12
Jul

FSLRC on Micro-prudential Regulation

By Deepti George, IFMR Finance Foundation

This post is part of our blog series on the FSLRC Report.

The financial-legal framework envisaged by the FSLRC comprises nine important components, one of which is Micro-prudential regulation. Micro-prudential regulation refers to those regulations that concern the safety and soundness of financial service providers, with the intention of promoting stability and resilience of the Indian financial system. While all providers would be concerned about their institution’s health, there is a need for regulator-intervention in the form of regulations. The motivation for this is the protection of consumers as well as the mitigation of systemic risks, both of which are linked to each other in many ways in terms of outcomes. Therefore, as the FSLRC explains, these regulations are aimed at one firm at a time, in contrast to macro-prudential (systemic risk) regulation that involves the financial system as a whole. FSLRC describes two reasons for micro-prudential regulation:

  • Governance failures within firms: These are failures that arise from the principal-agent problem between the managers and shareholders of the firm, where the shareholders (Board) may not have enough control over the managers’ (agent) actions which could be detriment to the interests of shareholders and customers.
  • Moral hazard: Any indication of an implicit guarantee available from the Government in the event of failure of a financial institution would produce ‘moral hazard’ behavior on part of managers to take indiscriminate risk, or to make decisions for short-term gains with undesirable long-run repercussions for the institution.

These undesirable outcomes have added significance with respect to the financial system due to the balance sheet obligations some of the institutions make to their consumers (such as deposits placed by consumers in banks, or pension assets managed by pension funds), and also due to systemic risk concerns. The difficulty in bridging information asymmetry gaps between institutions and consumers make it impossible to address these issues in the absence of regulation.

Given micro-prudential regulations are expensive and intrusive, FSLRC has taken the view that these must be applied only where it is required, the intensity of which should be proportional to the nature of the issue to be addressed, and will be guided by the Draft Financial Code. FSLRC clarifies this point in the following manner: An institution that has balance sheet obligations to a small set of customers who are well-equipped to assess the credit risk of the institution, would face less stringent micro-prudential regulations than an institution having fixed balance sheet obligations to a large number of small retail consumers. Similarly, in those situations where informational asymmetries between institutions and consumers are very low and can be easily bridged due to the local nature of such institutions, there is a lesser requirement for such regulations. Also, all systemically important institutions identified by the FSDC will be subjected to micro-prudential regulation as specified by the respective regulator.

FSLRC has laid out principles that regulators must be guided by in framing micro-prudential regulations. Among others, these principles keep in mind the feasibility of implementation and supervision, the need to facilitate access to and innovation and competition in financial products and services, and the desire to minimize differences in regulatory approaches that target similar activities or mitigate similar risks.

Micro-prudential regulations have been further categorized into the following:

FSLRC_MicroPrudentialRegulation

In conclusion, FSLRC has envisaged micro-prudential regulations as a means to reduce but not eliminate the probability of failure of financial firms.

This post concludes our FSLRC Blog series. If you have any feedback for the authors or on the topic please do share in the comments section below or drop us a line at blog [at] ifmr.co.in

19
Jun

FSLRC on Systemic Risk

By Vishnu Prasad, IFMR Finance Foundation

This post is a continuation of our blog series on the FSLRC report.

Following the IMF-FSB-BIS definition, the FSLRC defines systemic risk as “[a] risk of disruption to financial services that is caused by an impairment of all or parts of the financial system and has the potential to have serious negative consequences for the real economy.” The Commission envisages systemic risk oversight as the fourth pillar of financial regulation, along with consumer protection, micro-prudential regulation and resolution.

However, unlike the other pillars, systemic risk oversight presents two unique challenges. First, mitigation of systemic risk requires a comprehensive system-wide perspective of the consequences of failure of an individual entity. Second, responses to systemic risk events often require inter-regulatory coordination that combines diverse perspectives. The Commission thus believes that monitoring and addressing of systemic risk must not lie with any specific sector regulator but with the Financial Stability and Development Council (FSDC).

Institutional architecture

The FSDC is envisaged as a council of regulatory agencies which will allow it to utilise the expertise of all regulatory agencies. The FSDC board will be headed by the Minister of Finance, Central Government. Other members of the board will be the head of the regulator for banking and payments, the head of the regulator for other financial sectors, the chief executive of the resolution corporation, the chief executive of the FSDC and an administrative law member. It will be served by an executive committee chaired by the regulator for banking and payments, which will have managerial and administrative control.

