India needs a new financial regulatory architecture

India’s current regulatory architecture for the financial sector is a maze. There are over 60 Acts with myriad rules and regulations that govern the sector, some of which have been written decades ago. In addition, many ad hoc changes have been made over time to these regulations. As things stand, the Indian financial sector is suffering from regulatory gaps, overlaps, inconsistencies and also provides opportunity for regulatory arbitrage. Securities and Exchange Board of India’s (Sebi) extended litigation against the Sahara group, and the recent investigations on alleged money laundering by some banks using insurance products are good examples of both regulatory gaps as well as opportunities for arbitrage.

Enter the ‘Indian Financial Code’, drafted by the Justice Srikrishna Commission on financial sector legislative reforms, which promises to address each of these problems and more. The purview of the code is expansive and will doubtless have many critics. Needless to say, the finance ministry will do well to take constructive inputs on board. But it will be a pity if the code gathers dust just because of disagreements on who administers certain sections of the new law.

The code has a number of positives for the regulation of financial markets as well as financial services. It lays out a good foundation for regulatory governance, with each of its proposed seven financial agencies given clear objectives (as pointed earlier, the allocation of tasks must be criticized separately), powers and accountability mechanisms. The code also lays out the process through which each financial agency must make new rules. Both Sebi and the central bank are notorious for making rules by issuing circulars. If the new financial code becomes law, they would first have to publish a draft of the proposed regulations, also stating the objectives of the new regulations, the problems they seek to address, the expected outcome, a cost-benefit analysis of the proposed regulations. This should be made available for public comments and before turning the proposals into regulations, the agency must publish all the comments it received and a general account of its response to these comments. The code does provide for emergency situations, where this process needn’t be followed; adding, however, that regulations made this way will lapse after a six-month period. Regulated firms can even challenge these regulations at the Financial Sector Appellate Tribunal, if they feel they go against the objectives set out in the code. This is one example of the Commission’s attempt to make regulatory agencies accountable and transparent, and is much welcome.

Another big idea of the Commission is to have a unified financial agency to oversee consumer protection, micro-prudential law for all financial firms other than banking and payments and organized financial trading. As pointed in this column before, financial trading is getting more and more inter-connected, and many market participants have simultaneous positions in different markets either to hedge or leverage on the same trading idea. Some traders use such separate positions because of regulatory arbitrage opportunity. It is a good idea to have a unified regulator who oversees all positions across asset classes. The same principle applies in the case of selling and distribution of financial services. For instance, the rules and principles of the code will apply across the board on anyone issuing a security, regardless of how the issuing entity is structured legally.

In addition, the commission has done well to give clear definitions for various relevant financial terms. For instance, Sebi’s battle with the Sahara group would have been much shorter with the clear definition of the term ‘security’ proposed in the code. Another important step has been to include requirements related to company disclosures in the statute, which will make it far easier for financial regulators to govern this area. Currently, these requirements are covered in the Companies Act, as far as statutory law goes, which is outside the purview of Sebi. While disclosure requirements are mandated under the listing rules of stock exchanges, these evidently lack the effectiveness of statutory law.

Some of the early commentary as well as some of the dissent notes in the Commission’s report show that the suggested allocation of tasks between regulatory agencies could be difficult to swallow. But this is a matter of who administers the law, which isn’t the crux of what the Commission has submitted. While the government will do well to take feedback on board, it should also keep in mind that streamlining India’s financial regulatory architecture is essential for India’s economy. A robust financial system ensures that funds move in a cost effective way from those who have savings to those who have productive use for them. While no one is discounting India’s other malaises such as a high fiscal deficit, corruption etc. which also affect growth, the current regulatory maze makes things worse. This should be corrected sooner than later.

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