back-office and in front of the customer.

2. Development of shared service platforms for back-office management. There was a strong sense that such a platform would help reduce costs as well as enhance the operating capabilities of the smaller banks.

There were several CDFIs (such as United Bank from Atmore, Alabama and City First Bank of DC) that had done well and their core strengths seem to be:

1. Deeper knowledge of the customer relative to other banks due primarily to their proximity and continuous presence (some for over 100 years) in the community.

2. Better product designs suited to their customer’s needs which were hard for their competitors to copy.

3. On cost and technology front they did not seem to be at all competitive relative to the bigger banks.

Also amongst the regulators there was a real sense that partnerships between financial institutions were desirable that that, unlike in India, larger banks did not have to do it all “themselves” to fulfil all of their priority sector requirements (which exist even in the US).

By Darshana Rajendran, IFMR Finance Foundation

An asset becomes non-performing when it ceases to generate income for the bank. In India, a Non-Performing Asset (NPA) is broadly defined as one with interest or principal repayment instalment unpaid for more than 90 days.

There exist defined mechanisms to deal with NPAs of banks and financial institutions today. However prior to 1993, banks had to take recourse to the long legal route against defaulting borrowers, beginning with the filing of claims in the courts. A lot of time was therefore spent in the judicial process before banks could have any chance of recovery on their loans. On average, a civil suit decision took anywhere between 5 to 7 years.

Under the Recovery of Debts to Banks and Financial Institutions Act 1993, Debt Recovery Tribunals (DRTs) were set up for recovery of loans of banks and financial institutions. This led to speedy recovery of loans in about 1 year’s time as against the average time of 5 to 7 years required in civil suits. While initially the DRTs performed well, their progress suffered as they got overburdened with the huge volume of cases referred to them.

To speed up the process of recovery from NPAs, The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act (SARFAESI) Act was enacted in 2002 for regulation of securitization and reconstruction of financial assets and enforcement of security interest by secured creditors. The SARFAESI Act empowers Banks / Financial Institutions to recover their non-performing assets without the intervention of the Court. The Act provides three alternative methods for recovery of non-performing assets, namely: -

• Securitisation
• Asset Reconstruction
• Enforcement of Security without intervention of the court

Secured creditors are given the power to take possession of the securities in the event of default and sell such securities for the purpose of recovery of the loan. The Act provides for enforcement of Security interest by a secured creditor without intervention of the court, in cases of default in repayment of instalments and non-compliance with the notice period of 60 days after the declaration of the loan as a non-performing asset.

The Act also provides for setting up of Securitisation Companies/ Reconstruction Companies (SC/RC), which acquire the NPAs from banks and financial institutions by raising funds from Qualified Institutional Buyers (as defined by the Act) by issue of Security Receipts (As defined by the Act) representing undivided interest in such financial assets. The Act enables SC/RCs to take possession of secured assets of the borrowers including right to transfer and realize the secured assets. SC/RCs act as debt aggregators or agents of the banks or financial institutions focused in the resolution of NPAs. The SC/RCs buy the impaired assets from banks and financial institutions, thereby cleaning the balance sheets of the banks and permitting them to focus on their normal banking business.

The promulgation of the SARFAESI Act has been a benchmark reform in the Indian banking sector. The progress under this Act had been significant, as evidenced by the fact that during 2002-03 when the Act came into effect, there was an overall reduction of non-performing loans to 9.4 per cent of gross advances from 14.0 per cent in 1999-2000¹.

Currently, three legal options are available to banks for resolution of NPAs- the SARFAESI Act, Debt Recovery Tribunals and Lok Adalats. The SARFAESI Act has been the most important means for recovery of NPAs. The amount of NPAs recovered under the SARFAESI Act formed over half of the total amount of NPAs recovered in 2009-10. Banks have referred as many as 78,366 loan default cases by end march 2010 under the SARFAESI Act involving a loan amount of Rs. 14, 249 crores. Against this, banks managed to recover Rs. 4,269 crores representing 30% of the loans².

Recently the ‘Report of the Working Group on the Issues and Concerns in the NBFC Sector’ laid out recommendations to extend the coverage of SARFAESI to NBFCs as well. This move will benefit NBFCs, ensuring quicker recovery of their non-performing assets. This, in turn, could encourage NBFCs to provide access to a wider range of financial products and serve better the cause of financial inclusion.

