Opinion | Financial sector reforms will shape a more conducive regulatory setup5 min read . Updated: 25 Sep 2020, 08:20 AM IST
- It is important to recognize that the key objective behind any financial regulatory reform is to build for a more resilient system, and this becomes a primary objective while dealing with any form of economic or financial crisis
Among the series of substantial economic reforms that have been undertaken by the current administration, two legislations have the potential to alter the regulatory landscape and improve stability of our financial system.
It is important to recognize that the key objective behind any financial regulatory reform is to build a more resilient system, and this becomes a primary objective while dealing with any form of economic or financial crisis. Consequently, the financial sector reforms undertaken by the government in the recently concluded Parliament session, amid the covid-19 pandemic, become extremely important.
These two specific reforms are important as they will strengthen our financial institutions and build a more resilient system. One relates to creating a legal framework for bilateral netting of qualified financial contracts while the other relates to expanding the regulatory oversight of RBI to cooperative banks.
Bilateral netting is a useful concept in the financial sector as it enables two parties in a bilateral financial contract to offset claims against each other to determine a single net payment obligation due from one party to other party in the event of default. While the legal frameworks in other countries have enabled bilateral netting of financial contracts, it was prohibited in India in the absence of an unambiguous legal framework of bilateral netting. The Bilateral Netting of Qualified Financial Contracts Act, 2020 removed this deficiency in the legal framework by providing legal enforceability of close-out netting for bilateral financial contracts in India. That is, two parties could now determine the net amount payable amount in a bilateral financial contract.
The move will be critical, especially for further development of the over-the-counter (OTC) derivatives market, and it would also strengthen the resilience of the financial sector in India. In the erstwhile regime, the capital requirement for banks was reckoned on the basis of gross value of the OTC derivative, while now it will be calculated on the net basis, resulting in capital saving. Further, this will enable introduction of an efficient margining system for such OTC derivatives and facilitate productive use of bank funds.
The funds saved by banks in terms of lesser regulatory capital and fund savings in margins for OTC derivatives would be critical in ensuring price efficiency for banks while offering hedging instruments to businesses. It will also act as a catalyst for the development of the corporate bond market by energising the credit default swap market. To provide some perspective, the estimated savings for banks could be around ₹42000 crores for 2017, if the bilateral netting was enabled and the margin system was in place. For 2019, this figure goes up to about ₹67000 crores. This illustrates the extent of additional savings of banks which could be productively used by banks for lending thereby financing fresh investments and creating assets in the economy.
At a time when banks will find it critical to preserve adequate capital while also serving the critical function of credit creation to revive economic growth, the move to allow for bilateral netting assumes much significance. Very likely, we will witness the savings available with banks could be used to meet the demand for credit by private sector as they attempt to repair their balance-sheets post the pandemic. Moreover, the measure will reduce the overall risk on the balance sheets of systemically important financial intermediaries and thereby strengthen the systemic stability of the financial sector.
Another important bill is the Banking Regulation (Amendment) Bill, 2020 which was made essential due to the recent instance of fraud in the case of PMC Bank. In India, the word 'bank' is associated by depositors as an institution viewed with public trust. Thus, most depositors park their funds with banks without any fear of the safety of their deposits.
This is also because of the fact that India has not witnessed a failure of any scheduled commercial bank thanks to the proactive response by the Reserve Bank of India. Add to this the fact that a bulk of India’s banks are owned by the Government and thus, are quasi-sovereign. Therefore, most people deposit their money with banks without any fear or inhibitions. However, the existing law allowed cooperative banks, which are formed under separate rules and are governed by different regulations, to use the name banks. PMC is an example of such a cooperative bank.
The use of the word bank led many to believe that the same regulatory system has an oversight over PMC as in the case of any scheduled commercial bank. However, the same is not true and a good example of this is the contrasting experience of handling the Yes Bank. Yes Bank which was under the direct supervision of the RBI saw early identification of the problem which made a speedy resolution possible.
The new law makes a concerted attempt at bringing such banks under the regulatory oversight of the RBI. The central bank will now have the right to approve the appointment of auditors and recommend removal of auditors to these cooperative banks with the intention of improving their governance and also timely identification of any financial vulnerabilities to prevent a future crisis.
Deficiencies in the audit oversight of the erstwhile regime made timely detection of financial irregularities and stresses difficult, thus accentuating the problem and reducing the chances of a successful and timely resolution. The new law has the potential to prevent such occurrences in the future. The experience of PMC bank is thus critical as a catalyst in fixing this regulatory anomaly whereby cooperative banks could use the word bank while they were governed under a different regulatory framework. The new law attempts to correct this anomaly, which is critical for protecting the interest of several depositors in many such cooperative banks.
Moreover, this is important to prevent such situations in the future and even in the instance of any such financial intermediary facing trouble, the government has all legal rights to intervene in the interest of safeguarding depositors. It is also important to recognize here that this law has nothing to do with cooperatives – and that it looks only into cooperative banks that explicitly use the word bank in their name. This is important as many have raised questions on what this means for several cooperatives across the country or the Primary Agricultural Societies that serve as last mile lenders to our farmers across the country.
These new banking law does not cover these institutions, and they shall continue to operate in as they do before the passing of the bill. A famous phrase is to never let a crisis go waste as it is an excellent opportunity for undertaking reforms. The two legislations discussed above seek to achieve precisely the same as they look at various gaps in our regulatory regime and make genuine attempts at fixing them. These reforms will go a long way in shaping a more conducive regulatory setup for growth of our financial sector and for safeguarding the rights of different participants in our financial system.
(Vivek Singh is additional private secretary to the finance minister. Karan Bhasin is a Delhi-based independent economist and a policy researcher. These are authors’ personal views.)