Super Regulator for Financial Sector: Critical Analysis of FSLRC’s Revolutionary Proposals

Cutting Edge

Super Regulator for Financial Sector: Critical Analysis of FSLRC’s Revolutionary Proposals

Lex Witness Bureau | November 2012

The FSLRC’s Approach Paper has started a debate on the kind of regulatory framework India must have to make its financial system not only vibrant but also responsive to its needs. This story explores the debate

INTRODUCTION

With the mandate to review and recast legal institutional structures of financial sector in the country, the Financial Sector Legislative Reforms Commission (the ‘Commission’), in October 2012 came out with its ‘Approach Paper’ (‘the Paper’) for doing so.

While concluding the Paper, the Commission outlines its concern that it aims at establishing ‘sound financial regulatory agencies, which will continually reinterpret principles-based laws in the light of contemporary change, and draft subordinated legislation that serves the needs of the Indian economy. This subordinated legislation, coupled with the jurisprudence built up at the FSAT (Financial Sector Appellate Tribunal) and the Supreme Court, will continually reflect the changing needs of the Indian economy.’

This story is about what has been proposed by the Paper, critical examination of its desirability and feasibility

“In theory, the concept of a super regulator may seem like an attractive solution to improve co-ordination and consistency of regulatory supervision, ensure greater predictability and eliminate regulatory turf wars. However, in India, the responsibilities and expertise of each financial regulator is extremely sector specific and accommodating these myriad interests under one umbrella may not be the best way forward. The super regulator model has also not been very successful in other parts of the world.

What we need is a solution that is customised to Indian conditions yet robust enough to withstand and adapt to global impacts on our financial markets. The universe of hybrid financial products is expanding and we need an effective mechanism in place to not only deal with regulatory arbitrage but also avoid over regulation. Towards this end, the FSLRC should focus on strengthening the existing framework to settle the inter-regulatory disputes without compromising on the autonomy of individual regulators.

The proposals to introduce the Financial Redressal Agency and the Financial Services Appellate Tribunal are a step in the right direction but the FSLRC must also evaluate the feasibility of regulators engaging with each other and entering into MoUs to reduce friction and facilitate clear demarcation of regulatory turfs.”

What the approach paper proposes?

The Approach paper proposes a Financial Regulatory Architecture Act which sets out the work allocation across different financial agencies. The belief being ‘changes in the work allocation should not require changes to the underlying laws themselves’. It in effect means a shift in regulatory approach towards financial sector. From current Sectoral approach, where each individual financial sector viz. Capital Markets, Insurance, Commoditiesand Pension apart from monetary policy is under a separate regulator it proposes a tasks/functions based approach that financial laws must perform like consumer protection and redressal of grievances, Micro-Prudential management, Single Appellate body across all financial sector etc. The suggested framework is as follows

A Central Bank: to be responsible for monetary policy and the enforcement of consumer protection law and macroprudential law in the fields of banking and payments.
A Unified Financial Regulatory Agency: instead of SEBI, IRDA, PFRDA and FMC to be responsible for the enforcement of consumer protection law and macroprudential law in all finance other than banking and payments;
A Resolution Agency/Corporation: A ‘Resolution Corporation’ would watch all financial firms which have made intense promises to households, and intervene when the net worth of the firm is near zero (but not yet negative). It would force the closure or sale of the financial firm, and protect small consumers either by transferring them to a solvent firm or by paying them.
Financial Sector Appellate Tribunal (FSAT):Single Appellate Authority against all financial regulatory agencies;
The Financial Redressal Agency (FRA):Single consumer disputes redressal agency to address consumer complaints across the entire financial system. It will be a nationwide machinery to become a one stop shop where consumers can carry complaints against all financial firms
Financial Stability and Development Council (FSDC)
An Independent Debt Management Office

DESIRABILITY

Origins of Desirability

The reasons outlined, for rewriting the entire financial sector legislative framework, to quote the FSLRC itself, is that ‘there are over 60 Acts and multiple Rules/Regulations in the sector and many of them date back decades when the financial landscape was very different from what is obtaining today’. This anachronism of laws is made worse by piecemeal modifications leading to ‘regulatory gaps, overlaps, inconsistencies and regulatory arbitrage’. And this confused and complicated situation has led to ‘loss of scale and scope that could be available from a seamless financial market with all its attendant benefits of minimising the intermediation cost’

Need for appropriate and adequate financial services

Further reasoning, the Commission maintains that “the extent to which a given amount of investment translates into GDP growth depends on the financial system. A good quality financial system processes information, makes forecasts, and allocates capital to the right projects. A bad financial system misallocates capital, which yields reduced growth”.The paper quotes some examples, from infrastructure, SMEs, Agriculture sector and argues that if given proper institutional support in terms of financial services like hedging services, insurance or financing in local currency these sectors can see a turnaround in their fortunes which are lagging due to either absence or inefficiency of such services, which includes:

