Financial Sector Legislative Reforms Commission


The Financial Sector Legislative Reforms Commission was constituted by the Government of India, Ministry of Finance, in March, 2011. The setting up of the Commission was the result of a felt need that the legal and institutional structures of the financial sector in India need to be reviewed and recast in tune with the contemporary requirements of the sector.
The institutional framework governing the financial sector has been built up over a century. There are over 60 Acts and multiple rules and regulations that govern the financial sector. Many of the financial sector laws date back several decades, when the financial landscape was very different from that seen today. For example, the Reserve Bank of India (rbi) Act and the Insurance Act are of 1934 and 1938 vintage respectively. Financial economic governance has been modified in a piecemeal fashion from time to time, without substantial changes to the underlying foundations. Over the years, as the economy and the financial system have grown in size and sophistication, an increasing
gap has come about between the requirements of the country and the present legal and regulatory arrangements.
Unintended consequences include regulatory gaps, overlaps, inconsistencies and regulatory arbitrage. The fragmented regulatory architecture has led to a loss of scale and scope that could be available from a seamless financial market with all its attendant benefits of minimising the intermediation cost. A number of expert committees have pointed out these discrepancies, and recommended the need for revisiting the financial sector legislations to rectify them. These reports help us understand the economic and financial policy transformation that is required. They have defined the policy framework within which reform of financial law can commence.
The remit of the Commission is to comprehensively review and redraft the legislations governing India’s financial system, in order to evolve a common set of principles for governance of financial sector regulatory institutions. This is similar to the tradition of Law Commissions in India, which review legislation and propose modifications. 
The main outcome of the Commission’s work is a draft ‘Indian Financial Code’ which is non-sectoral in nature (referred to as the draft Code throughout), which is in Volume II of the report and replaces the bulk of the existing financial law. 
Financial Legal Framework
The first set of questions that the Commission dealt with was about the purpose of the financial legal framework. Regulation is not an end in itself; it exists in order to address market failures. From this point of view, nine components were envisioned: 1. Consumer protection – The Commission found that a mere ‘buyer beware’ approach is not adequate in finance; regulators must place the burden upon financial firms
of doing more in the pursuit of consumer protection. This perspective shapes interventions
aimed at prevention (of inducing financial firms towards fair play) and cure (redress of grievances).
2. Micro-prudential regulation – When financial firms make promises to consumers, e.g. the repayment of a bank deposit, regulators are required to monitor the failure probability of the financial firm, and undertake interventions that reduce this failure probability.
3. Resolution – Micro-prudential regulation will diminish, but not eliminate, the failure of financial firms. A specialised resolution capability is required, which swiftly and efficiently winds down stressed financial firms, and protects the interests of small customers.
4. Capital controls – These are restrictions on cross-border activity on the capital account. The Commission has no view on the sequencing and timing of capital account liberalisation. The work of the Commission in this field was focused on placing the formulation and implementation of capital controls on a sound footing in terms of public administration and law.
5. Systemic risk – Micro-prudential regulation thinks about the collapse of one financial firm at a time. A very different point of view is required when thinking of the collapse of the entire financial system. Micro-prudential regulation is about the trees, and systemic risk regulation is about the forest. It calls for measurement of systemic risk, and undertaking interventions at the scale of the entire financial system (and not just one sector) that diminish systemic risk.
6. Development and redistribution – Financial economic governance in India is charged with the development of market infrastructure and processes, and with redistribution. These objectives have to be achieved through sound principles of public administration and law.
7. Monetary policy – Objectives, powers and accountability mechanisms have to be setup for monetary policy.
8. Public debt management – A specialised framework on public debt management has to be setup that takes a comprehensive view of the liabilities of Government, and establishes the strategy for low-cost financing in the long run.
9. Contracts, trading and market abuse – Certain adaptations to the foundations of commercial law, surrounding contracts and property, are required to enable the financial system. Alongside this, the legal foundations for the securities markets are established.
The overall task of constructing financial law comprises the above nine elements, and of establishing sound foundations of regulatory governance. This problem statement differs considerably from approach taken by existing laws in India, which are sector-specific. The existing laws deal with sectors such as banking, securities and payments. The Commission analysed this issue at length, and concluded that non-sectoral laws constitute a superior strategy.
As an example, a non-sectoral consumer protection law would lead to harmonisation of the consumer protection across multiple sectors. If this approach were not taken, there is the possibility of a certain sector having more lax standards of consumer protection than another. Profit-seeking financial firms would rush to exploit the profit opportunities, and distort the structure of the financial system.
