WG on Banking

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WG on Insurance, Pensions and Small Savings

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WG on Payments

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WG on Public Debt Management

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WG on Securities

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Independence of Regulators

Turning to the issue of independence, there are four arguments in favour of independence:

1. The regulator is able to set up a specialised workforce that has superior technical knowledge.
2. This is assisted by modified human resource and other processes, when compared with the functioning of mainstream government departments.
3. With such knowledge, and close observation of the industry, an independent regulator is able to move rapidly in modifying regulations, thus giving malleability to laws.
4. The presence of independent regulators improves legal certainty.

At the same time, independence cannot be given to an agency in isolation. Parliament should not delegate power to unelected officials without adequate accountability mechanisms. New channels of accountability need to be constructed as independent agencies are not subject to accountability through elections. An example of accountability is found with central banks worldwide: when lawmakers gave central banks independence, in most cases, they placed the burden upon central banks to deliver on an inflation target. This was the accountability mechanism through which the independent agency was brought under check. In most other areas of financial law, the accountability mechanisms required are much more complex.

FSLRC promises to endeavour to find a judicious middle road which combines appropriate levels of independence achieved through concrete mechanisms in the law, coupled with an array of accountability mechanisms, through which sound outcomes will come about under Indian conditions. This will yield substantial gains for the Indian economy when compared with the present arrangements.

Accountability of Regulators

As argued above, regulatory independence is desirable so as to support the functioning of the regulator as an expert body, and to ensure that rule-making and enforcement of rules does not fluctuate with changes in political executives. But independence is not an unmixed blessing: when unelected officials are given power, this needs to be accompanied by accountability mechanisms. FSLRC will pursue all four pathways to accountability:

1. Avoid conflicting objectives: When a government agency has multiple objectives, it is easier for the agency to explain away failure. This problem is heightened when there are conflicts of interest. It is, hence, desirable to structure regulatory bodies with clarity of purpose and the absence of conflicting objectives. This perspective has shaped the thinking of fslrc on the financial regulatory architecture.
2. A well structured rule-making process: Public choice theory teaches us that regulators may sometimes draft regulations that are convenient for the regulator rather than the larger national interest. A well structured rule-making process will introduce checks and balances that will avoid suboptimal outcomes. To ensure that the benefits of the regulations out weigh the costs, for every proposed regulation there should be:
   1. A compact statement of the objects and reasons of the subordinate legislation;
   2. A description of the market outcome which is an inefficient one ("a market failure" in Economics parlance);
   3. Demonstration that solving this market failure is within the objectives of the regulator;
   4. Clear and precise exposition of the proposed intervention;
   5. Demonstration that the proposed intervention is within the powers of the regulator;
   6. Demonstration that the proposed intervention would address the identified market failure;
   7. Demonstration that the costs to society through complying with the intervention are outweighed by the gains to society from addressing the market failure.

This will help ensure that adequate analysis has preceded rule-making, and show the full regulatory intent to citizens and judges. This will be followed by a consultative process where market participants will be given sufficient time and information to understand the regulation and comment on it.

One key element of the rule-making process is appeal. When an independent regulator comes into being through a well drafted law, this law contains specific objectives and specific powers. If the regulator strays from either of these – catering to objectives that were not specified in the law, or claiming powers that were not mentioned in the law – it should be possible to strike down the regulation through appeal.

3. The rule of law: A crucial element of accountability and independence of regulators is three core principles of the rule of law:
1. Laws should be known before an action takes place.
2. Laws should be applied uniformly across similar situations.
3. Every application of law should provide the private party with the information for application of the law, the reasoning by which the conclusion was arrived at, and a mechanism for appeal.

The Commission believes that a formal and transparent system of regulation, rooted in the rule of law, encourages entry of new financial service providers and thereby reduces costs and financial exclusion.