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1 – Reserve Bank of India on Trend and Progress of Banking India 2002-2003
2 – Reserve Bank of India on Trend and Progress of Banking India 2009-2010

By Deepti George, IFMR Finance Foundation

Following the sessions by Dr. Isher Ahluwalia and Mr. Vikram Kapur, (covered in this post) the workshop participants discussed critical topics such as decentralisation and governance, political economy and institutional fragmentation, revenue generation and infrastructure financing, water and sanitation, capacity building, and land and city growth. The discussions, group exercises and presentations coalesced around a few themes, highlighting their importance for the urban agenda.

These themes provide rich scope for further analysis and research, and highlight the need for deeper exploration of specific issues critical to understanding and managing the urbanisation process.

For instance, the discussion on financing strategies for cities to raise the huge quantum of investment required to build and maintain infrastructure and services, brought the following issues into sharp relief:

1. The importance of own revenue generation and the ability to leverage funds:

Cities in India have traditionally been used to financing themselves purely through grant funds provided by higher levels of government. This has led to a culture of dependency and lack of accountability to citizens. It was pointed out that in order to raise the magnitude of investments required for urban infrastructure over the next 20 years, cities would have no choice but to leverage their grant funds by reaching out to the debt markets. Currently, on account of poor capacities and insufficient own-revenue generation, most Indian cities are unable to access debt markets.

This brings into sharp relief the critical importance of cities being able to generate own-revenues (from sources such as property tax and user charges), because without sufficient internal revenue generation, external debt will not be serviceable. Strategies for cities to improve their internal revenue generation will be key to developing sustainable financing models for urban infrastructure.

The TNUDF model (a PPP focused on raising debt for small and medium cities) was also seen as a scalable mechanism for other states to enable their cities to raise debt funds from the market.

2. Market-worthiness of ULBs as a tool to enable flow of funds from capital markets:

ULBs will be constrained in raising funds from the markets also because the rating models used to rate ULB debt do not take into account the operating models of cities in performing their duties. Because rating agencies focus their analysis purely on the financial aspect of ULBs and the associated credit risk that this implies, they tend to miss out on the many other aspects critical to the way a ULB functions. This results in low credit ratings (below investment grade) overall for ULBs, and further it does not distinguish between cities that are financially similar but vastly different in terms of their management and operating capacities. These capacities have tremendous impact on the performance of local governments.

In this context, the role of a set of “market-worthiness” standards that provide deeper insights into the operating, technical and management capacities of ULBs was seen as being an important complement to the credit rating process. Taken together, the credit rating and “market-worthiness” rating could provide a more comprehensive sense of the risks associated with the ULB. Discussants saw this type of market-making activity as being especially important in the context of small and medium cities.

Similarly, there were deep discussions on a number of themes such as the importance of standards for public service delivery, the need for capacity building, the nature of decentralisation and the mechanisms for improved governance.

This note describes these themes in greater detail.

Following the release of a discussion paper on deregulation of savings bank deposit interest rates, the Reserve Bank of India (RBI) has in its second quarterly review of Monetary Policy 2011-12, deregulated savings bank deposit rates with immediate effect. Given the low penetration of savings bank accounts in India (only 36 bank accounts for every 100 persons as on March 2009^[1]), we are very excited by this significant step. In the short run, this is expected to increase returns to consumers on their savings accounts by triggering competition between banks, in a manner that may be similar to what was observed for deregulation of domestic term deposit interest rates. In the long run, bringing down the ‘negative real returns’ characteristic will make bank accounts a more attractive savings instrument.

We look forward to the operational guidelines for this deregulation move. We hope that these guidelines will take into consideration consumer protection measures to safeguard the interests of about half of all Indian households that save, invest and diversify into various physical assets in the absence of access to suitable financial assets. Our responses to RBI’s discussion paper on the same can be found here.

[1] Basic Statistical Returns of Scheduled Commercial Banks in India and Handbook of Statistics on the Indian Economy, RBI, Various Issues

By Shweta Aggarwal, IFMR Rural Finance & Deepti George, IFMR Finance Foundation

The High Powered Expert Committee, chaired by Dr. Isher Ahluwalia submitted its Report on Indian Urban Infrastructure and Service Delivery. The report lays out the infrastructure investment needs for urban India in the next twenty years and makes recommendations for mechanisms to finance such a magnitude of investments.

