[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.

What is the state of financial regulatory architecture in India? Is the regulatory architecture optimal for the modern financial system that the Indian economy needs? What do the recent changes in the regulatory architecture mean for the financial system? How can the regulators be better prepared to take on the challenges for the next 10 years?

Dr Ajay Shah, Professor at the National Institute for Public Policy and Research answers these questions and more in a detailed conversation with Suyash Rai of IFMR Finance Foundation. This interview is the second 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 three weeks.

Listen Now [powerpress]

Click to read the transcript of the complete interview.

Brief summary of the discussion:

The basic framework of the regulatory architecture in India has largely remained unchanged over past few decades, the RBI being a case in point where the last legislation was done in 1934. The laws behind the current architecture are completely out of touch with India’s needs today.

On Issues with regulatory architecture

One of the many things that need attention today is the issue of conflict of interest. If the Central Bank is an investment banker to the government and is also in charge of the monetary policy, there is an inherent conflict of interest. In order to serve the function of being an investment bank, the central bank may like to make the interest rate as low as possible. This would persistently generate an inflation bias.

The issue of conflict of interest is the first check-point that an elected government should deploy. An agency with multiple functions would not have accountability because, unless there are clear, sharp functions, conflict of interest is bound to arise.

The financial system should evolve based on efficiency and productivity considerations and the financial regulatory system should be re-designed to suit the needs of the “modern, efficient, capable financial system”. But today, the opposite is true where the financial firms are forced to redesign themselves to suit the architecture. This imposes cost and inefficiencies on the economy.

On Multiple regulators and the FSDC

Though in many places multiple regulators have problems talking to each other, in India, the problems are much more acute. This is where an agency like the Financial Stability and Development Council (FSDC) comes in handy. In a financial system, there are bound to be “cross cutting issues” – consumer protection or most importantly, financial stability. This is important because, when things get bad, they affect markets in a complex manner.

The impact of cross-cutting issues is not just when there is a crisis. The prevention side of systemic risk is also inherently cross-cutting. The heart and soul of financial stability thinking is to look at the overall financial system, look at the inter-connections that cut across all elements of finance. And no one regulatory agency in India is capable of doing that because by their very nature, each regulatory agency tends to be a silo. Since the RBI does a lot regulation and supervision work, it makes sense to place financial stability work under the FSDC.

Was India ‘isolated’ from the recent crisis?

India is integrated weakly into the world economy and so to that extent, we were a little less affected by the crisis. Having said that, the shock was quite a big one for India. In September and October 2008, the very operating procedure of monetary policy of RBI broke down. The call money rate went to 15% even though the repo and the reverse repo were far, far below. I can’t think of too many countries in the world, where the very operating procedure of monetary policy broke down in this fashion. If you take the seasonally adjusted quarter on quarter growth for GDP, in the pre-crisis period it was at the peak of 12%, in the crisis it dropped all the way to 4%. An 8 percentage point drop of GDP growth is pretty bad by international standards.

Not just India, but many other countries were equally unaffected. Canada, for example, whose economy is tightly connected to the US economy, experienced no big crisis. Australia is also another case in point.

On Vision for the regulatory architecture

First, monetary economics is not finance and the two should be kept separate. RBI should be a narrow agency that does only one thing and that is to choose short term interest rate. Second, it makes sense to unify all regulation and supervision of securities market into one agency.

From an Indian political perspective, it would be advisable to have a single very strong agency doing too many things. This is good in the longer term when the process of appointment is much more efficient. But I would be unhappy if there was a single very strong agency doing too many things, because in India, we will run into trouble on the appointment process and the entire field of Indian finance could choke for a few years if the wrong people are put in charge of an agency. I am pessimistic about the appointment process. The reasonable way to see it is to imagine that there are 3-4 agencies and 1-2 of them will always have low quality people at the top and 1-2 will have high quality people at the top, so at any point in time we will end up making progress in some areas and there will be a creative tension between these multiple agencies who will have different views on various questions. If we unify too much into a single agency, then I think that’s too much concentration of power.