Systemic Risk Regulation process

Systemic Risk regulation is envisioned as a five-element process:

  1. Data, Research and Analysis: The first step in the process is to gather information from all sectors of the financial system. For this purpose, the FSLRC recommends the creation of a system-wide, unified database which will be operated by the Financial Data Management Centre (FDMC). The FDMC will be housed within the FSDC and will collect data from all regulated entities and other financial firms. Using the data so collected, the FSDC will conduct a research programme that will identify the interconnectedness and systemic risk concerns in the financial system, provide quick response to systemic risk events and develop systemic risk indicators among other research objectives.
  2. Identification of Systemically Important Financial Institutions (SIFIs): The FSDC will formulate the methodology to identify SIFIs, which will then be applied to FMDC’s database to designate systemically important firms and conglomerates. Such institutions will face a higher level of regulation and supervision and will be monitored carefully by the FSDC.
  3. Formulation and implementation of system-wide measures: The Commission recommends the creation of a counter-cyclical capital buffer, which can be applied to large parts of or the entire financial system. As systemic risk builds up, the FSDC can increase the capital requirements. Such a decision will require all the regulatory agencies to formulate regulations and translate them into action. As research in the nascent field of systemic risk develops, the Commission recommends that new measures of systemic risk be included in the Indian Financial Code (IFC) through appropriate amendments in Parliament.
  4. Inter-regulatory agency co-ordination: The Commission believes that the FSDC will strive to improve inter-regulatory agency co-ordination by implementing measures such as establishment of joint-working groups, cross staffing initiatives and resolution of disputes. The board of FSDC will be empowered to create its own dispute resolution process to solve disputes between FSDC members and other regulatory agencies. The FSDC is also expected to reduce regulatory uncertainty by promoting consistency in principles and practices adopted by regulators in the areas of rule-making and enforcement.
  5. Crisis Management: This element of systemic risk oversight will be spearheaded by the Ministry of Finance, Central Government. During a systemic risk event, the FSDC is expected to assist the Ministry of Finance in efficient crisis management by providing research that seeks to understand and resolve the crisis, implementing system wide measures such as the counter-cyclical buffer and assisting regulators in their efforts to solve the crisis. Ministry of Finance will need to consult the FSDC before making decisions regarding financial assistance or other extraordinary assistance to financial service providers. The actions of the FSDC will be subject to a post-crisis audit to ensure accountability.

The recommendations of the FSLRC are keeping in line with international experience. For example, US has established the Financial Stability Oversight Committee and the European Union (EU) has established the European Systemic Risk Board for systemic risk oversight. The creation of an independent statutory body to tackle systemic risk events will improve our capacity and readiness to deal with financial crises like the 2008 financial crisis.

Note: Given our focus on Systemic Risk in this post, do also read Ajay Shah’s blog post on “Dr. Subbarao’s comments about FSLRC’s treatment of systemic risk“.

23
May

FSLRC on Financial Regulatory Architecture

By Darshana Rajendran, IFMR Finance Foundation

This post is a continuation of our blog series on the FSLRC report.

India’s regulatory architecture has been driven by the creation of product-specific regulators. We have multiple regulators: Reserve Bank of India (RBI) that regulates savings and credit, Securities and Exchange Board of India (SEBI) that regulates the securities market and exchanges, Insurance Development and Regulatory Authority (IRDA) for the insurance sector, the Forwards Market Commission (FMC) for the regulation of forwards and futures markets and the Pension Funds Regulatory Development Authority (PFRDA) for pension products. This approach of multiple sectoral regulators has been criticised by expert committee reports that have studied the regulatory architecture in India1. Some of the issues with the current regulatory framework that have been discussed are:

  • It creates certain conflicts of interest for some regulators. (For example, there are conflicts of interest arising from housing the functions of monetary policy as well as banking supervision under RBI)
  • Regulatory arbitrage leading to forum-shopping
  • Overlaps in regulation
  • Gaps in regulation of financial instruments (For example, ponzi schemes are not currently being regulated by any of the existing agencies)
  • Induces economic inefficiency (Many activities that naturally sit together in one financial firm are forcibly spread across multiple financial firms)
  • Reduced ability to understand risk (No single supervisor has a full picture of the risks that are present)
  • Problems of inter-regulatory coordination

The FSLRC established the following principles in order to analyse the financial regulatory architecture: (a)Independence and accountability, (b)Avoiding conflicts of interest, (c)Regulatory architecture based on a complete picture of a financial firm’s activity, (d)Avoiding sectoral regulators, (e)Increasing and utilizing economies of scale to address resource utilization issues.

The FLSRC proposed a new structure featuring seven agencies.