4. Reporting: Once the objectives of an agency have been defined, it is meaningful to ask the agency to report – e.g. in the Annual Report – the extent to which it has achieved these objectives. Each agency should report on how it has fared on pursuing its desired outcomes, and at what cost.

Consumer Protection

The first objective of financial regulation is consumer protection. The existing strategy on consumer protection in Indian finance is primarily focused on a caveat emptor doctrine, where consumers are protected from fraud, and there is a program to ensure full disclosure. For the rest consumers are left to their own devices.

Consumers of financial services are often more vulnerable than consumers of ordinary goods and require a special effort by the State. The present body of financial law is not animated by consumer protection. The Commission believes this is a major gap in Indian financial law and regulation, which needs to be addressed.

FSLRC proposes a unified consumer protection law which would contain three components: an enumerated set of rights and protections for consumers, an enumerated set of powers, and principles that guide what power should be used under what circumstances. The details of consumer protection would, of course, lie in the subordinated legislation that financial regulators would draft. As an example, whether or not loads and other conflicted remuneration structures should be banned is a question that would be addressed by the regulator. The proposed law will clearly pose this question to the regulator. The regulators would then utilise the powers provided to pursue the goals specified in the law, through subordinated legislation which would evolve over the years reflecting financial innovation, technological change, and the changing nature of the Indian economy. Alongside this rule-making mandate, there would be a supervisory function to ensure compliance with these rules.

In India, so far, the financial regulatory structure has been defined by sector, with multiple laws and often multiple agencies covering various sectors. This has led to inconsistent treatment, and regulatory arbitrage. Regulators of a sector have sometimes adopted the perspective of the industry, and opted for lax regulation as a path to growth of the industry. These problems would be reduced by having a single principles-based law which would cover the entire financial system. It is, then, likely that consumers would be treated fairly with consistent treatment across all aspects of their engagement of the financial system.

FSLRC will propose the creation of a unified Financial Redressal Agency (FRA). FRA would have front-ends in every district of India, where consumers of all financial products would be able to submit complaints. Modern technology would be used to connect up these front-ends into a centralised light-weight adjudication process. A well structured workflow process would support speedy and fair handling of cases. Consumers would deal only with FRA when they have grievances in any financial activity: they would not have to deal with multiple regulators.

Micro-prudential Regulation

This is the efforts by financial regulators to reduce the probability that a financial firm collapses. The motivation for micro-prudential regulation is rooted in consumer protection. When a consumer deals with (say) an insurance company, there should be a very high probability that the insurance company will be solvent and able to discharge on its promises. In addition, if a large number of financial firms fail at the same time, this can disrupt the overall financial system. Sound micro-prudential regulation thus caters to reducing systemic risk.

As with the field of consumer protection, the law that FSLRC will propose will have enumerated objectives, enumerated powers and principles that guide the use of the power. The main objective would be to reduce the probability of failure of financial firms, but this will be balanced with a principle that requires the regulator to consider the consequences for efficiency. The regulators will have the powers to impose requirements around capital adequacy, corporate governance standards, liquidity norms, investment norms, and other instruments. The principle of proportionality will apply: regulatory interventions should be related to the risks faced.

A single micro-prudential law will govern the entire financial system, thus ensuring uniform treatment of all aspects of the financial system, and largely eliminating areas of regulatory arbitrage. Multiple regulators may enforce the law for various components of the financial system.

Resolution

Sound micro-prudential regulation will reduce the probability of firm failure. However, eliminating all failure is neither feasible nor desirable. Failure of financial firms is an integral part of the regenerative processes of the market economies: weak firms should fail and thus free up labour and capital that would then be utilised by better firms. However, it is important to ensure smooth functioning of the economy, and avoid disruptive firm failure.

This requires a specialised 'resolution mechanism'. A 'Resolution Cor- poration' 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. In the case of banks, the deposit insurance program (where all households are guaranteed up to Rs. 100,000 of their bank deposits) would be operated by the resolution corporation.