The job of a banking regulator is not to regulate all the activities of a bank. For example, when a bank does depository participant business, the depository participant activity is regulated by SEBI. When the bank trades on an exchange, this is regulated by SEBI. So, a regulator should be charged with enforcing only one of the many laws of the land.

On challenges impeding realisation of the vision

The first challenge that needs to be overcome is that of creating intellectual consensus around issues related to reforming the regulatory architecture. The second is getting the Financial Sector Legislative Reforms Commission (FSLRC) right. Justice Srikrishna and his fellow commission members have an immense burden of responsibility on their shoulders to do a great job of this. The third piece to this is the bureaucratic politics that shape this process.

We need a series of top quality academic papers that will answer one question at a time. For example, one research pointed to fairly high levels of unhedged interest rate exposure in the banks of India, which suggests that the regulation and supervision of interest rates was not being done properly. These are valuable raw materials for thinking policy. But there is not much research happening in this area. That is a key problem that we need to overcome.

[The views expressed above are Dr. Ajay Shah's and do not necessarily reflect the views of IFMR Trust or its associate entities.]

It is happening again – regulators debating openly to clarify their turfs. This time it is PFRDA Vs. IRDA for regulation of pension products offered by insurance companies, and just a few months ago, SEBI was competing with IRDA for regulation of Unit Linked Investment Plans (ULIPs) offered by insurance companies. There have been temporary solutions or backtracking in some of these cases. For example, in the recent PFRDA-IRDA issues, the PFRDA Chairman later clarified that since the regulation in India is still entity-based and not product-based, there is no case for a regulatory turf battle between his agency and the insurance regulator. The matter has now been referred to the newly formed Financial Stability and Development Council (FSDC) for clarification. No matter what the details of these specific cases, one thing seems clear –all is not well with our regulatory architecture, because it leaves room for such fundamental conflicts, which are not around some obscure technical issues, but actually raise questions about the very architecture itself.

The Present Regulatory Architecture

In this context, one immediately relevant characteristic of the Indian financial system’s regulatory architecture is its complexity – both in terms of the sheer number of regulatory, quasi-regulatory, non-regulatory-but-still-regulating bodies, and also because of their overlapping, ambiguously defined respective spheres of concern and influence. This figure depicts the regulatory architecture in some detail (adapted from Report of the Committee on Financial Sector Reforms).

Regulatory agencies: Broadly, there are supposed to be product-wise demarcations of regulatory space for various regulators: Reserve Bank of India (RBI) regulates credit products, savings and remittances; the Securities and Exchange Board of India (SEBI) regulates investment products; the Insurance Regulatory and Development Authority (IRDA) regulates insurance products; and the Pension Fund Regulatory and Development Authority (PFRDA) regulates pension products. The Forward Markets Commission (FMC) regulates commodity-based exchange-traded futures. Practically, as was illustrated by the recent PFRDA-IRDA conflict, since certain entities (especially insurance companies) primarily engaged in one product also offer other products, it becomes difficult to impose product-based regulation. So, essentially, most regulation turns out to be entity-based. Another example here is of cooperative banks, which, except in terms of their ownership structure, are very much like other banks – they take deposits and give loans. Still, their regulation is largely left to the registrar of cooperatives.

Quasi-regulatory agencies: There are other government bodies which perform quasi-regulatory functions, including National Bank for Agriculture and Rural Development (NABARD), Small Industries Development Bank of India (SIDBI), and National Housing Bank (NHB). NABARD supervises regional rural banks as well as state and district cooperative banks. NHB regulates housing finance companies, and SIDBI regulates the state finance corporations.

Central government ministries: In addition to these regulatory and quasi-regulatory agencies, certain ministries of the government are also involved in policy making in the financial system. Of course, Ministry of Finance (MoF) is most prominently involved, through its representatives on the Boards of SEBI, IRDA and RBI. MoF and Ministry of Small Scale Industries have representatives on SIDBI Board, and Ministry of Urban Development is represented on the NHB Board.  MoF representatives are also on Boards of public sector banks and DFIs. Forward Market Commission (FMC), which regulates commodity exchanges and brokers, comes under the Ministry of Consumer Affairs.

