Let’s stop kicking the can down the road: Highlighting important and unaddressed gaps in microcredit regulations
It is happening again – regulators debating openly to clarify their turfs. This time it is PFRDA Vs. IRDA for regulation of pension products offered by insurance companies, and just a few months ago, SEBI was competing with IRDA for regulation of Unit Linked Investment Plans (ULIPs) offered by insurance companies. There have been temporary solutions or backtracking in some of these cases. For example, in the recent PFRDA-IRDA issues, the PFRDA Chairman later clarified that since the regulation in India is still entity-based and not product-based, there is no case for a regulatory turf battle between his agency and the insurance regulator. The matter has now been referred to the newly formed Financial Stability and Development Council (FSDC) for clarification. No matter what the details of these specific cases, one thing seems clear –all is not well with our regulatory architecture, because it leaves room for such fundamental conflicts, which are not around some obscure technical issues, but actually raise questions about the very architecture itself.
The Present Regulatory Architecture
In this context, one immediately relevant characteristic of the Indian financial system’s regulatory architecture is its complexity – both in terms of the sheer number of regulatory, quasi-regulatory, non-regulatory-but-still-regulating bodies, and also because of their overlapping, ambiguously defined respective spheres of concern and influence. This figure depicts the regulatory architecture in some detail (adapted from Report of the Committee on Financial Sector Reforms).
Regulatory agencies: Broadly, there are supposed to be product-wise demarcations of regulatory space for various regulators: Reserve Bank of India (RBI) regulates credit products, savings and remittances; the Securities and Exchange Board of India (SEBI) regulates investment products; the Insurance Regulatory and Development Authority (IRDA) regulates insurance products; and the Pension Fund Regulatory and Development Authority (PFRDA) regulates pension products. The Forward Markets Commission (FMC) regulates commodity-based exchange-traded futures. Practically, as was illustrated by the recent PFRDA-IRDA conflict, since certain entities (especially insurance companies) primarily engaged in one product also offer other products, it becomes difficult to impose product-based regulation. So, essentially, most regulation turns out to be entity-based. Another example here is of cooperative banks, which, except in terms of their ownership structure, are very much like other banks – they take deposits and give loans. Still, their regulation is largely left to the registrar of cooperatives.
Quasi-regulatory agencies: There are other government bodies which perform quasi-regulatory functions, including National Bank for Agriculture and Rural Development (NABARD), Small Industries Development Bank of India (SIDBI), and National Housing Bank (NHB). NABARD supervises regional rural banks as well as state and district cooperative banks. NHB regulates housing finance companies, and SIDBI regulates the state finance corporations.
Central government ministries: In addition to these regulatory and quasi-regulatory agencies, certain ministries of the government are also involved in policy making in the financial system. Of course, Ministry of Finance (MoF) is most prominently involved, through its representatives on the Boards of SEBI, IRDA and RBI. MoF and Ministry of Small Scale Industries have representatives on SIDBI Board, and Ministry of Urban Development is represented on the NHB Board. MoF representatives are also on Boards of public sector banks and DFIs. Forward Market Commission (FMC), which regulates commodity exchanges and brokers, comes under the Ministry of Consumer Affairs.
State governments: Through the registrar of cooperatives, who are typically under the departments of agriculture and cooperation, the state governments regulate the cooperative banking institutions in their respective states. The state government have also sometimes claimed a regulatory role in certain other cases. Though it never became an open battle, the Andhra Pradesh government’s Ordinance directing operations of Micro Finance Institutions (MFIs) – many of them NBFCs registered with and regulated by RBI – falls into this space. Such actions by state government have been matters of contention in the past as well, and some of them have gone to the courts as well. The court cases to clarify the RBI Vs. State government issue are still being heard in the Supreme Court, and a judgement from the Apex Court could help clarify this ambiguity.
Special statutes for certain financial intermediaries: Some key financial services intermediaries like SBI and its Associate Banks, Public Sector Banks, LIC and GIC are governed by their own statutes. These statutes give a special status to these institutions vis-a-vis the other institutions performing the same functions. Earlier, IFCI, UTI and IDBI also operated under special statutes, but now there special statutes have been repealed.
Establishment of FSDC: In the recent past, there has been an important addition to the regulatory architecture in the form of the Financial Sector Development Council (FSDC), which has replaced the High Level Committee on Capital Markets. FSDC, which is convened by Ministry of Finance, does not have statutory authority, and it is structured as a council of regulators, with a permanent secretariat and with the Finance Minister as chairman. The council would be expected to resolve inter-agency disputes. It will look at regulation of financial conglomerates that fall under various regulators’ purview, and also the wealth management function, which also effectively deals with multiple products.
