Aligning Financial Regulatory Architecture
with Country Needs:
Lessons from International Experience
Opening Address
N S Sisodia, Secretary, Financial Sector,
It is indeed a privilege for me
to be associated with this conference on ‘Aligning Financial Regulatory
Architecture with Country Needs’. I had
promised to be here in the hope of learning from this extremely distinguished
gathering of experts. This hope,
however, is likely to be belied by the call of my duty to the new Government
facing its first Parliament session even as it prepares for the Budget. This would require me to leave earlier then
I had anticipated.
The importance of regulation, as indeed this august
gathering very well knows, lies in curtailing monopoly power, fostering
competition and protecting consumer interest.
The focus of financial regulation is two fold. At the macro level,
financial regulation is concerned with
maintaining systemic stability. Systemic stability is crucial specially
for the financial sector as social costs of financial distress which has a
contagion effect are heavy. The East Asian experience and the more recent
experiences in Turkey and Argentina, amply demonstrate that. At the micro level, on the other hand, the
concern is with protecting consumer
interest. A retail investor is unable to afford the cost of getting
information, acquiring or employing analytical expertise and learning from the
experience of many large transactions.
He also does not have a large enough portfolio to spread risks and is
thus unable to match the might of a financial intermediary. Economies of scale are possible in gathering
and monitoring information on a collective basis and this is a very strong
rationale for effective financial regulation.
Why has financial regulation assumed added importance in
recent times? Firstly, the rapid growth of financial sector has a concomitant
development of integration of financial markets, which has blurred the
distinction between banking, securities and insurance activities. Secondly, even if the institutions and
activities are treated distinctly and risks are considered separable, the close
linkages between different elements of the financial sector make it impossible
to contain contagion effects. Thirdly, globalization has led to the growth of
multi-dimensional global conglomerates which call for appropriate restructuring
of domestic regulation.
In
India, financial regulation evolved in the context of a planned economy. Consequently, its major objectives,
somewhat different from those of other jurisdictions, were, mobilization of
savings and allocation of resources mainly through the public sector and
administered prices of financial products.
Systemic stability was sought to be achieved through a sovereign
guarantee, which was taken for granted.
Given the multiple objectives of financial sector management, many
financial sector institutions were nationalized; and many like the Industrial Development Bank of
India, SIDBI, Unit Trust of India and the National Housing Bank were created in
the public sector. The role of
competition as a policy instrument for promoting efficiency was, in this
context, relegated to a somewhat secondary position. Coordination of financial institutions was sought to be achieved
through administrative fiat rather than through the play of market forces.
I must mention here how the Governor of Reserve Bank of
India (RBI), Dr. Y. V. Reddy, from
whose writings I have borrowed
generously, describes the paradigm of financial regulation in
India. He uses the expression “joint
family approach” to describe financial regulation. What it signifies is a hodge
podge, lacking transparency and accountability. Like many other countries, the Indian Financial sector is
characterized by multiplicity of institutions.
While the specific objective has varied from deposit protection and
investor protection to market regulation, the common concern of these
institutions has been in maintaining financial stability. The Reserve Bank of India regulates and
supervises the major part of the financial system through its various
departments. The supervisory role
covers commercial banks; non-banking financial companies, to an extent; and
urban cooperative banks, again only to an extent. RBI also supervises some of
the All-India financial institutions.
At the same time, some of these institutions, regulate or supervise
other institutions in the financial sector.
Regional Rural Banks and Central and State Cooperative Banks are supervised
by the RBI through the National Bank for Agricultural and Rural Development
i.e. NABARD. The State Financial Corporations were supervised by the Industrial
Development Bank of India earlier and are now supervised by SIDBI. But SFCs are also supervised and governed by
the State Governments.
The Board of Financial supervision, constituted by the
Reserve Bank of India, operates as a committee of the Central Board of
Directors of RBI and functions as a supervisory body in respect of banks, NBFCs
and All-India Financial Institutions.
It is noteworthy that the RBI’s supervisory role in respect of All-India
Financial Institutions is of a more recent origin. The All-India Financial Institutions have significant direct
links with the Ministry of Finance, but expected to operate on commercial
principles with regard to their borrowing and lending activity. The RBI-NABARD relationship has many
different aspects. On behalf of RBI as
its representative, NABARD supervises the banks in the rural cooperative segment,
that is, the State and Central Cooperative Banks. The banks in this sector are
not supervised by the Board of Financial Supervision. NABARD supervises the Regional Rural Banks also which are in part
regulated by the RBI. The RBI currently
licenses and regulates Local Area Banks which are treated as commercial banks
but the supervisory responsibility for these is with the RBI. Statutory provisions govern the supervisory
responsibilities of Housing Finance Companies by NHB and State Finance Corporations
by SIDBI. Then there are the Registrars
of Cooperative Societies in different States. They are joint regulators for
banks in the cooperative sector, both urban and rural. For multi-state institutions, the Central
Registrar of Cooperatives under the Ministry of Agriculture is really the main
regulator. RBI and NABARD are concerned
with their banking functions, and the management control rests with States and
Central Government. This dual or multiple control impacts the quality of
supervision over institutions in this sector.