In similar fashion, a non-sectoral micro-prudential law would ensure that similar reasoning about risk is applied all across the financial system. If micro-prudential regulation is done differently in different sectors, then profit-seeking financial firms will have an incentive to portray activities as belonging to sectors where capital requirements are weaker.
Non-sectoral laws are closely related to the idea of principles-based law. The draft Code is non-sectoral principles-based law. Regulators will issue regulations, that will often be sectoral and often be rules-based. 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.
At present, financial law in India is fairly complex. The drafting style used in most current laws is relatively complex and thus unreadable to non-specialists. The Commission has tried to achieve a simple writing style for the draft Code. The unification of many laws into a single draft Code has greatly assisted simplification. A single set of definitions of terms is utilised across all 450 sections of the law. The entire draft Code is internally consistent, and has a simple and logical table of contents. This emphasis on simplicity would reduce the complexity faced by law-makers, bureaucrats, legal professionals and finance practitioners in understanding the law and working within it.
The first task of financial law is to establish a clear strategy for the nine areas listed above. The second task of financial law is to establish financial regulators. In a liberal democracy, the ‘separation of powers’ doctrine encourages a separation between the legislative, executive and judicial functions. Financial regulators are unique in the extent to which all three functions are placed in a single agency. This concentration of power needs to go along with strong accountability mechanisms. There is a strong case for independence of regulators. Independent regulators would
yield greater legal certainty. The quest for independence of the regulator requires two planks of work. On one hand, independence needs to be enshrined in the law, by setting out many processes in great detail in the law. On the other hand, alongside independence there is a requirement of accountability mechanisms.
The Commission has adopted five pathways to accountability. First, the processes that the regulator must adhere to have been written down in considerable detail in the draft Code. Second, the regulation-making process (where Parliament has delegated lawmaking power to regulators) has been established in the draft Code with great care, with elaborate checks and balances. Third, systems of supervision have been established in the draft Code with a great emphasis on the rule of law. Fourth, strong reporting mechanisms have been established in the draft Code so as to achieve accountability. Finally, a mechanism for judicial review has been established for all actions of regulators through a specialised Tribunal.
At present, laws and regulations in India often differentiate between different ownership or corporate structures of financial firms. The Commission has pursued a strategy of ownership-neutrality: the regulatory and supervisory treatment of a financial firm would be the same, regardless of whether it is private India, foreign, public sector and co-operative. This would yield a level playing field.
At present, many public sector financial firms (e.g. Life Insurance Corporation of India (lic), State Bank of India (sbi)) are rooted in a specific law. The Commission recommends that they be converted into companies under the Companies Act, 1956. This would help enable ownership-neutrality in regulation and supervision. This recommendation is not embedded in the draft Code.
A related concern arises with co-operatives which fall within the purview of state Governments.
The Commission recommends that State Governments should accept the authority Of Parliament (under Article 252 of the Constitution) to legislate on matters relating to the regulation and supervision of co-operative societies carrying on financial services.
This recommendation is also not included in the draft Code. The Commission proposes that regulators may impose restrictions on the carrying on of specified financial services by co-operative societies belonging to States which have not accepted the authority of Parliament to legislate on the regulation of co-operative societies carrying on financial services.
The footprint of regulation
As a first step in determining the appropriate form and extent of regulation for the Indian financial sector, the Commission began with an identification of the basic subject matter of regulation - financial products and services. In the view of the Commission, particular forms of dealings in financial products, such as securities, insurance contracts, deposits and credit arrangements, constitute the rendering of financial services. This includes services such as, sale of securities, acceptance of public deposits, operating investment schemes and providing credit facilities. The Commission however recognises that a principles-based approach to defining financial products and financial services comes with the risk of unintentionally casting the net of regulation too wide. Therefore, it was decided that financial regulation should apply to only those persons who are engaged in the business of carrying on financial services.
While proposing a list of financial products and services in the draft Code, the Commission is fully aware of the constant innovation in the field of finance. In order to ensure that the law can keep pace with these changes, the draft Code empowers the Government to expand the list of financial products and services, as required. At the same time, the draft Code also allows the regulators to exclude specific financial services carried out by specific categories of persons from the scope of financial services. Using this power the regulator will be able to specify exemptions, e.g. for hedge funds that do not access funds from more than a particular number of persons or investment firms that only advise their related persons. In doing so, the regulator would of course be bound by the objectives
and guided by the principles set out under the draft Code.
