One head is better than many

A single financial regulator, rather than sectoral ones, is what India needs

The Union cabinet recently approved two bills expanding the powers of relatively small financial sector regulators. The PFRDA bill and the FCRA Amendment bill, if passed by Parliament, would give statutory powers and greater teeth to the pensions regulator and the commodity futures regulator. Though this may appear to be a reformist move in the current context, it could create difficulties for longer term financial sector regulatory reform.

These two bills were first proposed before the government set up a slew of expert groups to examine financial regulation in India. Almost all these committees suggested that all non-banking financial regulation, at least, be brought under a single regulator. They argued from Indian and international experience that it is becoming increasingly difficult to effectively regulate modern financial firms through a sectoral approach.

It seems unlikely that the cabinet is turning down these expert recommendations, including those from a group chaired by its present chief economic advisor, Raghuram Rajan. It is more likely that in its attempt to fast-track reforms, it has approved all the financial sector and economy bills that had been placed in limbo, without re-examining them carefully in this post-global-crisis world.

The expert groups, including the Mistry, Rajan, Aziz and Sinha committees, have examined the role and function of various regulators and suggested that they be modified to remove the various conflicts of interest, regulatory overlaps and gaps that plague the system today. They also raise questions about economies of scale in the regulation of organised financial trading. At present, regulatory functions on organised financial trading are spread across SEBI, RBI and the Forward Markets Commission (FMC). This separation between multiple regulators has forced an inefficient partitioning within private firms too: for example, a brokerage firm operating on the stock market where it faces SEBI regulation is forced to create a separate subsidiary to trade on commodity futures markets with FMC regulation and a separate subsidiary to be a primary dealer, which involves an engagement with the RBI.

Given the nature of organised financial trading, there could be economies of scale and scope for both government and the private sector through unification of regulation of organised financial trading. This requires pulling together the functions related to the bond and currency market from the RBI, functions related to the stock market from SEBI and functions related to commodity futures markets from the FMC, and merging these into a single agency.

Further, the Indian financial system has changed from one almost entirely dominated by public sector firms to an incipient role for private and foreign firms, which has helped bring a substantial rise in the sophistication of the firms. This has given rise to large, complex financial institutions such as the ICICI and HDFC, which serve households and firms across all aspects of financial services. At the same time, these firms have chosen to organise themselves through a large number of sectoral financial firms, each of which fits the requirements of one financial regulator. But no single sectoral regulator gets a full picture of the risks in such large conglomerates.

The recent cabinet approvals may have consequences similar to the RBI Amendment Act of 2006, which established the RBI as a regulator of the bond market and the currency market. This was a step in the wrong direction, given India’s reform agenda on the regulation and supervision of securities markets. In all the OECD countries but one, a single government agency — the securities regulator or the unified financial regulator — deals with all aspects of organised financial trading. In the US, the treatment of organised financial trading is split between the CFTC, which deals with all derivatives, and the SEC, which deals with the spot market. Apart from this, the OECD practice involves a single agency that regulates all organised financial trading, with a unified treatment of equities, commodity futures, interest rate, currencies, corporate bonds and derivatives.

This mistake led to serious consequences for the bond market. In the equity market, the strategy for critical financial infrastructure, exchanges, clearing corporations and depositories, was based on three principles. First, there was a three-way separation between shareholders, the management team and the member financial firms. Second, there was a competitive framework. Third, the regulator, SEBI, did not own critical financial infrastructure.

None of these three principles was applied to the bond market. The critical bond market infrastructure involved a depository (the SGL) and an exchange (NDS) both owned and operated by the RBI. This was a problematic arrangement because the RBI had conflicts of interest by virtue of being an owner and service provider, and at the same time, the regulator (after the enactment of the RBI Amendment Act of 2006). There was a loss of competitive dynamism when the RBI’s policy decisions leaned in favour of blocking competition against NDS and SGL. Only financial firms regulated by the RBI, the banks and the primary dealers were allowed to tap into this infrastructure. This framework was thus unable achieve bond market liquidity. On paper, India has an impressive bond market with trading screens, a clearing corporation, etc. But the essence of a market is liquidity, speculative views, and the resilience of liquidity. None of these is found in the Indian bond market.

The Indian discussion on the role and function of government agencies in financial regulation needs to be examined in the context of the difficulties of staffing high quality agencies. Even when an agency starts with a clean slate, without institutional baggage from a pre-reforms India, without conflicts of interest and archiac legal foundations, without expert staff, there is still a substantial risk of failure in institution building.

In India, there are many delays in processing legislations. At every stage, the government should be checking back whether it still want to propose a certain legislation. A little more thought in 2005 would have prevented the RBI Amendment Act of 2006, and a little more thought today will prevent mistakes on FMC and PFRDA. The government already has the benefit of the views and recommendations of various expert committees, which have studied the issue in detail and set the direction of long-term financial sector reform. Government policies policies in the short run should fit with its long term goals.

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