  1. The RBI, which will perform three functions: monetary policy, regulation and supervision of banking in enforcing the proposed consumer protection law and the proposed micro-prudential law, and regulation and supervision of payment systems in enforcing these two laws.
  2. The unified financial regulatory agency (UFA), which will enforce the consumer protection and micro-prudential provisions across the financial sector, other than in banking and payment systems. This proposed unified financial regulatory agency would also take over the work on organised financial trading from RBI in the areas connected with the Bond-Currency-Derivatives Nexus, and from FMC for commodity futures, thus giving a unification of all organised financial trading including equities, government bonds, currencies, commodity futures, corporate bonds, etc.
  3. A resolution corporation, which will implement the provisions on resolution of financial firms. The present DICGC will be subsumed into the Resolution Corporation which will work across the financial system.
  4. The Financial Sector Appellate Tribunal (FSAT), which will hear appeals against RBI for its regulatory functions, the unified financial agency, decisions of the Financial Redressal Agency (FRA) and some elements of the work of the resolution corporation
  5. The Financial Redressal Agency (FRA), which will address consumer complaints across the entire financial system.
  6. The Financial Stability and Development Council (FSDC), which will be responsible for systemic risk oversight.
  7. The Public Debt Management Agency (PDMA), an independent agency that will manage public debt

The FSLRC therefore proposes to subsume a number of existing sector specific financial regulators (SEBI, IRDA, PFRDA, FMC) into a Unified Financial Authority. The UFA would be the primary consumer protection and micro-prudential regulator for sectors other than banking and payment systems, which would remain with the RBI. There would also be a single appellate mechanism or the FSAT for appeals from all regulatory agencies. In addition, there would be an agency to address consumer complaints across the system, a public debt management agency, a resolution corporation and the FSDC.

After the proposed laws come into effect over a horizon of five to ten years, these questions need to be revisited. The FSLRC suggests two possible solutions in the long term: One possibility is the construction of a single unified financial regulatory agency, which would combine all the activities of the proposed Unified Financial Authority and also the work on payments and banking. Another possibility is to shift to a two-agency structure, with one Consumer Protection Agency which enforces the proposed consumer protection law across the entire financial system and a second Prudential Regulation Agency which enforces the micro-prudential regulation law across the entire financial system. In either of these paths, RBI would then concentrate on monetary policy.


1 – 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

17
May

FSLRC on Financial Inclusion and Market Development

By Vishnu Prasad, IFMR Finance Foundation

This post is a continuation of our blog series on the FSLRC report.

The FSLRC report identifies three problems that occur when regulators pursue the objectives of financial inclusion and market development like subsidizing credit for agriculture or increasing the flow of credit into certain states, for example:

  1. When a bank is forced by regulation to provide more loans to open a branch in a non-profitable location, this imposes a hidden cost or tax on other branches, depositors and shareholders.
  2. There could be dilution of accountability of the regulator due to conflicting objectives. For example, the number of households that participate in a certain financial product maybe increased quickly by reducing the burden of consumer protection. Similarly, the function of redistribution to exporters, by requiring banks to give loans to exporters, is in direct conflict with the function of protecting consumers who deposit money with banks.
  3. The report takes the view that imposing costs on certain consumers for providing gains to others is a form of taxation. Such a selective taxation of certain consumers is inherently inefficient.

Due to the problems cited above, there is a need to clearly define the scope of objectives, powers and accountability of regulators. The report’s recommendations throw much clarity on three aspects-what the objectives of the regulators should be, how these objectives should be implemented and what the principles guiding policy-making should be. These are discussed below.

The FSLRC identifies three regulatory objectives of financial inclusion and market development:

  1. Modernisation of market infrastructure or market process, especially those that relate to adoption of new technology.
  2. Deepening consumer participation by undertaking measures that provide for the differentiation of financial products/services to specified categories of consumers, or that enlarge consumer participation in financial markets generally.
  3. Aligning market infrastructure or market process with international best practices.

The report recommends the following institutional architecture for implementing the objectives identified above:

  1. The Central Government should direct specific regulators on matters of financial inclusion. For example, regulators may be asked to ensure effective and affordable access to any specific financial service for a class of consumers. The Central Government is expected to reimburse the cost incurred by financial service providers in granting such in the form of cash or cash benefits and tax benefits.
  2. Regulators should pursue a developmental strategy that seeks to achieve the objectives outlined. However, the goal of market development should be subordinate to the goals of consumer protection and micro-prudential regulation and should be pursued only when there is evidence of market failures that hinder it. The report recommends that the rule making process should involve features like cost-benefit analysis and notice-and-comment periods. There should also be ex-post evaluation of these initiatives, assessing their costs and benefits.
  3. In initiatives that involve multiple regulators, the FSDC (Financial Stability and Development Council) will play the dual role of a think-tank (measuring the progress of initiatives, analysing past initiatives, recommending new ideas etc.) and be the agency that coordinates between regulators.

The report recommends that the regulators and the central government keep the following balancing principles in mind while formulating policies:

  1. Minimize any potential adverse impact on the ability of the financial system to achieve an efficient allocation of resources.
  2. Minimize any potential adverse impact on the ability of a consumer to take responsibility for transactional decisions.
  3. Minimize detriment to objectives of consumer protection, micro prudential regulation, and systemic risk regulation.
  4. Ensure that any obligation imposed on a financial service provider is commensurate and consistent with the benefits expected to result from the imposition of obligations under such measures.