Structure of the regulator
Just as the draft Code does not differentiate between different sectors in the financial system, the draft Code establishes a single framework for regulatory governance across all agencies. This is rooted in the fact that the requirements of independence and accountability are the same across the financial system. With small adaptations, this standard framework is used in the draft Code for all agencies created therein. The draft Code creates a series of obligations for the Government and for regulators. The draft Code covers all functions of regulators, and defines the behaviour that is required from the regulator.
All regulators will have an empowered board. The Commission has drafted a precise selection-cum-search process for the appointment of all members. Four kinds of members are envisioned: the chairperson, executive members including an administrative law member, non-executive members and Government nominees. The role of each of these kinds of members has been defined. The appointment conditions for board members have been defined.
The draft Code establishes certain elements of the functioning of board meetings, so as to ensure adequate oversight of the board over the organisation, and an emphasis on transparency.
A general framework for establishing advisory councils, that will support the board, has been created. This is sometimes invoked in the draft Code in constructing statutory advisory councils. Apart from this, the board will be free to construct additional advisory councils based on its needs.
The Commission envisages that fees charged to the financial system will fund all regulatory
agencies. Financial regulation will, therefore, generally impose no burden upon the exchequer. This will assist independence by giving regulators greater autonomy, and help the creation of a pecialised workforce.
Functions and powers of the regulator
The actual functioning of the regulator lies in three areas: regulation-making, executive functions and administrative law functions. In each area, the draft Code defines the functioning of regulators with considerable specificity. 
At present, in India, there is a confusing situation with regulators utilising many instruments such as regulations, guidelines, circulars, letters, notices and press releases. The draft Code requires all regulators to operate through a small number of well defined instruments only.
The first task of a regulator is that of issuing regulations. If laws are poorly drafted, there is a possibility of excessive delegation by Parliament, where a regulatory agency is given sweeping powers to draft regulations. The Commission has consistently sought to define specific objectives, define specific powers and articulate principles that guide the use of powers. Through this, regulation-making at the regulator would not take place in a vacuum.
A structured process has been defined in the draft Code, through which regulation making would take place. The regulator would be required to articulate the objective of the regulation, a statement of the problem or market failure that the regulation seeks to address, and analyse the costs and benefits associated with the proposed regulation. A systematic public consultation process is written into the draft Code. This structured regulation-making process would reduce arbitrariness and help improve the quality of regulations.
This structured regulation-making process requires a considerable expenditure of time and effort at the regulator. This is commensurate with the remarkable fact that Parliament has delegated law-making power to a regulator. In an emergency, the regulator can issue regulations without going through the full regulation-making process. However, these regulations would lapse within six months.
Alongside regulations, the draft Code envisages a process through which regulators
can issue ‘guidelines’. Guidelines clarify the interpretation of regulations but do not,
themselves, constitute regulations. Specifically, violation of guidelines alone would not
constitute violation of the law.
At present, regulations are not subject to judicial review. The Commission envisages an important process of judicial review of regulations. It would be possible to challenge regulations either on process issues (i.e. the full regulation-making process was not followed) or substantive content (i.e. the regulation does not pursue the objectives, or exceeds the powers, or violates the principles, that are in the Act). The Commission believes that these checks and balances will yield considerable improvements in the quality of regulation-making in India.
Turning to executive functions, the draft Code has specifics about each element of the executive powers. The first stage is the processing of permissions. A systematic process has been laid down through which permissions would be given. The second element is information gathering. Regulators require a substantial scale of regular information flow from financial firms. The  commission envisages a single ‘Financial Data Management Centre’. All financial firms will submit regular information filings electronically to this single facility. This would reduce the cost of compliance, and help improve data management within regulators. Turning to penalties, the draft Code has a systematic approach where certain standard categories are defined, and principles guide the application of penalties. This would help induce greater consistency, and help produce greater deterrence. A critical component of the framework for penalties is the mechanisms for compounding, which are laid on a sound foundation, and consistently applied across the entire financial system. Once an investigation has taken place, and the supervisory team within a regulator
believes there have been violations, the principles of public administration suggest that
the actual order should be written by disinterested party. At the level of the board, an ‘administrative
law member’ would have oversight of ‘administrative law officers’ who would not have any responsibilities within the organisation other than performing quasi-judicial functions. A systematic process would operate within the regulator, where administrative law officers and the administrative law member would be presented with evidence and write orders.
The working of the regulator ultimately results in regulations and orders. These would face judicial review at the Tribunal. The Commission envisages a unified Financial Sector Appellate Tribunal (fsat)that would hear all appeals in finance. A considerable focus has been placed, in the draft Code, on the functioning of the registry of fsat, so as to achieve high efficiency.
