By Anand Sahasranaman, IFMR Finance Foundation
Financial Sector Legislative Reforms Commission (FSLRC) was set up by the Indian Government in 2011 with a mandate to help rewrite and harmonize financial sector legislation, rules and regulations. On March 22nd 2013 it released its final report and the draft law.
The Financial Sector Legislative Reforms Commission (FSLRC) has submitted its final report to the Ministry of Finance with its recommendations on the legal and institutional framework for the future of India’s financial system.
It is widely recognised that there is a need for a framework of financial laws and regulation in order to address market failures and protect consumers. Market failures can be due to many reasons, some of the important ones being:
- Information asymmetry: Because of the expertise that is required for the development of most financial products and strategies, the seller of a financial product is always at an “informational” advantage over the buyer (who generally lacks expertise). This information asymmetry has the potential to adversely incentivise the seller to mis-sell the product, which could lead to poor financial outcomes for the buyer.
- Nature of financial decisions and outcomes: Many important financial decisions such as investing in a mortgage or saving for retirement are undertaken very infrequently in the course of a lifetime. The outcome of many financial investments and strategies becomes obvious only in the long term, and not immediately upon product purchase.
- High Search Costs and Price Dispersion: Despite the fact that financial service providers provide almost identical products, there can be substantial price differences between them. These price variations across sellers of similar financial products can be attributable to high search costs that consumers have to incur to meaningfully compare products and as a result, lead them to pay higher prices than they should.
- Behavioural Characteristics of Consumers: Consumers are beset with a number of cognitive limitations and biases which influence their decision making and make them act in ways contrary to the traditional model of hyper-rationality.
The fact that the Commission started off by taking a first principles view of the financial sector and the need for regulation, has meant that the their approach has been guided by the objective of developing appropriate legal and institutional frameworks to address different types of market failure. Considering the fact that financial sector laws in India have developed piece-meal over time, this is a welcome move. As a result, the sectoral focus that characterises India’s financial sector today is absent in the FSLRC’s approach, which has enabled it to harmonise laws on issues such as consumer protection and micro-prudential regulation.
The other important aspect of FSLRC’s approach, one that is closely tied to the non-sectoral approach, is the creation of princples based law. The incremental changes of financial sector laws in India so far has meant that there are no clear over-arching principles underlying the law and therefore, a lack of coherence. On taking the principles based approach, the report states the following:
“The advantage of this arrangement is that specific details of technology and market process are not embedded in the law. Over the years, changes in technology and institutions would lead to modifications in regulations. Timeless principles would be re-interpreted in the future by courts and the tribunal, which would create case law. The Commission believes that the draft Code will, with no more than minor modifications, represent the essence of financial law for many decades to come. In this respect, the work of the Commission has taken Indian financial law closer to its roots in the common law tradition.”
It is vitally important that the Commission has recognised the importance of the need to allow space for the financial markets to evolve and respond to changes. Considering the need to both broaden and deepen access to finance in India, it is critical that financial service providers have the incentives to innovate – in technology, product design and development, as well as channels of delivery. It is only in an environment that creates the space for financial service providers to constantly innovate can we meaningfully hope to address the challenge of financial inclusion. The need for innovation becomes all the more apparent when we consider some of the national socio-economic trends that India confronts, and that the financial system must respond to: retirement planning, healthcare financing, urbanisation and public infrastructure financing.
Overall, the Commission identifies nine components of focus for financial law: consumer protection, micro-prudential regulation, resolution, capital controls, systemic risk, development and redistribution, monetary policy, public debt management and contracts trading & market abuse.
In subsequent posts, we discuss some of these components in greater detail.