Drawing on the best international practice, the FSLRC proposal will involve a unified resolution corporation that will deal with an array of financial firms such as banks and insurance companies; it will not just be a bank deposit insurance corporation. It will concern itself with all financial firms which make highly intense promises to consumers, such as banks, insurance companies, defined benefit pension funds, and payment systems. It will also take responsibility for the graceful resolution of systemically important financial firms, even if they have no direct links to consumers.

A key feature of the resolution corporation will be speed of action. It must stop a financial firm while the firm is not yet bankrupt. The international experience has shown that delays in resolution almost always lead to a situation where the net worth is negative, which would generally impose costs upon the taxpayer. Hence, a sophisticated legal apparatus is being designed, for a resolution corporation that will act swiftly to stop weak financial firms while they are still solvent. The resolution corporation will choose between many tools through which the interests of consumers are protected, including sales, assisted sales, mergers, etc.

Capital controls

The grand question of this field is the appropriate sequencing and pace of India's capital account liberalisation. All prosperous countries have negligible capital controls, and India's peers among developing countries have greater capital account openness than India. As Indian policy makers have repeatedly stated, in the long run, India will move towards capital account openness. The Commission will leave the timing and sequencing of capital account liberalisation entirely to policy makers. However, the drafting of law has to envisage the kinds of regulatory instruments used in this field today and in the future. From this perspective, three key questions can be identified.

The first question concerns the economic purpose of capital controls. One possible approach in justifying capital controls lies in the argument that conditions in the global economy are sometimes turbulent. Capital controls could then be useful as a tool for shielding India from those problems. This economic purpose for capital controls suggests the use of temporary capital controls, which are brought in during certain periods.

The second question concerns the nature of controls. Capital controls can either be structured as detailed microeconomic interventions (e.g. specialised rules about margin payment by foreign investors trading on exchanges) or they can be structured as macroeconomic instruments (e.g. an unremunerated reserve requirement, that discourages short-term flows). Both these alternatives have strengths and weaknesses.

The third issue is about the agency structure. Where should the law, that is enacted by Parliament, place the functions of rule-making and supervision for capital controls? At present, capital controls in the field of FDI (e.g. liberalisation of FDI in multi-brand retail) are determined by the government. In addition, there are tight connections between the liberalisation of outward flows and a fiscal question: the extent of domestic financial repression (the forced lending by households through banks to the government). Further, capital account restrictions are analogous to protectionism in the financial sector. As with liberalisation of trade, capital account decontrol involves analysing the political ramifications of gainers and losers from liberalisation. This raises questions about whether the rule-making function (i.e. the drafting of subordinated legislation under the capital controls law) should be placed with the Ministry of Finance or the RBI. Similarly, supervisory functions (i.e. the enforcement of the subordinated legislation) could potentially be placed at RBI or at the Financial Intelligence Unit (FIU), which watches India's cross-border flows from the viewpoint of restraining the financing of terrorism. Each of these alternatives has strengths and weaknesses.

The Commission will debate these questions, which define the basic character of capital controls law. The Commission will take a view on them, and draft laws analogous to the approach adopted in other laws: emphasising enumerated objectives, enumerated powers, a sophisticated rule-making process, and the rule of law.

Systemic risk

The problem of systemic risk requires a bird's eye perspective of the financial system. The first function in this field is that of reducing the probability of a breakdown of the financial system. This requires understanding the financial system as a whole, as opposed to individual sectors or firms, and undertaking actions which reduce the possibility of a collapse of the financial system. Each financial regulator tends to focus on regulating and supervising some components of the financial system. With sectoral regulation, financial regulators sometimes share the worldview of their regulated entities. What is of essence in the field of systemic risk is avoiding the worldview of any one sector, and understanding the overall financial system.

Systemically important financial institutions (SIFIs), which are often conglomerates operating across multiple elements of the financial system, pose special problems for micro-prudential regulation and resolution. An integrated statistical picture of the entire financial system would be used to identify SIFIs, and help coordinate joint work between multiple regulatory agencies in their micro-prudential regulation.