State governments: Through the registrar of cooperatives, who are typically under the departments of agriculture and cooperation, the state governments regulate the cooperative banking institutions in their respective states. The state government have also sometimes claimed a regulatory role in certain other cases. Though it never became an open battle, the Andhra Pradesh government’s Ordinance directing operations of Micro Finance Institutions (MFIs) – many of them NBFCs registered with and regulated by RBI – falls into this space. Such actions by state government have been matters of contention in the past as well, and some of them have gone to the courts as well. The court cases to clarify the RBI Vs. State government issue are still being heard in the Supreme Court, and a judgement from the Apex Court could help clarify this ambiguity.

Special statutes for certain financial intermediaries: Some key financial services intermediaries like SBI and its Associate Banks, Public Sector Banks, LIC and GIC are governed by their own statutes. These statutes give a special status to these institutions vis-a-vis the other institutions performing the same functions. Earlier, IFCI, UTI and IDBI also operated under special statutes, but now there special statutes have been repealed.

Establishment of FSDC: In the recent past, there has been an important addition to the regulatory architecture in the form of the Financial Sector Development Council (FSDC), which has replaced the High Level Committee on Capital Markets. FSDC, which is convened by Ministry of Finance, does not have statutory authority, and it is structured as a council of regulators, with a permanent secretariat and with the Finance Minister as chairman. The council would be expected to resolve inter-agency disputes. It will look at regulation of financial conglomerates that fall under various regulators’ purview, and also the wealth management function, which also effectively deals with multiple products.

Issues with the Regulatory Architecture

An important implication of this architecture is the regulatory arbitrage emerging from it, because there are spaces in the financial system that are either regulated by multiple entities with little clarity on division of responsibilities, or are regulated by agencies that do not have the competence to regulate them effectively. An example of this is the regulation of district cooperative banks, which are supposed to be regulated by the RBI and by the registrar of cooperatives in their respective states. While the former has the expertise, it does not have the regulatory bandwidth to regulate these institutions, and the registrar of cooperatives have a more direct role in their regulation, but they typically do not have the expertise to regulate such deposit-taking entities. Similarly, when investment/pension products are offered by insurance companies, though the entity is regulated by the insurance regulator, the specific product should fall under the purview of the respective regulator (investment/fund management – SEBI, pension – PFRDA), which may be more capable of regulating the product, and may have developed more effective ways of regulating it in terms of capital, expenses and disclosure. Since the regulation is practically entity-based, the entities can enjoy regulatory arbitrage.

The present architecture makes it very difficult to create financial intermediaries that offer a range of financial services and benefit from economies of scope. An example is the regulation of financial services distribution, which has significant inter-regulator differences. So, it is almost impossible to create distribution agencies or front-end intermediaries that can offer a complete range of financial services to the clients.

The present architecture creates certain conflicts of interest for certain regulators. RBI is not just the banking regulator, it is also the investment banker for the government and the monetary policymaker. The role of investment banker to the government may conflict with the role of banking regulator because banks buy a bulk of government securities. The monetary policy can help the banks in maintaining their health, and if the same agency is responsible for banking regulation and monetary policy, conflict of interest may arise, and the agency’s actions may turn out to be good for the banks but bad for the long-term development of the markets.

This architecture also creates problems of coordination among agencies. For managing systemic risks, regulatory coordination at the level of financial system is crucial. In India’s financial system, unless the FSDC plays an active role, the inter-agency coordination mechanisms are quite weak.

Though it is clear that the regulatory architecture needs to see some changes to avoid regulatory arbitrage, gaps, costs, and coordination problems, the exact nature of these changes is not obvious. There are multiple ways of addressing these issues, each with varying advantages and disadvantages.

Through the next four weeks, we will pursue this theme in detail, through interviews with experts, case studies from other countries, and more articles on this theme.