The RBI governor, Dr Raghuram Rajan, on Tuesday attacked the recommendations of FSLRC by asking are we trying to solve a problem that does not exist?

The Reserve Bank of India (RBI) governor Dr Raghuram Rajan, while commenting on Tuesday on the report by Financial Sector Legislative Reforms Commission (FSLRC) said, the Central Bank is engaged in consumer protection framework as per the guidelines mentioned in the report. However, at the same time, he also opposed the idea of creating a Unified Financial Agency by merging all regulators, saying, "if it ain’t broke, don’t fix it!" It may be recalled that FSLRC has proposed a whole new draft law for the financial sector last year.

Speaking at the first State Bank 'Banking and Economic Conclave in Mumbai, the RBI governor said, "The FSLRC’s recommendations (on appropriate size and scope of regulators) seem somewhat schizophrenic. On the one hand, it emphasizes synergies in bringing together some regulators into one entity. But in the process it suggests breaking up other regulators, with attendant loss of synergies. There is no discussion of the empirical magnitude of the synergies gained or synergies lost, which makes the recommendations seem faddish and impressionistic rather than based on deep analysis. Indeed, across the world, we see a variety of organizational structures in existence, suggesting that there is no one right structure. If so, there should be strong arguments for departing from the status quo, which the FSLRC does not provide."

Talking about financial consumer protection laws which are lacking in India, he said, "In laying out the need for consumer protection, raising the issue of whether products sold are suitable for the target customer, and putting the onus on the financial institution to determine suitability, the (FSLRC) report has forced regulators to review their consumer protection frameworks. We, at the RBI are indeed engaged in such an exercise, informed by the valuable guidelines in the FSLRC report."

Indeed, the Reserve Bank of India has been quick in moving towards a fairer system of consumer protection rules and is engaging with different stakeholders in the process.

The FSLRC submitted its report in March 2013 and one of its key recommendations was the setting up of a Unified Financial Authority (UFA) that would merge the regulators of capital markets, insurance and banking. However, it turns out that FSLRC itself may have been an exercise in futility and a waste of taxpayers’ money. Each of its key members–YH Malegam (well-known chartered accountant and director on the RBI board for over 19 years), Kishori J Udeshi (ex-RBI deputy governor), PJ Nayak (ex-bureaucrat and former chief of Axis Bank) and JR Varma (academic)–voiced formal dissent against its core recommendations. The Commission made meagre attempts to engage with core stakeholders–the consumers of financial services–who have been getting a raw deal under every financial regulator.

Dr Rajan, while welcoming a few recommendations of the FSLRC, like the need for a clear monetary framework and creating new institutions like Financial Resolution Authority, said he sees two fundamental problem areas in FSLRC recommendations: oversight of regulators, and appropriate size and scope of regulators.

"The logic for regulation according to the FSLRC is to deal with market failure or more colloquially, bad behaviour. The Commission talks about incomplete information or poor incentives as a reason for bad behaviour, but one of the most important reasons for the bad behaviour necessitating regulation is what economists call incomplete contracts; that is, the behaviour of the regulated entity (vis a vis customers, the public at large, the taxpayer, or the market) cannot be completely specified in contracts because it is too difficult to observe or verify in real time, or it can only be gauged across many contracts," he said.

"This means that while courts can enforce specific contracts, the regulator can sometimes do better," the RBI governor said. “A bank may attract a lot of complaints from its credit card customers. While no single customer may think the case worth taking to court, and while no customer may be able to prove the bank was in the wrong, the large number of complaints will suggest to the regulator that the bank needs to shape up. By comparing the nature of the complaints it gets from this bank’s customers with the complaints it gets from other banks, the regulator can gauge whether something is wrong with the bank and act. Similarly, if a particular product attracts a lot more complaints than other products, the regulator can ask the industry to modify the product appropriately, or even ban it."