Having contributed to the drafting of the report, IFMR Finance Foundation and the Centre for Development Finance (CDF) invited Dr. Ahluwalia to speak about the report in a workshop on Urban Infrastructure and Service Delivery. Held on 8th September 2011, this workshop had participation from a small but diverse mix of people actively engaged in shaping the urban agenda, from practitioners, representatives from Government bodies, to academicians. The workshop commenced with a session by Dr. Ahluwalia, followed by a session by Mr. Vikram Kapur, IAS (who previously held the position of CEO of TN Urban Development Fund) and concluded with panel discussions by the participants.

The Sessions:

Dr. Isher Ahluwalia presented the report’s findings and shared experiences from the process of writing the report. While she spoke about the need for planning, financing, creating and maintaining urban infrastructure, she also specified that standards of service delivery must be available to all including the poor.  All efforts must be made towards consciously building rural-urban synergies in policy and planning. To this end, reforming governance at all levels of government, from the Urban Local Bodies (ULBs) to the Centre, as well as investing in capacity building of the ULBs should be the need of the hour. She stated that municipal entities need to be strengthened with ‘own’ sources of revenue and predictable transfers from state governments, to help them discharge the larger responsibilities assigned to them by the 74th Constitutional Amendment.

Dr. Ahluwalia also noted that having a ‘local bodies’ list in the Constitution and making devolution mandatory would empower ULBs by giving them opportunities to collect specific local body taxes and charges (such as motor vehicle tax, entertainment tax, advertisement fee). Policies will need to be altered to incentivise states that devolve more powers to the ULBs. Dr. Ahluwalia conveyed best practices that she had opportunity to see during the course of her work, which she regularly writes about in her monthly columns in the Indian Express.

Mr. Vikram Kapur shared experiences from Tamil Nadu while addressing Long Term Infrastructure Financing needs of Urban Local Bodies (ULBs), especially small and medium cities in India. He stressed that investment needs for small and medium cities over the next 20 years was 65 times the current level of investments. Mr. Kapur stressed that given India’s phenomenal growth rate of 8% and a record of healthy savings rates, the government should tap domestic capital markets to finance these needs. He stated that the key today is to shift the way government funds are used, to leverage government funds rather than looking at them purely as grants.

The below video contains some excerpts of the two sessions. The full video of the two sessions can be accessed here: Dr Isher Ahluwalia – Mr Vikram Kapur.

Excerpts from the two sessions:

Workshop:

The group discussions that ensued were based on critical themes such as decentralisation and governance, political economy and institutional fragmentation, revenue generation and infrastructure financing, water and sanitation, capacity building, and land and city growth. Many interesting ideas and themes were generated in this workshop. We will be carrying these in a subsequent post.

By Vineet Sukumar, IFMR Capital

The Reserve Bank of India yesterday released a fresh set of draft guidelines governing securitisation and assignment transactions. While the draft was released by the Department of Banking Operations and addressed to banks, it is expected that a similar draft will be issued for NBFCs as well.

The draft guidelines are comprehensive and cover various aspects of a securitisation including minimum holding period (MHP), minimum retention or risk (MRR), accounting treatment, true sale, credit enhancement requirements and due diligence by the purchaser. Further, the RBI seeks to cover assignment transactions under the ambit of its regulations.

Securitisation and assignment transactions have emerged as preferred financing routes for NBFCs in the last few years. On the whole, banks have been net buyers, acquiring largely priority sector portfolios from NBFCs. Given the stringent first loss requirements imposed by the RBI in the 2006 guidelines (marked off against Tier I and Tier II Capital, fixed till maturity of the transaction), banks issuers have been rare.

At the same time, securitisation has emerged as a viable route for non-traditional originators to access the capital markets. Microfinance institutions (MFIs) have raised substantial funds through this route, with the first rated assignment in 2004 and the first rated securitisation in 2009. In October 2010, the microfinance sector faced headwinds after the Andhra Pradesh government issued an ordinance curtailing microfinance activities. Post the ordinance, securitisation has emerged as the largest source of financing for MFIs, with an estimated INR 15 billion raised via this route¹.

