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.”