Infrastructure Financing: Multi-decade financing in local currency is available in mature market economies worldwide, in India today it is not feasible. Repayment over short time periods drives up user charges. Many infrastructure projects have borrowed in foreign currency: there is a mismatch between rupee revenues and foreign currency repayment obligations. This has generated acute difficulties for infrastructure developers.
Agriculture Sector: A farmer needs the ability to manage and mitigate risks like monsoon failure and price fluctuations which present system is unable to do.
An Export oriented unit: may need a sophisticated multi-currency hedging program.

Need for making regulators more Accountable and Transparent: Clarity of mandate reduces the possibility of direct conflicts of interests and helps in bringing in better Accountability

Before creating a UFA, there are many important issues which need to be analysed and discussed such as – how will Government of India operationally ensure to provide effective regulatory service at one place through the UFA? There will be several operational challenges to integrate the different regulatory authorities/ services under one umbrella. Further, change in the financial regulatory structure will also lead to a lot of reshuffling amongst the exiting regulatory authorities and will bring extra burden on Government exchequer.

Regulators’ Accountability

Clear mandates avoiding conflicting objectives

The legislature while defining the mandate and making provisions therefor for a regulator must avoid conflicting charter for it. Because it not only leads to conflict of interest for the regulator but also allows it to ‘explain away failure’.

Well structured rule-making process

While reasoning that the regulators may sometimes draft regulations that are convenient for the regulator rather than the larger national interest. The Paper argues that since ‘all regulation imposes costs upon society. The regulator should be obliged to analyse the costs and benefits of a proposed regulation. Therefore the rule making power which is to be granted to a Regulator must be within clearly defined parameters and must be punctuated by a process that compares the costs against the market failures that motivate the regulation. This can be achieved by thorough documentation of the analytical reasoning for the proposed Regulations and publicly circulating it; followed by thorough consultative process whereby substantially all misgivings and suggestions are considered and suitably incorporated. Finally a proper appellate process to appeal against ultra vires regulations would provide a well structured rule making process.

TRANSPARENCY THROUGH REPORTING

By way of ‘Annual Report’ or any other suitable mechanism whereby the performance of the Regulator qua theobjectives with which it was set up, alongwith a full management information system about the activities of each agency should be placed into the public domain.

Present system not conducive to greater economies of scale

The argument advanced in the paper is that “at present, many activities that naturally sit together in one financial firm are forcibly spread across multiple financial firms, in order to suit the contours of the Indian financial regulatory architecture. Financial regulatory architecture should be conducive to greater economies of scale and scope in the financial system”

Staffing Woes

A paucity of talent and domain expertise in government, and constructing a large number of agencies is relatively difficult from a staffing perspective. It is efficient to place functions that require correlated skills into a single agency.

DESIRABILITY : COUNTER ARGUMENTS

But many experts in the field do not agree with the reasoning of the Commission as to the desirability of such a revamped financial regulatory arrangement and explains as to why such a change is not needed.

For example C. Rangarajan, former governor RBI and currently Chairman of the Prime Minister’s economic advisory council, whose views have been published in the respected Business newspaper Mint state that: “We still have not reached a stage in which our various financial segments have developed to a full extent.” Relying on the international experience he reasons that “The UK had a single regulator and it ran into problems. The US had multiple regulators and they also ran into problems. The experience that is now available does not point to very clear evidence as to which is better”. “The draft report talks in terms of single regulator for all financial other than banking,’ Rangarajan said. “This again is not very consistent.”

And further Sunil Seth, Senior Partner, Seth Dua& Associates, reasons that although the intent of the Central Government may be noble, there is no guarantee that by having a Unified Financial Agency (“UFA”) in place of SEBI, IRDA, FMC, PFRDA, we would achieve better governance in order to serve the community/public interest at large. If the emphasis in the Approach Paper would have been to identify and implement ways to achieve better co-ordination amongst the various regulatory authorities in India instead of having one UFA, in our view, it would have been a better recommendation since every regulatory organization has, over the years, developed its own unique identity, purpose and expertise in a particular financial sector.

The paper published by the Financial Sector Legislative Reforms Commission (FSLRC) suggests a significant departure from the current financial regulatory architecture. The paper is critical of sector specific regulators, which have made regulatory arbitrage a reality and forced artificial splits of financial activities into multiple companies. The evolution of law suggested is certainly welcome, but whether the words live up to the spirit and there is (political) will to bring about such changes remains to be seen. The suggestion of a more horizontal approach to regulation, creation of a unified financial agency and independent consumer redressal mechanisms, are certainly more efficient.