We will attempt to highlight the key changes / inclusions in the draft guidelines and potential implications on issuances

• Minimum Holding Period (MHP)

MHP for loans is distinguished on two parameters:  a) frequency of repayment schedule (quarterly or more frequent) and b) tenor of loan (less or greater than 24 months). While the logic behind including the former is understandable and a good move, it is unclear why the RBI has split the market on a 24 month tenor basis. It would be significantly better from a regulatory perspective  to assess MHP requirements based on the average life of the underlying loans. This would prevent the possibility of having a 6 month MHP on a loan with weekly repayments and tenor of 12 months.

Imposing a high MHP will, in effect, prevent securitisation of lower tenor loans completely. Potentially, this could disincentivise originators from providing lower tenor loans due to lack of financing, thus increasing balance sheet risk.

• Minimum Retention of Risk (MRR)

The guidelines also advise a MRR of 5%. This is a welcome inclusion and in line with global practices. The concept of a dynamic cash collateral and reduction of the MRR through the transaction tenor is a good step that should bring bank originators back into the market. Further, this will force rating agencies to model and monitor asset behavior more closely.  It would be better, in our view, if the RBI allowed market forces to determine the frequency / amount of release of credit enhancement, rather than stipulate time / amount of release – given the variation in performance of different asset classes.

The draft guidelines also permit originators to invest into the equity tranche of a securitisation, unlike the existing regulation that allows originators to invest only into senior securities issued by an SPV.

• Accounting of Profits

The guidelines allow originators to recognise the cash profit on a limited basis on premium structure deals. Such profits is to be termed as “Cash Profit on Loan Transfer Transactions Pending Recognition” and maintained on a transaction basis. This divergence from regular accounting standards will encourage corporates to move away from amortisation to straight line basis. In a financial year, any loss on account of Mark to Market and write off will be adjusted in this account and net effect will be transferred to profit and loss account

• Assignments

The  RBI has finally stepped in to fill the regulatory vaccum that existed with respect to bilateral assignment of assets. Bilateral assignment is now governed by guidelines similar to that of securitisation. One major difference however, is that “external” credit enhancement by the originator is banned under the assignment route. The offered justification is that subscribers to this route are sophisticated, institutional investors who should be able to assess the risk involved and take a decision on the exposure. Disallowing credit enhancement will only increase investor discomfort in this route and prevent such transactions from taking place. The sophisticated market forces that exist under the assignment route should be able to determine the need for cash collateral.

• Purchaser due diligence

The guidelines place a greater onus on the buyer with respect to due diligence. Purchasers must carry out verification on at least 5% of the obligors. Such verification cannot be delegated to a specialized firm. The guidelines also require rigorous credit monitoring and identification of non-performing borrowers 90 days after the loans are due. Banks are required to collect information regarding default rates, prepayment rates, loans in foreclosure, collateral type and occupancy, and frequency distribution of credit scores or other measures of credit worthiness across underlying exposures, industry and geographical diversification.

It is essential that buyers are aware of the assets that they are investing in and the above requirements will ensure that quality of due diligence improves.

Last year, securitisation volumes fell by 29%. This was largely believed to be a fall-out of the draft guidelines released in April 2010.  The revised draft guidelines are significantly more comprehensive and include features that could completely transform the market. However, the draft guidelines are also too prescriptve. This could stifle a sector that has just begun to find its feet in the Indian market. A nuanced regulatory policy that recognizes the varied and dynamic nature of the market and encourages financial innovation is necessary.

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1 – IFMR Capital estimates

The first IFMR Conference on Financial Systems Design was held at our office in Chennai on Aug 5-6, 2011. The objective of the conference was to engage in an in-depth conversation on the future of the Indian financial system and some of the underlying design challenges being faced in various markets.

In order to retain a functional perspective, the conference was organised into three main sessions for discussion — Origination, Transmission and Aggregation — as three broad buckets of questions and concerns – one involving customers and customer protection issues, the other involving markets and derivatives and the third involving large, nationally important financial institutions and systemic risk concerns.

In the introductory session, Nachiket shared some of his thoughts on the Indian financial system.

The format of the conference allowed for collaborative work and visioning by the participants. Following a lead presentation for each of the main sessions that identified key themes, each table came up with vision statements for that theme which were then shared across the room and discussed. Following the visioning, there was an exercise to identify the pathways for us to get to the desired end-state. These pathways were categorised into Research, Regulation, Innovation and Public Infrastructure.

The conference yielded very rich discussions and the participants identified several interesting issues and priorities for the Indian financial system. In the following weeks, we will share the summary of discussions and identified pathways for each of the three sessions.