Inter-agency coordination is particularly important in a crisis. Decisions that impact on multiple sectors need to be swiftly taken, and correctly enforced by multiple different agencies. Crisis management might involve utilising taxpayer resources, which can only be authorised by the government. Decisions may also be required about drawing on emergency lines of credit from the central bank, in its capacity as the lender of last resort. This analysis needs to be taken in a coordinated fashion between all financial agencies, drawing on an accurate picture of the full financial system.

The Commission will debate these questions, and will take a view on them, and make recommendations accordingly.

Development

A uniquely important policy problem in India is that of financial inclusion. This forms the rationale for the development agenda in finance. The agenda relates to (i) the development of missing markets, such as the bond market, and achieving scale and outreach with nascent markets; (ii) redistribution and quasi-fiscal operations where certain sectors, income or occupational categories are the beneficiaries.

The first, or the development of missing markets, requires information gathering and analysis on the scale of the full financial system, rather than within one sector at a time. Inter-regulatory coordination is required.

The fundamentals of public administration suggest that quasi-fiscal functions should only be performed by the fiscal authority. This could be achieved by placing rule-making functions related to development (e.g. regulations for priority sector lending) closer to the fiscal authority, while asking regulatory agencies to verify compliance (i.e. to perform the supervisory function).

The open question in the field concerns the institutional mechanism through which this could be achieved. These functions could be placed at regulatory agencies or elsewhere. The Commission will debate these questions and make recommendations emphasising enumerated objectives, enumerated powers, a sophisticated rule-making process, and the rule of law.

Monetary policy

Monetary policy is the function of creating 'fiat money', i.e. money that derives its value because the State asserts that it is legal tender. It involves (a) creating the Indian rupee, (b) setting the short-term interest rate, and (c) operating a 'lender of last resort' facility whereby liquidity is temporarily extended to solvent but illiquid financial firms.

Monetary policy independence is required, in order to avoid election-related cycles in monetary policy. Alongside this independence, an accountability mechanism needs to be set up. The mainstream strategy that is used worldwide is that of tasking the monetary authority with achieving price stability.

Debt Management

The management of public debt requires a specialised investment banking capability. A series of expert committees have suggested that this should be done in a professional debt management office for two reasons:

1. Debt management requires an integrated picture of all onshore and offshore liabilities of the government. At present, this information is fragmented across RBI and the Ministry of Finance. Unifying this information, and the related debt management functions, will yield better decisions and thus improved debt management.
2. A central bank that sells government bonds faces conflicting objectives. When RBI is given the objective of obtaining low cost financing for the government, this may give RBI a bias in favour of low interest rates which could interfere with the goal of price stability.

Foundations of Contract and Property

The last component of financial law is the set of adaptations of conventional commercial law on questions of contracting and property rights that is required in fields such as securities and insurance. Statutes as well as case laws have shaped the rules regarding creation of financial contracts, transfer of rights, title or interest in such contracts and enforcement of such rights. These developments have largely been sector specific.

The FSLRC has looked into the necessity of keeping these sector specific rules and will retain them only under special circumstances. Where the law can be made sector neutral or the law has been unable to keep pace with financial innovation, the FSLRC will propose new formulations of law.

For instance, financial transactions have to be defined in a functional manner to ensure that financial innovations do not exceed regulatory jurisdiction. Rules regarding enforceability of derivative contracts have to be laid down. Clarity in rules of enforcement of contracts involving the market infrastructure institutions such as, exchanges, clearing corporations and depositories, is indispensable for organised financial trading. The priority of clearing houses in the bankruptcy process needs to be examined. Developing the over-the-counter market also comes with its own set of contractual issues. The FSLRC has also looked into issues of market integrity which may have implications on creation and transfer of contracts in the financial sector.