SEBI regulates the capital markets and supervises
institutions such as the stock exchanges, mutual funds and other asset
management companies, securities dealers and brokers, merchant bankers and
credit rating agencies. It also
regulates venture capital funds.
Companies in the insurance sector are regulated by the Insurance
Regulatory and Development Authority.
Banks are permitted to engage in insurance activity through joint
ventures, equity participation and selling agency type arrangements.
And as if that is not enough, we have the Department of
Company Affairs, which regulates the deposit taking activities of non-banking
and non-financial companies and also some activities of NBFCs! We are also witnessing the birth of a Pension Fund Regulatory and Development
Authority. This is in the process of
being set up and has to still find a statutory basis.
It is necessary to recognize that there are several
mechanisms by which coordination among these regulators in the financial system
is being sought. Firstly, there is
exchange of some information on a regular basis and sometimes on special
request. Secondly, a nominee of the
Reserve Bank of India is on some Boards including that of SEBI. Thirdly, there
is a High-Level Committee on Capital Markets which is presided over by the
Governor of the Reserve Bank of India of which Finance Secretary,
Secretary-Financial Sector, Chairman-SEBI and Chairman-IRDA are members. The high-level committee has constituted a
standing working group to enable coordination among the Ministry of Finance,
RBI and SEBI at the operating level and to assist the committee in its
deliberations. Finally, the nominees of
Ministry of Finance and Dept. of Company Affairs are on the Board of SEBI along
with the Deputy Governor of RBI. A
predominant role for regulatory and supervisory coordination remains with the
Ministry of Finance for several reasons such as the statutory basis of many
financial intermediaries performing commercial functions. Ministry of Finance has powers of
appointment and dismissal of Board level functionaries in public sector
Financial Institutions. The
predominance of public sector ownership of financial intermediaries continues. This necessitates accountability to the
Parliament.
Some initiatives have been taken to address the existing
regulatory gaps. One is a comprehensive
amendment of the Banking Regulation Act 1949 which seeks to bring the
cooperative structures under the clear regulatory control of the Reserve Bank
of India. At present, there is duality
of control and the intention is that those cooperatives which are engaged in
banking operations, should be regulated by the Reserve Bank of India and there
should be no duality of control there.
This issue has been debated by the Standing Committee of the previous
Parliament and there are varying views on whether this kind of structure is
appropriate for institutions which are essentially democratic and
self-governed.
There is an attempt to strengthen the system of credit
information and dissemination. As far
as stock markets are concerned, a number of initiatives have been taken, partly
in response to the recommendations of the Joint Parliamentary Committee, which
had been set up following the stock market scams. One of the important reforms being attempted is demutualization
and corporatization of stock exchanges through an amendment in the existing
Securities Contracts and Regulation Act.
There is also a move to integrate commodities and securities derivatives
markets. It has been decided to set up
a National Institute of Securities Market to develop professional skills for
better regulation and also for self-regulation and certification of persons
working with securities markets intermediaries.
A glimpse of the developments in the thinking of various
options for regulation would perhaps be useful. The Narasimham Committee on Financial Systems, in 1991, had
strongly recommended that the duality of control over banking system between
the Reserve Bank of India and the Banking Division of Ministry of Finance
should be done away with and that the Reserve Bank should be the primary agency
for regulation of the Banking System.
The report of the Narsimham Committee-II, recommended restructuring of
the Board of Financial Supervision. The
committee also recommended that an integrated system of regulation and
supervision be put in place to regulate the banks, financial institutions and
NBFCs. The concept of a super regulator
was also mooted in the Report of the Working Group for Harmonizing The Role And
Operations of Development Financial Institutions and Banks, headed by Mr. S. H. Khan. This group recommended establishment of a
super regulator who would supervise and coordinate the activities of multiple
regulators in order to ensure uniformity of regulation. The Advisory Group on Securities Market
Regulations, set-up in 2001, and chaired by Mr. Deepak Parekh, highlighted the
issue of multiplicity of regulatory authorities, their overlapping roles and
certain gaps. The Committee also
suggested greater coordination and regulation through the High-Level Committee
on Capital Markets and recommended that this Committee be given a legal
status. This recommendation is in
consonance with what has since come to be described as the ‘Reddy Formula’ for
handling regulatory gaps and overlaps.