Consumer protection
The work of the Commission in the field of consumer protection marks awatershed compared with traditional approaches in Indian financial law. It marks a break with the tradition of caveat emptor, and moves towards a position where a significant burden of consumer protection is placed upon financial firms. The draft Code first establishes certain basic rights for all financial consumers. In addition, the Code defines what is an unsophisticated consumer, and an additional set of protections are defined for these consumers. The basic protections are:
1. Financial service providers must act with professional diligence;
2. Protection against unfair contract terms;
3. Protection against unfair conduct;
4. Protection of personal information;
5. Requirement of fair disclosure;
6. Redress of complaints by financial service providers.
In addition, unsophisticated consumers have three additional protections:
1. The right to receive suitable advice;
2. Protection from conflicts of interest of advisors;
3. Access to the redress agency for redress of grievances.
The regulator has been given an enumerated set of powers through which it must implement these protections. Alongside these objectives and powers, the regulator has been given a set of principles that guide the use of the powers. This framework of rights – powers – principles will shape the drafting of regulations. Once this has been done, regulators are obliged to undertake supervisory actions to verify  that regulations are being complied with. This goes along with enforcement and disciplinary actions.
This regulatory and supervisory strategy will yield considerable gains in consumer protection, when compared with the present Indian practices. At the same time, there will be certain consumers who are aggrieved. The Commission envisages a single unified Financial Redress Agency (fra) which would serve any aggrieved consumer, across all sectors. This would feature a low-cost process through which the complaint of the consumer against the financial firm would be heard, and remedies awarded. As with the fsat considerable effort has been made by the Commission to obtain an fra that has high operational capabilities and thus imposes low transactions costs upon
all participants.
The fra is important as a mechanism for addressing the unfair treatment of one consumer. The fra is also envisaged as a valuable measurement system, for the case database of the fra is a map that shows where the problems of consumer protection lie. Hence, the Commission envisages a systematic process through which the analysis of this data would feed back into improvements in regulation and supervision. The Commission recognises that competition is a powerful tool for the protection of consumers. The Competition Act enshrines a non-sectoral approach to competition 
policy. The Commission has envisaged a detailed mechanism for better co-operation between financial regulators and the Competition Commission through which there is greater harmony in the quest for greater competition.
Micro-prudential regulation
The pursuit of consumer protection logically requires micro-prudential regulation: the task of constraining the behaviour of financial firms so as to reduce the probability of failure. When a financial firm makes a promise to a consumer, it should be regulated so as to achieve a certain high probability that this promise is upheld. The first component of the draft Code is a definition of the class of situations where micro-prudential regulation is required. This is done in a principles-based way, focusing on the ability of consumers to understand firm failure, to co-ordinate between themselves, and the consequences of firm failure for consumers. Regulators have five powers through which they can pursue the micro-prudential goal: regulation of entry, regulation of risk-taking, regulation of loss absorption, regulation of governance and management, and monitoring/supervision. The draft Code specifies each of these powers in precise legal detail. Alongside this, it specifies a set of principles that guide the use of these powers.
Eleven principles have been identified that must be complied with. For example, principles
require proportionality (greater restrictions for greater risk), equal treatment (equal treatment of equal risk), and so on. It is envisaged that regulators will pursue the micro-prudential objective by writing
regulations that utilise the five powers. At the same time, these regulations would have
to satisfy the ten principles.
In this framework, there may be broadly three grounds for appeal against regulations. A regulation engages in micro-prudential regulation of an activity where micro-prudential regulation is not required. A regulation utilises powers which are not prescribed in the law. Finally, a regulation violates the principles which the regulator is required to follow.
The Indian financial system has traditionally been dominated by public sector firms. When consumers deal with a Public Sector Undertaking (psu) bank or insurance company 
for all practical purposes, they are dealing with the Government, and there is no perceived possibility of failure. Over the last 20 years, however, India has increasingly opened up entry into finance, and a new breed of private financial firms has arisen. These firms can fail, and when this happens, it can be highly disruptive for households who were customers of the failing firm, and for the economy as a whole. Sound micro-prudential regulation will reduce the probability of firm failure. However,
eliminating all failure is neither feasible nor desirable. Failure of financial firms is an integral part of the regenerative processes of the market economies: weak firms should fail and thus free up labour and capital that would then be utilised by better firms. However, it is important to ensure smooth functioning of the economy, and avoid disruptive firm failure.