- By Darshana Rajendran, IFMR Finance Foundation

In a stylised sense, there are two fundamentally different perspectives for analysis of financial systems. The institutional perspective takes the institutional structure of the financial system as given, and looks to define what can be done to make those institutions perform their particular financial functions more efficiently. In contrast to the institutional perspective, a functional approach to designing and managing financial system, as proposed by Professor Robert Merton (Harvard Business School) and Professor Zvi Bodie (Boston University) in various papers over the last two decades, takes the functions performed by financial systems to be given, and studies the institutional structure that would best perform these functions.

Financial Markets and intermediaries have been rapidly evolving due to technological advances and integration of financial markets and intermediaries around the world. Financial innovation ensures that the structure of the financial system changes over time, but the functions per se of the financial system remain stable. The basic functions of the financial system are essentially the same in all economies and do not change over time. These functions ultimately set the benchmarks for innovation in financial systems. This is why a functional perspective is more reliable and long-term than an institutional one, especially in times of a rapidly changing financial environment. This functional perspective rests on these two basic premises:  ‘Financial functions are more stable than financial institutions’ and ‘Institution form follows function.’

The primary function of any financial system is to facilitate the allocation and deployment of economic resources, both spatially and temporally, in an uncertain environment. Professor Merton and Professor Bodie further distinguish six core functions performed by the financial system:

Function 1: Transferring resources across time and space.
 A well developed financial system provides a way to transfer economic resources through time and across geographic regions and industries. Loans help move resources from the future to today, and savings products help do the opposite, but the underlying function for these two seemingly different products is the same. Student loans, borrowing to buy a house and saving for retirement are all actions that shift resources from one point in time to another. The financial system also provides mechanisms to shift resources from one place to another. So, when a person sends money to a family member in a different location, the basic function the movement of resources to him to the recipient.

Function 2: Managing Risk
The financial system provides a way to manage uncertainty and control risk. Through financial securities and through private sector and government intermediaries, the financial system provides risk pooling and risk sharing opportunities, for both households and business firms. For example, suppose you want $100,000 to start a business. You get $70,000 from a private investor in equity capital in exchange for 75% share of the profits of the business, and you get a $30,000 dollar loan from the bank at 6% interest rate per year. Suppose the bank requires that you get other members of your family to guarantee the loan, thereby transferring the risk of default from the bank to your relatives. Thus the bank is now providing you with the money with minimal risk to itself and the risk of the loan is transferred to your relatives.  Just as funds are transferred through the financial system, so are risks. For example, Insurance companies are financial intermediaries that offer to transfer the risk from the customers to the investors in exchange for some premium. Many financial contracts transfer risk without transferring the funds, as in the case with most insurance contracts and derivatives.

Function 3: Clearing and settling payments
The financial system provides a payments system for the exchange of goods and services. Suppose you live in a country whose government sets a limit on the foreign currency that is accessible. In your country you will be able to pay for your goods and services with the local currency. But if you wish to travel, you will need to use other means of payment. One way of making payments is to barter, exchange goods without making payments, but this would be inconvenient. An important function of the financial system is to provide an efficient way for people and businesses to make payments for the goods and services they wish to buy. Depository financial intermediaries serve this function with wire transfers, checking accounts, and credit/cash cards. Other intermediaries such as money market mutual funds offer transaction-draft accounts and firms whose principal business is not financial, such as General Electric, offer general credit cards. The key elements for managing the costs and risks associated with the process of clearing and settling payments include netting arrangements, efficient use of collateral, delivery-versus payment, immobilization of securities, and extension of credit.

Function 4: Pooling resources and Subdividing shares
The financial system provides a mechanism for the pooling of funds to undertake large-scale indivisible enterprise or for the subdividing of shares in enterprises to facilitate diversification.

Suppose you wish to invest in a business that costs $100,000, but you only have $10,000 to invest. Since you cannot possibly divide the business to buy a part of it, you will not be able to make this investment. A financial system corrects this problem by bringing together a bunch of investors and distributing shares to them, thereby dividing the $100,000 investment into smaller economic pieces. Any money the business earns from the race will then be distributed among the shareholders.

Function 5: Providing information
The financial system provides price information that helps coordinate decentralized decision-making in various sectors of the economy. The clear function of financial markets is to allow individuals and businesses to trade financial assets. An additional function of the capital market is to provide information that assists in decision-making. For example Interest rates and security prices are information that households use in making their consumption-saving decisions.