Overall, the framework proposed by FSLRC focuses on regulatory functions that address market failures obstructing the efficient functioning of the financial system. The Commission is of the view that financial inclusion and market development are functions that aren’t strictly regulatory in nature. Financial regulators performing these functions could lead to distortions in the market (hidden costs, inefficient taxation and dilution of accountability). Such functions should therefore be pursued in case of market failures that hamper equitable distribution of financial services and market development.

29
Apr

FSLRC on Financial Consumer Protection

By Deepti George, IFMR Finance Foundation

This post is a continuation of our blog series on FSLRC report.

Keeping in mind the existing state of consumer protection measures in place for India, FSLRC has proposed a consumer protection framework for financial services, with the stated objectives being – to protect and further the interests of consumers of financial products and services; and to promote public awareness in financial matters. It is pertinent to mention here that the Commission has included, in its definition of retail consumer, not just individuals but also enterprises that avail a financial product or service whose value does not exceed a limit as prescribed by the regulator1, or who has less than a specified level of net asset value or turnover, also as prescribed by the regulator . The previous post mentioned the rights and protections that the draft Code sets out. Among these rights are the right against unfair contract terms and the right to redress of complaints.

The right against unfair contract terms

The Draft Code deems an unfair term of a non-negotiated contract2 to be void. A term is unfair if it causes a significant imbalance in the rights and obligations of the parties, to the detriment of the consumer, and is not reasonably necessary to protect the legitimate interests of the provider3. Further, the Draft Code enlists a set of factors that would be considered in determining whether a term is unfair or not – such as the nature of the service, the extent of transparency of the term, the extent to which the term allows comparison with other financial products or services, and the dependency of the term with the remaining contract and with other contracts under question. If a term was found to be unfair, the contract will continue to be enforced with the remaining terms as long as it can do so without the unfair term.

This is very much in line with the laws laid out in Australia, in as late as 2010, through the Competition and Consumer Act 2010. While Australia already had laws in place to protect consumers against unfairness in contractual dealings (ex: prohibition of unconscionable or misleading and deceptive conduct), this Act introduced a new ‘unfair contract terms’ regime to standard form consumer contracts4 under which courts can decide if a term in the contract is found to be unfair5, in which case the contract is void. However, the contract will continue to bind parties if it is capable of operating without the unfair term. Examples of unfair terms are set out in an indicative list in the law6.

The right to redress of complaints

The Commission addresses this right in two steps – the first, is by placing a requirement on providers to have in place an effective mechanism to redress complaints internally, to inform consumers about their right to redress, and the process to be followed for it; and the second, is by having a statutory body external to the provider, that will be a unified grievance redressal system to redress complaints. This body termed the Financial Redress Agency (FRA), will replace sector-specific Ombudsmans currently in existence such as those for banking and insurance. Whether or not the FRA will replace the Consumer Courts (instituted by the Consumer Protection Act, 1986), will be decided later based on how well the FRA succeeds in its task.

FSLRC_CP1

FSLRC has also created a niche for consumer advocates to contribute to the regulator’s functions, through the creation of an Advisory Council on Consumer Protection. This body, with adequate representation from experts in the fields of personal finance and consumer rights, is expected to advice, comment on, and review the effectiveness of regulator’s policies. The regulator in turn is held accountable to respond to such proposals made by the Council, thereby bringing in an element of transparency to the regulatory decision-making process.

  1. This is not uncommon. In Australia, for instance, retail consumer includes small businesses, which are defined by s761G of Corporations Act 2001, as a business employing fewer than 100 people (if the business manufactures goods or includes manufacture of goods), or 20 people (otherwise)
  2. A non-negotiated contract is one in which the provider has a substantially greater bargaining power relative to the customer in determining the terms of the contract; and it is a standard form contract
  3. This however does not include a term that is reasonably needed to protect the legitimate interests of the provider, is a basic term such as the price of a product, or is a term required under any law or regulations
  4. All contracts will be presumed to be standard form contracts unless otherwise established. It is typically one that has been prepared by one party to the contract (the supplier) and is not subject to negotiation between the parties
  5. A contract term is considered unfair if:
    • – It would cause a significant imbalance in the parties’ rights and obligations arising under the contract, and
    • – It is not reasonably necessary in order to protect the legitimate interests of the party who would be advantaged by the term, and
    • – It would cause detriment (whether financial or otherwise) to a party if it were to be applied or relied on.
  6. s25, CCA 2010. Some are given below: A term permitting one party (but not another party)
    • – to avoid or limit contractual performance or to terminate the contract
    • – to renew or not to renew the terms of the contract
    • – to unilaterally determine whether to determine whether the contract has been breached
    • – a term limiting one party’s vicarious liability for its agents