This requires a specialised ‘resolution mechanism’. A ‘Resolution Corporation’ would watch all financial firms which havemadeintense promises to households, and intervene whenthe net worth of the firm is near zero (but not yet negative). It would force the closure or sale of the financial firm, and protect small consumers either by transferring them to a solvent firm or by paying them.
At present, for all practical purposes, at present, an unceremonious failure by a large private financial firm in India is not politically feasible. Lacking a formal resolution corporation, in India, the problems of failing private financial firms are placed upon customers, tax-payers, and the shareholders of public sector financial firms. This is an unfair arrangement. Establishing a sophisticated resolution corporation is thus essential. Drawing on the best international practice, the draft Code envisages a unified resolution corporation that will deal with an array of financial firms such as banks and insurance companies. It will concern itself with all financial firms which make highly intense promises to consumers, such as banks, insurance companies, defined benefit pension funds, and payment systems. It will also take responsibility for the graceful resolution of systemically important
financial firms, even if they have no direct links to consumers.
A key feature of the resolution corporation will be speed of action. It must stop a financial firm while the firm is not yet bankrupt. The international experience has shown that delays in resolution almost always lead to a situation where the net worth is negative, which would generally impose costs upon the tax-payer. The choice that we face is between a swift resolution corporation, which will stop financial firms when they are weak but solvent, and a slow resolution corporation which will make claims upon the tax-payer. Hence, a sophisticated legal apparatus is being designed, for a resolution corporation that will act swiftly to stop weak financial firms while they are still solvent. The resolution corporation will choose between many tools through which the interests of consumers are protected, including sales, assisted sales and mergers. It is important to make a clear distinction between micro-prudential regulation and resolution. Micro-prudential regulation and supervision is a continuous affair. Occasionally, when a firm approaches failure, resolution would come into action, and it would behave very differently from micro-prudential regulation. The resolution corporation would be analogous to a specialised disaster management agency, which is not involved in everyday matters of governance, but assumes primacy in a special situation. The resolution
corporation will have close co-ordination with micro-prudential regulation. For strong firms, the resolution corporation will lie in the background. As the firm approaches default, the resolution corporation will assume primacy.
The resolution corporation will charge fees to all covered entities, who benefit from greater trust of unsophisticated consumers. This fee will vary based on the probability of failure, and on the financial consequences for the resolution corporation of the event of failure. This risk-based premium would help improve the pricing of risk in the economy, and generate incentives for financial firms to be more mindful of risk-taking. The first three pillars of the work of Commission – consumer protection, micro-prudential regulation and resolution – are tightly interconnected. All three are motivated by the
goal of consumer protection. Micro-prudential regulation aims to reduce, but not eliminate, the probability of the failure of financial firms. Resolution comes into the picture when, despite these efforts, financial firms do fail.
Capital controls
India has a fully open current account, but many restrictions on the capital account are in place. A major debate in the field of economic policy concerns the sequencing and timing towards capital account convertibility. The Commission has no view on this question. The focus of the Commission has been on establishing sound principles of public administration and law for capital account restrictions. A large array of the difficulties with the present arrangements would be addressed by emphasising the rule of law and by establishing sound principles of public administration.
In terms of creation of rules, it is envisaged that the Ministry of Finance would make ‘rules’ that control inbound capital flows (and their repatriation) and that rbi would make ‘regulations’ about outbound capital flows (and their repatriation). With rbi, the regulation making process would be exactly the same as that used in all regulation-making in the Commission framework. With Ministry of Finance, the rule-making process would be substantially similar.The implementation of all capital controls would vest with the rbi. The draft Code envisages the full operation of the rule of law in this implementation.
Systemic risk
The field of financial regulation was traditionally primarily focused on consumer protection, micro-prudential regulation and resolution. In recent years, a fresh focus on the third field of systemic risk has arisen. Systemic risk is about a collapse in functioning of the financial system, through which the real economy gets adversely affected. In the aftermath of the 2008 crisis, governments and lawmakers worldwide desire regulatory strategies that would avoid systemic crises and reduce the costs to society and to the exchequer of resolving systemic crises.
The problem of systemic risk requires a bird’s eye perspective of the financial system:
it requires seeing the woods and not the trees. This is a very different perspective when compared with the engagement of conventional financial regulation, which tends to analyse one consumer, one financial product, one financial market or one financial firm at a time. The essence of the systemic risk perspective to look at the financial system as a whole. This differs from the perspective of any one financial regulatory agency, and particularly divergent from the perspective of any one sectoral regulator which is likely to see that sector and not the overall financial system.