Issues with the Regulatory Architecture
An important implication of this architecture is the regulatory arbitrage emerging from it, because there are spaces in the financial system that are either regulated by multiple entities with little clarity on division of responsibilities, or are regulated by agencies that do not have the competence to regulate them effectively. An example of this is the regulation of district cooperative banks, which are supposed to be regulated by the RBI and by the registrar of cooperatives in their respective states. While the former has the expertise, it does not have the regulatory bandwidth to regulate these institutions, and the registrar of cooperatives have a more direct role in their regulation, but they typically do not have the expertise to regulate such deposit-taking entities. Similarly, when investment/pension products are offered by insurance companies, though the entity is regulated by the insurance regulator, the specific product should fall under the purview of the respective regulator (investment/fund management – SEBI, pension – PFRDA), which may be more capable of regulating the product, and may have developed more effective ways of regulating it in terms of capital, expenses and disclosure. Since the regulation is practically entity-based, the entities can enjoy regulatory arbitrage.
The present architecture makes it very difficult to create financial intermediaries that offer a range of financial services and benefit from economies of scope. An example is the regulation of financial services distribution, which has significant inter-regulator differences. So, it is almost impossible to create distribution agencies or front-end intermediaries that can offer a complete range of financial services to the clients.
The present architecture creates certain conflicts of interest for certain regulators. RBI is not just the banking regulator, it is also the investment banker for the government and the monetary policymaker. The role of investment banker to the government may conflict with the role of banking regulator because banks buy a bulk of government securities. The monetary policy can help the banks in maintaining their health, and if the same agency is responsible for banking regulation and monetary policy, conflict of interest may arise, and the agency’s actions may turn out to be good for the banks but bad for the long-term development of the markets.
This architecture also creates problems of coordination among agencies. For managing systemic risks, regulatory coordination at the level of financial system is crucial. In India’s financial system, unless the FSDC plays an active role, the inter-agency coordination mechanisms are quite weak.
Though it is clear that the regulatory architecture needs to see some changes to avoid regulatory arbitrage, gaps, costs, and coordination problems, the exact nature of these changes is not obvious. There are multiple ways of addressing these issues, each with varying advantages and disadvantages.
Through the next four weeks, we will pursue this theme in detail, through interviews with experts, case studies from other countries, and more articles on this theme.
Suyash – nice piece. Sorts out a fair bit of confusion.
Also, i think a closely related issue (not sure whether its a potential sub-theme here, or perhaps another candidate theme for the proposed series) which requires deliberation is whether the nature of regulations themselves ought to be rules-based or principles-based. I think its fair to categorise the Indian approach as falling more or less in the former category (a lingering offspring no doubt of our licence raj mindset). That we need to move towards the latter in the interests of allowing continued innovation in financial markets and reducing regulatory capture, amongst other considerations, is becoming clearer in the academic literature. I wonder if it might be appropriate for Advocacy to assume this agenda only once the architecture question is settled or whether it may be better off pursued concurrently (given that this sub-optimal architecture pointed above is likely here to stay given ground realities).
A good article covering the spectrum of regulation and issues thereon. The figure depicting regulatory architecture is well presented. I think as the complexity in the financial system increases, regulatory architecture should become more simpler and objective.
Thanks for the comment Jayanth. The particular theme being pursued in this series is around how the regulatory architecture of the country should be organised. As discussed, presently it is supposed to be product-based, but is largely based on institution-types. There are many overlaps and ambiguities in regulatory mandates. All these lead to certain issues, which will be discussed in this series, and hopefully we will have some thoughts on alternative pathways from here. Watch this space for interviews and case studies that will illuminate aspects of this theme.
The issue of principles-based vs. rules-based regulation you have raised primarily concerns how the regulators should pursue their respective regulatory mandates, given the regulatory architecture. This somewhat tactical issue, though relevant to this theme, will be discussed later, once we have had some discussion on the architecure itself.
Priyanka Yadav …….
The problem with our regulatory architecture is multiplicity of regulators and coordination among them. So, solution over here can be go for single “super regulator” concept or develop a mechanism for strengthening inter -regulatory coordination.It is a time to wait and watch how effectively the newly created FSDC will carry out this task. When debate goes for Rule based v/s principle based regulation. Taking into account, the maturity level of Indian financial system when compared todeveloped economies, the solution can be adoption of former occupying dominant position while latter acting as a complementary to the former one. According to me, only defining rules and regulation won’t serve purpose. It must be backed by effective supervision also. Better match of both along with inter regulatory coordination can prove helpful to our financial system,given the current scenario.