What is regulation for?

The approach paper of the Financial Sector Legislative Reforms Commission (FSLRC) has proposed a new direction for financial regulation in India. While on one hand, half the Indian population still does not have access to finance, on the other, regulations have restricted the growth of financial services. In a country growing at such a rapid pace that the GDP doubles every 8 to 10 years, the needs of people and firms are constantly changing. In recent years, various government committees have pointed to the need for policy change. But it was found that the required changes could not be made under the existing, mostly outdated, financial laws. This prompted a review of the financial legislative framework.

The FSLRC was given the job of reviewing, simplifying and modernising the legislation that affects financial markets in India. It was asked to prepare legislation in tune with the present-day needs of finance. The commission has recently released an approach paper on its website. The paper discusses its strategy and philosophy.

News reports about the commission have focused on the FSLRC recommendations for India's financial regulatory architecture. But that is only one of the many aspects of Indian finance that the commission was mandated to review. In its proposed recommendations, it has endorsed a transition to a modern regulatory architecture recommended by previous government reports such as the Raghuram Rajan and the Percy Mistry committee reports. These reports had described the problems in the Indian financial sector arising from regulatory cracks and overlaps. The novel element of the FSLRC approach is the emphasis on the modes of independence, accountability and the rule-making process of regulators in India.

The modern approach to financial regulation allows greater innovation. It emphasises the objectives of regulation. Regulation is needed when markets fail. The approach emphasises that the objective of regulation is to protect consumers. This can be achieved by creating a system in which it is difficult to indulge in unfair practices or sell consumers products that are unsuitable for their specific needs. Unlike in goods and services, where there may only be a small lag between payment and delivery, the lags in finance are long and often contingent on a state of nature. A customer keeps paying a premium to buy a promise from an insurance company to pay his family if he dies. The customer does not know if the company is taking on so much risk that when the time to pay comes, it will be bankrupt. It is the job of the regulator to protect him from fraudulent practices and prevent the company from taking on too much risk.

If consumer protection is the objective of the regulator, it must be empowered with instruments to ensure it. It should not be tasked with other objectives or with doing things "in the public interest". It cannot prevent innovation as long as the financial firm selling the service is not engaged in practices which violate these objectives and if it is not taking on excessive risk. This requires that regulatory objectives are clearly defined, and the regulator's powers clearly enumerated. Normally, a regulator might have an incentive to kill innovation so that risk is eliminated and no firm fails on its watch. But eliminating risk altogether will not allow finance to reach out to new customers, products and markets. Thus, the powers of the regulator have to be restricted. It has to be made accountable for what he does. If its regulations go beyond the objectives the law tasks it with, it can be questioned, its decisions can be appealed against. This is a mechanism to restrict the arbitrary use of power and lack of reasoned regulations and orders.

The regulator must not prevent the failure of financial firms completely. Firms that are prone to take very high risks or are very weak should fail. However, firm failure must be happen at minimum cost to consumers and none to the taxpayer. The owner should lose money. The FSLRC approach paper discusses the creation of a new resolution agency for handling firm failure through mergers, acquisition or a close-down before the financial firm goes bankrupt.

The approach paper discusses a consumer protection law and a microprudential law which would lay out principles on the basis of which regulators would write regulations. These laws would not contain detailed regulations, which would be only written by the regulator. These laws will be separate from the regulatory agencies that enforce them. A law, such as a consumer protection or microprudential law, can be enforced by a number of agencies, each in their sector. A single financial redressal agency would hear complaints for all sectors.

Regulators in this approach will be given independence under the law. At the same time, they will be accountable. Accountability will be ensured through clearly defined objectives, avoiding conflicting objectives, a well-laid out rule making process and an appeals mechanism (there would be a newly created non-sectoral financial sector appellate tribunal).

As the Indian economy grows bigger, its need for finance increases. Households and firms often do not have access to the formal financial sector. Until now, the approach in the formal regulated financial sector has been to give explicit permissions for some products or markets. The rest of the financial products and markets are banned. This approach has restricted innovation in financial markets as no market or product is allowed unless the regulator prescribes it. The FSLRC approach should bring about a change to the pace of innovation.

We are, today, at the other end of the spectrum from the American model, where too much innovation appears to be a regulatory challenge. The lessons from the global crisis, which FSLRC proposes to build into the new regulatory framework, will help us to maintain a fine balance between too little innovation as in India today, and too much innovation that might pose risks to the financial system.

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