To some extent, systemic crises are the manifestation of failures on the core tasks of financial regulation, i.e. consumer protection, micro-prudential regulation and resolution. If the three pillars of financial regulation would work well, many of the crises of the past, and hypothetical crisis scenarios of the future, would be defused. Systemic risk in India will go down if institutional capacity is built for the problems of consumer protection, micro-prudential regulation and resolution. However, it will not be eliminated. First, despite the best intentions, errors of constructing the institutional framework,
and human errrs, will take place. Second, even if all three pillars work perfectly, some systemic crises would not be forestalled. This calls for work in the field of systemic risk, as a fourth pillar of financial regulation.
While there is a clear case for establishing institutional capacity in these areas, it is also important to be specific in the drafting of law. Unless systemic risk regulation is envisioned as a precise set of steps that would be performed by Government agencies, there is the danger that systemic risk law degenerates into vaguely specified sweeping powers with lack of clarity of objectives.
The Commission deeply analysed the problem of reducing the probability of a breakdown of the financial system. This requires understanding the financial system as a whole, as opposed to individual sectors or firms, and undertaking actions which reduce the possibility of a collapse of the financial system. Each financial regulator tends to focus on regulating and supervising some components of the financial system. With sectoral regulation, financial regulators sometimes share the world view of their regulated entities. What is of essence in the field of systemic risk is avoiding the worldview of any one sector, and understanding the overall financial system. In order to achieve this, Commission envisages a five-part process.
The first step is the construction and analysis of a system-wide database. This effort, which will be located at the Financial Stability and Development Council (Financial Stability and Development Council (fsdc)), will analyse the entire financial system and not a subset of it. The discussions at fsdc would communicate the results of this analysis to all regulators, who would co-operate in proposing and implementing solutions. The second step is the identification of Systemically Important Financial Institutions (sifis). The analysis of the unified database, using rules which are agreed upon at fsdc,
will be used to make a checklist of sifis. These will be subjected to heightened microprudential
regulation by their respective supervisors. The third step is the construction and application of system-wide tools for systemic risk regulation.
The fourth step is inter-regulatory co-ordination. Effective co-ordination across a wide array of policy questions is an essential tool for systemic risk reduction. Finally, the fifth step is crisis management. The Commission envisages the Ministry of Finance as playing the leadership role in a crisis. Here, fsdc will only play a supporting role. Four of the five elements of the systemic risk process involve a leadership role at fsdc. The Commission envisages that fsdc would be a new statutory agency, in contrast with its relatively informal existence at present.
Financial inclusion and market development
The development agenda in Indian financial economic policy comprises two elements:
(i) The development of market infrastructure and processes, and (ii) Redistribution and financial inclusion initiatives, where certain sectors, income or occupational categories are the beneficiaries.
The framework proposed by the Commission involves placing the first objective with regulators and the second with the Government. The draft Code envisages regulators undertaking initiatives in the first area. For the second area, the Government would issue notifications in the Gazette, instructing regulators to impose certain requirements upon stated financial firms. The Government would be obliged to make payments to firms toreflect the costs borne by them.
The Commission felt that all initiatives of this nature – in the pursuit of inclusion or of development – should be subject to systematic evaluation after a period of three years. Decision making would be improved by a process of articulation of specific goals, followed by an evaluation of the extent to which these goals were met.
Monetary policy
The framework envisaged by the Commission features a strong combination of independence
and accountability for rbi in its conduct of monetary policy. The first stage lies in defining the objective of monetary policy. The Ministry of Finance would put out a Statement defining a quantitative monitorable ‘predominant’ target. Additional, subsidiary targets could also be specified, which would be pursued when there are no difficulties in meeting the predominant target.
The draft Code places an array of powers with rbi in the pursuit of this objective. Decisionson the use of these powers would be taken at an executive Monetary Policy Committee(mpc). The mpc would meet regularly, and vote on the exercise of these powers,based on forecasts about the economy and the extent to which the objectives are likelyto be met.
The mpc would operate under conditions of high transparency, thus ensuring thatthe economy at large has a good sense about how the central bank responds to futureevents.
Alongside this core monetary policy function, rbi would operate a real time gross settlementsystem, that would be used by banks and clearing houses. It would also operatemechanisms for liquidity assistance through which certain financial firms would be ableto obtain credit against collateral.
Public debt management agency
The management of public debt requires a specialised investment banking capability for two reasons:
1. Debt management requires an integrated picture of all onshore and off-shore liabilities of the Government.
At present, this information is fragmented across rbi and the Ministry of Finance. Unifying this information, and the related debt management functions, will yield better decisions and thus improved debt management.
