Rules and not standards

At the meeting of the Group of Twenty (G-20) countries in November, the government is likely to push for a deferral of the stringent banking capital requirements under Basel III norms. This is not because of any systemic objections to the norms but to save the government from spending about ₹ 90,000 crore over the next five years to maintain its share in the public sector banks.

The Reserve Bank of India (RBI), while insisting that these norms must be met, will hang on to the coattails of the government and seek a redefinition of the liquidity coverage ratio in view of the existing statutory liquidity ratio (SLR) requirement of banks.

Two characteristics of the Indian banking sector—sovereign ownership and its pre-emptive custodianship of liquidity—point to basic flaws in the idea of any universal regulatory system.

Thus, there is much more to the Basel norms that are disruptive for emerging economies than merely the government having to shell out more money.

Historically, regulations have been based on the assumption of a self-correcting market. As such, they were never meant to correct structural failures but to align “market outcomes with desired objectives” of the government.

However, after the financial meltdown of 2008, two issues surfaced, resulting in these assumptions being questioned. First, markets are not self-correcting. Second, the socio-political structure of a country influences its regulatory policies, their design as well as implementation. Indeed, one of the proximate causes of the meltdown was the “comprehensive regulatory capture”. It became obvious that institutions and interests influenced regulatory behaviour. In India, most of the scams surfacing now have their origins not so much in regulatory failure as in design infirmities of regulations which suit certain interests.

Given that political and institutional variables are different across countries, reflecting their own variants of the “social contract”, creating a universally applicable set of regulations is a complex exercise.

Indeed, the fact that Basel III norms were designed for western institutions, it is not only difficult to implement them but is dangerous to adapt them for emerging economies. This is because of the different institutional structures—be it capital markets or the financial system at large—and the very different political context and the social objectives of these countries.

To overcome these uneven conditions, regulations have been replaced by “standard” setting, instead of rule-making and implementation of those rules. The difference is crucial; in the former the onus is on the regulated entity to reach a standard and in the latter the onus is on the regulator to enforce a rule.

More importantly, the “standard setting” route has detached the rule-making regulation from its socio-economic moorings and context. This is much more complicated in the case of financial sector regulations where each government has a “social contract” with the depositors.

These standards have made regulatory regimes highly technical, if not excessively bureaucratic.

This standards-based approach needs to be replaced by a political economy approach to regulations. Regulations and regulatory frameworks can’t be reductionist and standard-centric. Instead, they must be part of the overall public policy framework. Regulatory regimes have to fit organically into a national public policy framework. For countries do not choose individual regulations in isolation; rather, individual choices reflect broad approaches to the role of government in the economy.

The problem is that after globalization economies have been integrated, countries and their social contracts have not.

This calls for a New Regulatory Deal akin to US President Franklin Roosevelt’s New Deal in response to the great depression in the 1930s. That programme was based on three Rs: relief, recovery and reform. The new deal in regulation must be based on three Rs: review, re-design and re-regulate.

Depending on these three Rs, a choice has to be made of either regulating the “structure” of banks (as in ownership, level of competition etc.) or regulating the “behaviour” of banks (as in kinds of transactions they make).

Cross-country experience seems to suggest that it is better to regulate structure than behaviour since it is the supervisor/regulator, mostly the government in some form that is the source of the problem.

Given the complex interrelations between structure and behaviour, the ideal solution is to have “standards for structure” and “rules for behaviour”. The standards can be universal and rules can be specific to the context and the conditions.

The core idea in this scheme is to impose high and exacting standards on the entry of new banks and impose only critical, but simple, regulatory restrictions on the activities of banks. This method will circumvent, if not completely obviate, the difficulties in having uniform best practice guidelines for countries around the world.

Haseeb A. Drabu is an economist, and writes on monetary and macroeconomic matters from the perspective of policy and practice. Comments are welcome at haseeb@livemint.com

To read Haseeb A. Drabu’s earlier columns,go to www.livemint.com/methodandmanner-