Monday, May 11, 2015

The concerns with India's proposed financial code

I have five concerns with the proposals outlined in India's Financial Sector Legislative Reforms Commission (FSLRC) report.

1. Are such far-reaching reforms needed? – The FSLRC proposes certain far-reaching reforms, with atleast two fundamental shifts in the regulatory paradigm – the shift from rules based to principles based regulation; and the assumption that financial markets are inherently efficient and regulation is required to address market failures and not necessary to enable market development. Further, its specific proposals on realigning the regulatory architecture are equally transformational – shift from multiple to single capital and money markets regulator, and the judicial review of RBI’s regulatory actions. There is no evidence whatsoever, from India or elsewhere, to warrant such a radical departure – either by way of the superiority of the new paradigm or the relative inferiority of the prevailing system – on something like financial market regulation on which there is little global consensus on what is the best approach.

2. Judicial review of RBI’s regulatory actions - The RBI’s banking sector regulatory decisions would come for appeal before the Financial Sector Appellate Tribunal. In fact, this judicial over-sight is not just confined to issues like the magnitude of penalties, but also on policy decisions (involving exercise of judgment) like whether to ban a particular financial instrument or the magnitude of leverage caps on trading positions. Such decisions are invariably deeply judgemental in nature, based on a very comprehensive appreciation of trends and the theory and model being used to make the assessment. Further, most such invariably decisions have a compelling enough counter-point, again based on a different judgement arrived at through a different theory and model. In the circumstances, defending the decision before a court of law can become very tricky. It will encourage banking regulators to play safe – delay decision-making on throwing sand into the wheels of a booming asset market till the bubble bursts. It will also embolden financial market participants and their lobbyists to question, for example policy decisions that address systemic safety. This goes against the practice elsewhere, including in the US, where such decisions can only be reviewed (on grounds of legality and adherence to due process of law) and not appealed on merits. 

As the Governor of RBI has argued against the move saying that the regulator would “simply not have the capability, experience, or information to make, and where precise evidence may be lacking… a lot of regulatory action stems from the regulator exercising sound judgment based on years of experience. In doing so, it fills in the gaps in laws, contracts, and even regulations”. In this context, it is worth remembering that India’s recent experience with the Securities Appellate Tribunal (SAT) and its judgements on SEBI decisions has not been encouraging. 

3. Separation of capital flows regulation - One proposal in the Union Budget 2015-16 involves amending Section 6 of FEMA to provide that controls on capital flows as equity will be exercised by the government, in consultation with the RBI. This assumes that cross-border capital flows market can be segmented neatly into equity and debt components. In fact, equity flows are subject to much the same global financial linkages induced volatility as debt flows. Also, such separation of responsibilities and the resultant regulatory arbitrage opportunities may engender systemic distortions in equity and debt inflows. 

It therefore goes against the argument that capital flows management measures have to be undertaken in a comprehensive manner. Further, it increases the moral hazard for governments to keep open the equity market gates in good times and to that extent restrict the RBI’s ability to impose counter-cyclical macro-prudential measures to effectively manage the overall current account balance.

4. Creation of a super-regulator - Creation of a super-regulator UFRA that would subsume SEBI (securities trading), IRDA (insurance), PFRDA (pensions), FMC (commodities trading), and the RBI’s bond trading regulation activities. This is being done on grounds of synergies from such consolidation. This raises the question as to the need to fix institutions that are atleast not broken. India’s experience with financial market regulation has been far better than that elsewhere in the world. Its regulators, led by the central bank, have adopted a heterodox mixture of macro-prudential measures to limit asset and credit bubbles, keep a leash on the shadow banking system, and manage capital flows, with far greater success than in most other economies, developed and emerging. 

Further, there are no best-practice examples from anywhere in the world. A large variety of practices are the norm. Therefore, the most prudent strategy would be to introduce reforms in a gradual manner as has been happening – crossing the river by feeling the stones. In any case, there is little evidence either way to argue that unified regulatory institutions are superior to fragmented architecture. The example of countries with unified regulators like the UK - where the Bank of England, through the Financial Policy Committee (FPC) and the Prudential Regulatory Authority (PRA), is the sole regulator - is not encouraging enough to merit a whole-hearted switch to a single regulator regime. 

5. Separation of inter-bank bond market regulation - Another example comes from the shift in responsibility for regulating the interbank bond market (repo and reverse repo securities) from RBI to SEBI (this has been recently shelved, though it is not clear whether it is a temporary retreat). This assumes significance since these securities are the primary monetary policy transmission lever for the central bank. The RBI Governor himself opposed this move, “Is the regulation of bond trading more synergistic with the regulation of other debt products such as bank loans and with the operation of monetary policy (which requires bond trading) than with other forms of trading? Once again, I am not sure we have a compelling answer in the FSLRC report. My personal view is that moving the regulation of bond trading at this time would severely hamper the development of the government bond market, including the process of making bonds more liquid across the spectrum, a process which the RBI is engaged in.”