2. A central bank that sells government bonds faces conflicting objectives. When rbi is given the
objective of obtaining low cost financing for the Government, this may give rbi a bias in favour
of low interest rates which could interfere with the goal of price stability.
In its entirety, the problem of debt management for the Government includes the
tasks of cash management and an overall picture of the contingent liabilities of the Government.
These functions are integrated into a single agency through the draft Code.
Contracts, trading and market abuse
The last component of financial law is the set of adaptations of conventional commercial
law on questions of contracting and property rights that is required in fields such as
securities and insurance. Statutes as well as case laws have shaped the rules regarding
creation of financial contracts, transfer of rights, title or interest in such contracts and
enforcement of such rights. These developments have largely been sector specific.
The framework of the securities markets requires legal foundations for the issuance
and trading of securities. Issuance of securities requires three kinds of restrictions. At
the time of the issue, adequate information must be available for an investor to make an
informed decision about valuation. Once the trading commences, a continuous flow of
information must be available through which the investor can make informed decisions.
Finally, a set of rules must be in place through which all holders of a given class of securities
obtain the identical payoffs. These three objectives would be achieved through
Financial markets feature a important role for Infrastructure Institution. The rules
made by these organisations shape the design of financial markets to a substantial extent.
The draft Code constrains the behaviour of Infrastructure Institutions in three respects:
1. Infrastructure Institutions are required to issue bye-laws and abide by them;
2. The objectives that these bye-laws must pursue are defined in the law;
3. They are required to obtain approval from the regulator for bye-laws.
The information about prices and liquidity that is produced by financial markets has a public goods character. The draft Code has provisions that require dissemination of this information. In addition, the falsification of this information is termed ‘market abuse’. The draft Code defines market abuse and establishes the framework for enforcement against it.
Financial regulatory architecture
We now turn to the financial regulatory architecture, or the division of the overall work of financial regulation across a set of regulatory agencies. Many alternative structures can be envisioned for the financial regulatory architecture. Parliament must evaluate alternative block diagrams through which a suitable group of statutory agencies is handed out the work associated with the laws. These decisions could conceivably change over the years.
At present, Indian law features tight conne tions between a particular agency (e.g. Securities and Exchange Board of India (sebi)) and the functions that it performs (e.g. securities regulation). The draft Code does not have such integration. Changes in the work allocation should not require changes to the underlying laws themselves. From the outset, and over coming decades, decisions about the legal framework governing finance would proceed separately from decisions about the financial regulatory architecture. This would yield greater legal certainty, while facilitating rational choices about financial regulatory architecture motivated by considerations in public administration and public economics.
At present, India has a legacy financial regulatory architecture. The present work allocation, between rbi, sebi, Insurance Regulatory and Development Authority (irda), Pension Fund Regulatory and Development Authority (pfrda) and Forward Markets Commission (fmc), was not designed. It evolved over the years, with a sequence of piecemeal decisions responding to immediate pressures from time to time.The present arrangement has gaps where no regulator is in charge – such as the diverse  kinds of ponzi schemes which periodically surface in India, which are regulated by
none of the existing agencies. It also contains overlaps where conflicts between laws has consumed the energy of top economic policy makers.
Over the years, these problems will be exacerbated through technological and financial innovation. Financial firms will harness innovation to place their activities into the gaps, so as to avoid regulation. When there are overlaps, financial firms will undertake forum-shopping, where the most lenient regulator is chosen, and portray their activities as belonging to that favoured jurisdiction.
An approach of multiple sectoral regulators that construct ‘silos’ induces economic inefficiency. At present, many activities that naturally sit together in one financial firm are forcibly spread across multiple financial firms, in order to suit the contours of the Indian financial regulatory architecture. Financial regulatory architecture should be conducive to greater economies of scale and scope in the financial system. In addition, when the true activities a financial firm are split up across many entities, each of which has oversight of a different supervisor, no one supervisor has a full picture of the risks that are present.
When a regulator focuses on one sector, there are certain unique problems of public administration which tend to arise. Assisted by lobbying of financial firms, the regulator tends to share the aspirations of the regulated financial firms. These objectives often conflict with the core economic goals of financial regulation such as consumer protection and swift resolution. In order to analyse alternative proposals in financial regulatory architecture, Commission established the following principles:
Accountability Accountability is best achieved when an agency has a clear purpose. The traditional Indian notion, that a regulator has powers over a sector but lacks specific objectives and accountability mechanisms, is an unsatisfactory one. 