It is a well understood fact that financial sector reforms are very crucial for economic growth and the concept of such a super-regulator which unifies regulatory bodies will go a long way in strengthening the financial sector and promoting financial inclusiveness. However, the paradigm shift in the regulatory and operational framework necessitates a more through review and critical analysis of such reforms.

SUGGESTIONS FOR IMPROVEMENT

Kartik Ganapathy, Partner, INDUSLAW, Bangalore makes following suggestions for improving the proposed system better:

Perhaps the idea of an independent consumer redressal mechanism should have been made for banks as well, which is an area where the FSLRC stopped short.
The FSLRC has paid nodding obeisance to policy issues, but sidestepped them claiming a focus only on “incentives in public administration that shape the drafting and implementation of subordinated legislation”. One wonders if policy will be one of the obstacles preventing the FSLRC from achieving what it seems to have set out to do, reform the financial regulatory architecture. By making sure to include mechanisms of appeal and court supervision, hopefully the FSLRC will steer clear of the issues that plagued the Competition Act in its early days.

Mohan Kumar K., who is Lead Analyst with InGovern Research Services, A Corporate Governance Research and Proxy Advisory Firm in India opines that the following suggestions would make proposed regulatory arrangement even better:

It does not address the ethical and corporate governance issues facing the financial sector or on ways of how the firms in the sector can be regulated on such issues and focuses more on protecting consumer interests, complaint redressal and systemic and financial risks affecting the sector. Until we have a clear code of ethics and governance framework, no amount of jurisprudence can introduce sectoral reforms at the fundamental level. FSLRC should constitute a mandatory code of ethics and governance framework for financial institutions and financial intermediaries in India, with punitive actions for non compliance.
It is also not very clear, if real estate sector, one of the biggest asset classes and a sector rife with poor governance and lack of consumer redressal mechanisms is included in the legislative framework. The current emphasis is only on the reforms in stock market, insurance, pension andcommodities market. If consumer protection is the main ethos behind such a legislative framework, we need to include all asset classes which affect savings and investments of consumers. Further, the advent of newer financial products in the real estate classes will only necessitate appropriate regulatory and redressal mechanisms going forward.
It does not list out the operational issues of merging the regulatory bodies’ viz. SEBI, IRDA, PFRDA and FMC into a Unified Financial Agency (UFA). It is agreeable that a unified structure and an independent consumer redressal mechanism will be far better than the current vertical structure which allows for regulatory overlaps. But without a greater clarity on contentious issues such as those relating to regulatory functions and the subsequent risks relating to subsuming these bodies under one umbrella, the stakeholders will not have a clear idea on the effectiveness of such a framework and benefit associated with such a proposal.
Also there is huge difference in underlying regulatory beliefs of each of the regulatory bodies in India and bringing them under one umbrella might give rise to potential conflicts. For example, SEBI works towards increased equity participation and secondary market action, whereas IRDA and PFRDA are more measured in allowing companies they regulate in taking equity exposures. If these were to come under one regulatory agency, how these conflicts would be managed should be pondered over.
The framework also has to exactly enlist the type of financial products to be governed by each agency. For example, the current proposal suggests creation of an independent debt management office (DMO) to take over the responsibility of bonds and currency markets that are currently under the joint purview of SEBI and RBI and thus trimming down RBI’s functions in these products. So if companies were to issue convertible debt instruments with warrants or issue FCCBs, would they come under the purview of the UFA or the DMO is not very clear. This would again recreate the problems of regulatory overlaps. Another example, is where the banks cross sell financial products such as insurance and mutual funds. Would these come under the purview of RBI or the UFA? Until a very clear framework on regulatory responsibilities is established, the ethos of these proposals cannot be successfully implemented.
Also, the duration required for implementing the proposals will be a key concern. The proposals would work well, only if all the reforms mentioned in the paper are implemented simultaneously and not on a piece-meal basis. For example, if you were to merge all financial regulatory bodies, without creating a parallel financial appellate tribunal or financial redressal mechanism, the principles on which these structural changes were introduced will stand challenged. For a governance structure which took more than five years for amending simpler laws such as Companies Act, DTC, GST etc., and which are still under implementation; a proposal to revamp more than 60 laws along with institutional restructuring will be a challenge in itself.
Lastly, the paper does not specifically mention on how autonomy and independence of these regulatory bodies can be ensured. Although, FSLRC has stressed on the need for independence of regulators, how minimal government intervention can be achieved is still a grey area.

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