Function 6: Dealing with incentive problems
The financial system provides a way to deal with the asymmetric-information and incentive problems when one party to a financial transaction has information that the other party does not. An efficient financial system reduces these incentive problems. Incentive problems take a variety of forms – moral hazard, adverse selection and principal-agent problems. The financial institutions develop mechanisms to help overcome these problems. For example, they develop ways to take and manage collaterals to address the moral hazard and adverse selection problems.

Applicability of this perspective is useful in different levels of analysis. It offers a useful frame of reference for analysing the country’s entire financial system, by helping assess how well the system is doing vis-a-vis its essential objectives – as understood in terms of these functions. It is also useful in the study of a particular institutional form, which can be understood in terms of the functions it is supposed to fulfil is management of risk. The functional perspective may also be applicable at an activity level. For example – Lending is a homogeneous financial activity in the private and public sector decision making. But from a functional perspective, lending falls under the two basic functional categories of ‘intertemporal transfer of resources’ and ‘risk management’. The functional perspective can also be applied at the level of an individual financial product.

[This post is the fourth in a series on the theme “regulatory architecture of India’s financial system”. IFMR Blog will continue to feature this theme till the third week of June.]

In the introductory post under this theme, we introduced the regulatory architecture of India’s financial system, and highlighted some issues with it. For a subsequent post, we interviewed Dr. Ajay Shah of NIPFP to seek his views on why and how the regulatory architecture needs to be reformed. In this post, we present a summary of recommendations put forth by two important committees that have taken a long, hard look at the regulatory architecture to bring forth some ideas on how the architecture could be reformed to ensure development a modern financial system that India needs. The reports of these committees (The Committee on Financial Sector Reforms or the Raghuram Rajan Committee, 2009; and the High Powered Expert Committee on Making Mumbai an International Financial Centre or the Percy Mistry Committee, 2007) were released in the last few years, and therefore the analysis is fairly recent.

Committee on Financial Sector Reforms

The Committee recommended a reduction in the number of regulators, defining their jurisdiction in terms of functions rather than the forms of the players, and ensuring a level playing field by making all players performing a function report to the same regulator regardless of their size or ownership. The committee’s key recommendations in this context were:

• Consolidation of all market regulation and supervision under SEBI

In the committee’s view, the present system of market regulation spread across three agencies (RBI for government bonds and currencies, SEBI for equities and corporate bonds, and FMC for commodity futures) induces three major problems: loss of economies of scope and economies of scale for the government, exchanges, financial firms, and customers; fragmentation of liquidity, and encouragement of regulatory gaming; and loss of competitive pressure across markets, because markets operate under separate silos.

The committee recommended unifying all regulatory and supervisory functions connected with organized financial trading into SEBI. This would include equities, corporate debt, government bonds, currencies, commodities, and other kinds of products. This would include both spot contracts and derivatives, exchange-traded and OTC products.

• Consolidation of all deposit-taking entities under one banking supervisor

The committee recommended bringing all banks and any other deposit taking entities, including cooperative banks, under one supervisor – the RBI.

• Consolidation of monetary policy and banking supervision

The committee recommended continuing, over short term, with the present arrangement of both functions being under the RBI. The committee report states that though there are conflicts of interest emanating from housing both functions under one agency, there are reasons why the separation should not be immediate – given the traditionally poor inter-regulator coordination in India, if this happens between the monetary authority and the banking supervisor, it could lead to systemic problems; and other, more pressing changes need to be made in the monetary policy setting function and in banking regulation and supervision.

The committee’s view was that, India should move towards one consolidated prudential regulator and supervisor, and since this entity will be concerned with more institutions than only banks, it should be distinct from the monetary authority. Thus separation of monetary policy and supervisory authority should likely emerge in the medium term.

• Bringing all financial intermediaries governed by special statutes under general statutes

The committee recommended repealing special statutes governing certain intermediaries (eg. SBI and its associate banks, Public sector banks, LIC, GIC, etc), and corporatizing statutory corporations under the general statutes governing form of business enterprise (such as the Companies Act, 1956 or the proposed LLP law under consideration) and placed on a level playing field with all other financial services intermediaries.