Conflicts of interest In particular, direct conflicts of interest are harmful for accountability and must be avoided.
A complete picture of firms A financial regulatory architecture that enables a comprehensive view of complex multi-product firms, and thus a full understanding of the risks that they take, is desirable.
Avoiding sectoral regulators When a financial regulator works on a sector, there is a possibility of an alignment coming about between the goals of the sector (growth and profitability) and the goals of the regulator. The regulator then tends to advocate policy directions which are conducive for the growth of its sector. Such problems are less likely to arise when a regulatory agency works towards an economic purpose such as consumer protection across all or at least many sectors.
Economies of scale in Government agencies In India, there is a paucity of talent and domain expertise in Government, and constructing a large number of agencies is relatively difficult from a staffing perspective. It is efficient to place functions that require correlated skills into a single agency.
Transition issues It is useful to envision a full transition into a set of small and implementable
The Commission proposes a financial regulatory architecture featuring seven agencies.
This proposal features seven agencies and is hence not a ‘unified financial regulator’ proposal. It features a modest set of changes, which renders it implementable:
1. The existing rbi will continue to exist, though with modified functions.
2. The existing sebi, fmc, irda and pfrda will be merged into a new unified agency.
3. The existing Securities Appellate Tribunal (sat) will be subsumed into the fsat.
4. The existing Deposit Insurance and Credit Guarantee Corporation of India (dicgc)
will be subsumed into the Resolution Corporation.
5. A new Financial Redressal Agency (fra) will be created.
6. A new Debt Management Office will be created.
7. The existing fsdc will continue to exist, though with modified functions and a statutory framework.
The functions of each of these seven proposed agencies are as follows:
Reserve Bank of India It is proposed that rbi will performthree functions: monetary policy, regulation and supervision of banking in enforcing the proposed consumer protection law and the proposed micro-prudential law, and regulation and supervision of payment systems in enforcing these two laws.
Unified Financial Agency The unified financial regulatory agency would implement the consumer protection law and micro-prudential law for all financial firms other than banking and payments. This would yield benefits in terms of economies of scope and scale in the financial system; it would reduce the identification of the regulatory agency with one sector; it would help address the di_iculties of finding the appropriate talent in Government agencies. This proposed unified financial regulatory agency would also take over the work on organised financial trading from rbi in the areas connected with the Bond-Currency-Derivatives Nexus, and from fmc for commodity futures, thus giving a unification of all organised financial trading includig equities, government bonds, currencies, commodity futures and corporate bonds.
The unification of regulation and supervision of financial firms such as mutual funds, insurance
companies, and a diverse array of firms which are not banks or payment providers, would yield
consistent treatment in consumer protection and micro-prudential regulation across all of them.
Financial Sector Appellate Tribunal The present SAT will be subsumed in fsat, which will hear appeals against rbi for its regulatory functions, the unified financial agency, decisions of the fra and some elements of the work of the resolution corporation.
Resolution Corporation The present dicgc will be subsumed into the Resolution Corporation which will work across the financial system.
Financial Redressal Agency The fra is a new agency which will have to be created in implementing this financial regulatory architecture. It will setup a nationwide machinery to become a one stop shop where consumers can carry complaints against all financial firms.
Public Debt Management Agency An independent debt management office is envisioned. 
Financial Stability and Development Council Finally, the existing fsdc will become a statutory agency, and have modified functions in the fields of systemic risk and development. The Commission believes that this proposed financial regulatory architecture is a modest step away from present practice, embeds important improvements, and will serve India well in coming years. Over a horizon of five to ten years after the proposed laws come into effect, it would advocate a fresh look at these questions, with two possible solutions. One possibility is the construction of a single unified financial regulatory agency, which would combine all the activities of the proposed Unified Financial Authority and also the work on payments and banking. Another possibility is to shi_ toa two-agency structure, with one Consumer Protection Agency which enforces the proposed consumer protection law across
the entire financial system and a second Prudential Regulation Agency which enforces the micro-prudential regulation law across the entire financial system. In either of these paths, rbi would then concentrate on monetary policy.
These changes in the financial regulatory architecture would be relatively conveniently achieved, given the strategy of emphasising separability between laws which define functions, and the agencies that would enforce the laws. Over the years, based on a pragmatic assessment of what works and what does not work, the Government and Parliament can evolve the financial regulatory architecture so as to achieve the best possible enforcement of a stable set of laws.

Friday, 02nd Oct 2015, 11:29:37 AM

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