Pratik Datta said...

I will try to respond to some of the main issues you raise regarding the FSLRC proposals from a lawyer's perspective:

1. FSLRC recommended that the primary law (enacted by the Parliament) should be principle based. Subordinate legislations (like regulations made by regulators) need not necessarily be principle based - they can be detailed rules too. See p. 13 (last paragraph). If you read the current Indian laws, a lot of gritty details are mentioned in the primary statute - this is unnecessary. Compare this with FSMA is UK. You will see the difference for yourself.

Judicial review of RBI's regulatory actions has been recommended by a number of previous expert Committees. FSLRC merely reiterated the stand. For example, see p. 133 of the Raghuram Rajan Committee Report (A hundred small steps - 2009). Do note, there was no dissent note in this report.

2. It is a well-settled position under Indian law, as developed by the Supreme Court, that policy decisions are not within the remit of judicial review (public interest litigation by SC/HCs under writ jurisdiction being an exception). Therefore, any Indian lawyer would easily understand that the IFC does not prescribe judicial review of policy decisions by a Tribunal. If you get time, please do read my blog post on this point:

Your example on this point is incorrect. The substantive merit of the ban cannot be challenged under IFC. However, the ban must be by regulations. If the process for regulation making under IFC is not followed, then only can the regulation be struck down by the Tribunal. Therefore, the Tribunal does not second guess policy decision - it is just a process watch-dog.

As of today, a basic function like regulation making itself is quite haphazard in India. A maze of legal instruments like regulations, circular, guidelines, schemes etc are issued without any basic clarity as to the legal difference among these instruments. This process needs to be made more uniform and rigorous for obvious reasons. FSLRC seeks to achieve this goal.

3. On the merging of the regulators, let me pose a question: Why is ULIP not a security but an insurance contract? Once you start pondering over these kind of issues, you will see that these differences are mostly not based on economics but on historical legacy - which I prefer calling `legal inertia'. It is much better to have one regulator overseeing market conduct for all financial contracts and prevent any of them falling out through the jurisdictional gap between two or more regulators. This would prevent repetition of a ULIP kind of story.

Disclosure: I was involved in the FSLRC work. However, I hope you will find my reasoning logical and unbiased.

Amol Agrawal said...

I am not sure with this Gulzar. The current Governor himself was party to FSLRC report.

All these limitations of financial sector have been exposed after the crisis but continue to be appreciated and recommended.

The report caused much a headache for previous Governor and he made a case against the report as well. But was royally ignored. Just because we have a celebrity making the same statements does not make the issue a new one.

So you continue to believe in these ideas as an academic but not as a policymaker. You make an inroad from an academic to a policymaker based on so called new global ideas. Then very conveniently you throw them out on becoming a policymaker as you see your powers shrinking.

Talk of double standards in Indian monetary policy at the moment. It is all over the place..

Gulzar Natarajan said...

Thanks Pratik for the comments. I'll post longer clarifying on these issues one of these days.

I have multiple concerns on the rules/principles issue. But the primary issue is that I see no compelling argument for a paradigm shift, especially when there is nothing about the principles based legislation that makes it superior to rules based one and the latter any inferior. I have not come across any credible and widely accepted (across all shades of view) study/paper/opinion on the relative benefits of the contrasting UK/US models in financial regulation.

As to the judicial review, it is all well to argue across the table and enshrine in a statute that only reviews and not appeals will be allowed. Mission creep is inevitable with our judiciary (actually is true of all our institutions)... leave aside the several judgments that have been pronounced on union government policies, the judgments of the appellate tribunal on SEBI and IRDA decisions are ample proof of this inevitability...

Both this and the earlier point about rules/principles based regulation therefore may also have to be seen in light of the maturity of our democratic institutions ...

Finally, of course, there are so many good things about the Code and either ways it would count as one of the landmark events in the history of Indian financial markets. In any case, my argument on each of these points does not deny that its supporters have a case (sometimes compelling) to argue for, but just that their costs outweigh (in some cases, far outweigh) their benefits.

Amol, great to hear from you and thanks for the comments. I agree with you and there are many more other areas where he has flipped his stance for no good reason other than that he is more informed about the issue or has a vested interest of an insider.

Gulzar Natarajan said...

Pratik, thanks also for sending the link. will surely read it soon.