• Streamlining tier 2 regulators

The committee recommended focusing the tier-2 regulators (eg. NABARD, SIDBI and NHB) on the purely regulatory function (and consolidating these regulatory activities where possible with the single regulator for the function), and separating the refinancing and other commercial functions into a different body.

• Creation of a Financial Sector Oversight Agency

Even though the Committee recommended separate prudential regulators, it called for strengthening the coordination between them, especially to remove gaps and overlaps, to remove inconsistencies in approach, to regulate and supervise systemically important financial entities, and for overall monitoring of the entire financial sector and initiation of prompt and coordinated corrective action. The committee recommended a Financial Sector Oversight Agency (FSOA) to be set up by statute, with a focus on both macro-prudential as well as supervisory functions.

High Powered Expert Committee on Making Mumbai an International Financial Centre

The committee highlighted two alternative paths, both entailing some level of consolidation of regulatory agencies:

• Consolidation of regulatory functions to four regulators

Under this path proposed by the committee proposed regulatory functions would be consolidated down to four regulators covering finance with one each for:

a. banking with a regulator separate from the monetary authority;
b. capital markets, with a merger of securities markets functions on the fixed income, currency and commodity markets into a single securities and derivatives market regulator;
c. pensions with the consolidation of  pension regulation into a single pensions regulator; and
d. insurance regulator for the insurance space.

• Integration of all financial regulation into a single agency

The other path the committee suggested was to integrate all financial regulation under a single agency. The principle of the single regulatory agency is that it is able to take a complete view of all activities of all finance companies and a holistic view of trends in financial market development.

• Shift away from “entity-based regulation” towards “domain based regulation”.

The committee strongly recommended moving towards domain-based regulation, and away from the present entity-based regulation. This would entail, for example, that the banking regulator regulates the business of banking, but does not regulate all the activities of a financial firm that chooses to call itself a “bank”.

Both these committees called for consolidation of regulatory functions under fewer agencies, and making the regulation more domain or function-based, moving away from the prevailing entity-based regulation. Since the reports came out, the only recommendations on regulatory architecture that have been implemented are: formation of the Financial Stability and Development Council (FSDC), which is largely based on the concept of the FSOA proposed by the Committee on Financial Sector Reforms, and the approval of the PFRDA Act, which creates a dedicated regulator for the pension space.

- By Farzana Najeeb, IFMR Finance Foundation

[This article is the third in a series of posts on the theme “Regulatory architecture of India’s financial system”. IFMR Blog will continue to feature this theme through the next two weeks.]

As discussed in the introductory post of this series, and as Dr. Ajay Shah highlighted in an extensive interview, the Indian regulatory architecture needs significant changes to ensure the development of a modern financial system that can serve the economy of India. In this article, we look at Australia’s financial regulatory architecture to bring out insights that may be useful for thinking about reforming the regulatory architecture of India’s financial system.

Why look at the Australian regulatory architecture?

There is great diversity in the financial regulatory architectures across countries. While some countries have a highly consolidated architecture with only one agency responsible for regulating and supervising the financial system, there are countries like India with a range of regulatory agencies responsible for different parts of the financial system. Most countries are somewhere along this spectrum. Among the developed economies, the financial regulatory architecture in Australia, though not without its share of critics, is widely perceived as successful in terms of its ability to allow and adjust to financial innovations without compromising stability of the financial system. The Australian financial regulatory architecture is also a pioneer in consolidating the regulatory agencies based on functions. This can at least partially be attributed to the continuous and timely reforms of the regulatory architecture and approach. The Australian regulatory framework has undergone fundamental changes in the architecture itself.

Tracing the background of reform

Up until the 1960s the Australian regulatory system tried to implement its monetary and supervision policies through the direct control of banks. As a result they put restraints on the interest rates on deposits, as well as lending restrictions on banks as they were asked to put a majority of their funds in cash, government securities or as deposits with the central bank. This affected their operational flexibility and ability to compete. As a result, new Non Banking Financial Institutions emerged to fill the gap caused by the restraints on banks. Over a period of time, market share of commercial banks declined. The Australian government took a number of small steps towards banking deregulation, which were done mostly on an ad hoc basis.

In this context, the Australian Government appointed the Campbell Committee in 1979, to bring about the first major wave of financial sector reforms. The Inquiry recommended deregulation and removal of regulations, such as interest rate controls and lending restrictions. Deregulation also led to lowering the entry barriers and paved the way for entry of foreign firms, resulting in increased competition. This facilitated technological innovation and greater choice for customers. Deregulation also opened the financial markets to the world and they became more integrated with global financial markets.