According to this formula, the Board of Financial Supervision which was
created by the Reserve Bank of India can continue to supervise banks and
non-banks but with a Deputy Governor of the Central Bank as the Chairman. The insurance regulator would supervise
insurance companies and SEBI will continue with its regulatory
jurisdiction. This apex financial
regulatory authority is to have a statutory backing with Governor of Reserve
Bank of India as its Chairman and other regulators as its members. The apex body would also include some
outside experts, but they would work on a part-time basis. The Finance Secretary is to be a permanent
special invitee or a regular member but without voting rights. The apex authority could by law have the
powers to assign jurisdictional responsibility to one of the regulators in so
far as regulatory gaps are concerned.
It should also have the authority to arbitrate on regulatory overlaps
and ensure regulatory coordination. The
apex authority could be serviced by a part-time secretariat which could be
located in the Reserve Bank of India.
In a way, the proposal improves upon and formalizes the present informal
structure into a statutory authority.
The idea is that the existing coordinating mechanism be improved upon
and given a formal status and legal authority, under a statute. The pros and cons of this kind of an option
could be debated by this conference.
I would like to
briefly refer to some of the issues which this conference may wish to take into
account.
·
The
first issue relates to the institutional framework. The simple issue is whether the regulatory architecture should be
dominated by institutional structures or not.
By institutions one means organizational entities like the ones already
described in some detail; or whether we should superimpose another
organizational entity over all these institutions for regulatory compliance or
create an effective mechanism for coordination of these activities. The coordination mechanism need not always
require an institutional arrangement.
The job essentially remains with the Ministry of Finance for several
reasons I have mentioned earlier. One
reason is the statutory basis of many financial intermediaries, like the
Nationalised Banks, Development Financial Institutions and the UTI. Therefore, the powers of appointment and
above all the accountability to the Parliament devolve upon the Ministry. However, what precise role should the
Ministry play is an issue which is engaging our attention and I am sure we will
have a lot to learn in this regard from the deliberations in this conference.
·
The
second issue in India’s context is that of the relationship of the State with
regulators. The regulatory institutions
to be effective have to be independent as well as accountable. This issue becomes important in the Indian
context with the public sector representatives both on the regulatory boards as
well as on the boards of financial players, many of which are owned by the
state. Should there be a State
representative on boards of regulatory authorities like the RBI, IRDA,
SEBI? Is the suggestion that they
should have the status of an invitee without voting rights a better option and
does it help the Ministry in performing its responsibility of coordination and
accountability to the Parliament?
·
An
interrelated issue that needs to be highlighted is about the problem of
information gaps faced by different regulators as well as the State in the
absence of an apex organization. As a
participant in the High-Level Committee, I experienced that a major problem is
the lack of information. It is
difficult for the committee to see the linkages and causalities, if only bits
and pieces of information are available. Instead, what is needed is continuing
and detailed analysis by professionals on information inputs. In India’s context this information exchange
becomes particularly important because of the rapid diversification which
characterizes the financial markets. These include developments in the sphere
of Capital Markets, investment banking, universal banking, Insurance and
Pensions. How much information should
be required by one regulator regarding the activities of an entity, which is under
the domain of another regulator is an issue which also needs to be
considered. The quantum of money raised
or for instance, raised or invested by a bank in the capital market should be
known equally to the RBI and SEBI. This
is just one example of how complete information, without any gaps, needs to be
shared by regulators who are performing an interlinked responsibility. Any gap in such information could prepare
the ground for a regulatory failure.
·
Finally,
there is the issue of aligning regulatory architecture to facilitate the
economy’s transition towards globalization.
This aspect is increasingly important in the Indian context. It is significant that the Indian system
adopts some of the international best practices, so that its integration with
the global economy can be facilitated.
We are also inviting foreign direct investment. The foreign investors need to perceive the
Indian system as fair, safe, transparent and investor friendly.
What are the
possible options? We can have a single
regulator. We have multiple regulators
for reasons of history- institutional history and other factors like the size
of the country. Perhaps it might be difficult to unify them but there could be
a hybrid structure or there could be just a more effective coordination
mechanism. However, creating a good regulatory architecture is
only a part of the solution. There are
other important aspects which also need to be addressed and perhaps these
should find some space in this conference.
There is need for clarity on
regulation policy. The issue of limits,
objectives and instruments need to be clearly delineated. Another important issue is that of
information exchange and review.
Further, there is the need for laws which distinguish between owners,
regulators and market participants.
Sometimes that gets blurred because of the existing legal
structure. Another important aspect
relates to a better design and management of the existing regulatory
structures. There is also the need for
highly professional skills, where demand usually outstrips supply. Unless those skills are available, you might
have any number or one powerful regulator, success would be somewhat
limited. Finally, strong political will
is necessary to achieve the objectives of regulation effectively.
I would like to
conclude by saying that I am grateful to Mr.Carter and his colleagues for
having organized this conference, to Ms. Priya Basu and her team for having
gone out of their way to accommodate us, firstly, by relocating the conference
from Goa to Delhi and then permitting us many absences and quick
departures!
We keenly look forward to the sage advice emerging from the deliberations of this Conference.