However, deregulation introduced its own set of challenges for the regulators. Efficiency and competition increased but seemingly at the expense of stability. Deregulation enabled banks to take on high risk credit borrowers without putting in place efficient risk assessment procedures. As a result the credit quality deteriorated, leading to very high level of NPAs, recapitalization of govt owned banks etc, affecting the overall stability of the system. Also, with regulation still largely following an institutional basis, it was difficult to regulate the provision of similar products offered by different institutions.

The Wallis Inquiry

In 1996, Australian Government appointed the Wallis committee to recommend changes to the regulatory system to ensure an ‘efficient, responsive, competitive and flexible financial system to underpin stronger economic performance, consistent with financial stability, prudence, integrity and fairness.

Wallis committee’s proposals were guided by the approach that to address market failures (caused by anti competitive behaviour, market misconduct, information asymmetry and systemic instability), there need to be different regulatory tools. The Wallis enquiry put forward three main regulatory options- a mega regulator, a lead regulator and a ‘twin peaks’ regulatory model.

While under the mega regulator model, a single regulator would regulate financial markets, consumer protection and prudential regulation, the lead regulatory model envisaged a single agency responsible for gathering and providing information about financial groups to various regulatory agencies.

Considering the pros and cons of the various models and the status of existing Australian regulatory structure, the ‘twin peaks’ model of financial regulation was  adopted by the Australian Government. The rationale was that though a single regulator would create regulatory consistency and remove regulatory arbitrage, the agency would be very powerful and may have a “one size fits all” approach to regulation. The lead regulator, on the other hand, would retain the already existing regulatory agencies and have a coordinated approach towards financial groups, but may not work because of the competition and different objectives of the various regulators being coordinated.

The twin peaks model involved the creation of two new regulators: Australian Securities and Investments Commission (ASIC) ) and the Australian Prudential Regulatory Authority (APRA). Under the Wallis reforms, the key regulatory agencies and their functions are

This architecture brought about a clear distinction between regulations appropriate for ‘conduct and disclosure’ aspects of the financial system, and those appropriate for ‘prudential’ aspects of the financial system. The Wallis Inquiry highlighted the importance of moving away from the concept of entity based financial regulation to this functional based approach.

The committee also proposed separation of the central bank (monetary policy) and prudential regulator. This ensured that the Reserve Bank of Australia (RBA) would help in maintaining systemic stability and would not be burdened by the implicit guarantee to protect the financial institutions at the time of insolvency. At the same time all prudentially regulated entities in the financial system would come under the jurisdiction of a single agency, APRA.

If the function-based approach of regulation is introduced in India, the space for regulatory arbitrage and overlaps should diminish. A single APRA-type prudential regulator would bring regulatory consistency in prudential regulation across products like savings, insurance, investment and pensions. This would also help avoid the regulatory arbitrage across institutions, like the lack of regulatory clarity on cooperative banks. As mentioned in the first post under this series, the conflict of interest arising from RBI functioning as a regulator for monetary policy and as a banking regulator would also be eliminated with this twin peak model approach.

ASIC regulates companies, financial markets, financial services organizations and professionals who deal and advise in investments, superannuation, insurance, deposit taking and credit. It ensures that credit consumer activities, financial markets as well as financial service providers operate efficiently and honestly. This is important for protecting consumers against mis-selling and other unethical practices. In India, with different products regulated by different agencies, no single regulator has a complete understanding of the overall picture, especially on issues regarding product transparency, consumer awareness, financial planning and advice. Due to disparate regulations by different regulators, the existing regulatory architecture in India does not allow any institution-type to provide a complete range of financial services at the front-end. An ASIC-type agency could help overcome this problem by providing consistency in regulation of client-facing activities across products. It would also help in regulation and supervision of large complex financial institutions that cover a wide range of financial services. Presently, they are forced to organize themselves through various financial firms that meet the requirements of respective regulations.

There is potential for India to learn from some countries, and Australia seems to be near the top of that list. Even though the exact approach India adopts need not be the same, we need a shift towards a similar functional approach. Importantly, Australia’s journey of timely, prescient regulatory changes is in itself something Indian policymakers can learn from. Even though there is no perfect regulatory system, the focus should be on selecting the best fit for the country’s fast evolving economy.