According to the RBI governor, a lot of regulatory action stems from the regulator exercising sound judgement based on years of experience and in doing so, it fills in the gaps in laws, contracts, and even regulations. He said, "Not everything the regulator does can be proven in a court of law. Courts do not interfere in the specific decisions of a corporate board. Using the business judgement rule, they do not second-guess business decisions, and only pull up boards when there is a violation of the legal process of arriving at a decision. In the same way, there are a range of regulatory decisions where regulatory judgement should not be second guessed."

Appeals Against the Regulator's Actions
 

Talking about the dangers of excessive legal oversight, Dr Rajan said, “one reading of the FSLRC is that almost everything the regulator does, not just the framing of regulation or the process by which decisions are reached but also the exercise of regulatory judgement as well as policy decisions, is to be subject to legal appeal. This could create problems.” According to Dr Rajan "...the process by which the regulator reached a decision, as well as the conformity of the decision with basic principles such as natural justice, can already be challenged through a writ petition in High Court. Even now, some regulatory decisions can be appealed to the central government. But how much checking and balancing is enough? Do we want even policy decisions to be appealable? Can legal oversight become excessive?" he asked.

Dr Rajan said, “we ask ask tribunals to make judgements that they simply do not have the capability, experience, or information to make, and where precise evidence may be lacking. If we attempt to do this, we will undermine the very purpose of a regulator. Of course, one could trust the good sense of the tribunal to follow a 'regulatory judgement' rule and not intervene in a broad array of matters, but does this not imply a double standard — we trust the tribunal’s judgement but not that of the regulator. More likely, though, past experience suggests that entities like to justify their existence, and if set up, a tribunal will intervene more than necessary," he said.

He said, “in India, where the financial system is developing and many new regulations have to be framed (more so if we move to a principle based approach for legislation), and where the tribunals will have a significant amount of learning to do, the encouragement to appeal could paralyse the system and create distortions, as needed regulations are held up and participants exploit loopholes.”

Dr Rajan said, in every country, a healthy respect for the regulator serves to keep participants on the straight and narrow, especially for a developing country, where private behaviour is less constrained by norms or institutions, this is important. "But," he said, "to the extent that private parties with their high-priced lawyers can check the regulator, that healthy respect dissipates. So the final danger is that the regulator could become a paper tiger, and lose its power of influencing good behaviour, even in areas that are not subject to judicial review."

Market regulator Securities and Exchange Board of India (SEBI) is already under the Securities Appellate Tribunal (SAT) and some people ask why not bring other regulators under a Tribunal. Dr Rajan, feels, as long as the Tribunal only questions administrative decisions such as the size and proportionality of penalties, there is no problem. "But if it goes beyond, and starts entertaining questions about policy, the functioning of a regulator like the RBI, which has to constantly make judgements intended to minimize systemic risk, will be greatly impaired. Indeed, because of the tendency of any new organization to overreach to justify its existence, one should be careful about tying the financial regulator with further judicial oversight. Better to revisit these issues a few years from now when both regulation and oversight mechanisms are better developed," he said.

Unified Regulator
 

The FSLRC has proposed that all regulation of trading should move under one roof, all regulation of consumer protection should move under another roof, but the regulation of credit should be balkanized — banks should continue to be regulated by the RBI but the regulation of the quasi-bank institutions like non-banking financial companies (NBFCs) should move to the Unified Financial Agency, a regulatory behemoth that would combine supervision of trading as well as credit.

According to Dr Rajan, this balkanization would hamper regulatory uniformity, the supervision of credit growth, and the conduct of monetary policy. "while negotiations and cooperation between regulators can overcome organisational barriers, it is not wise to give a regulator a responsibility and leave the tools for exercising that responsibility in other hands. The RBI has responsibility for managing the internal and external value of the rupee, and more broadly, for macroeconomic stability. As a number of multilateral agencies and academics have recognized, the ability to shape capital inflows is now a recognized part of the macro-prudential tool kit. But by taking away control over internal capital inflows from the RBI, isn’t the FSLRC taking away an important tool from the RBI?" he asked.

"Undoubtedly our laws need reform, but that is no reason to try entirely new approaches to legislation, overlaid on entirely new regulatory structures, complemented by entirely new oversight over regulation. Undoubtedly, we have had, and will have, periods when regulators have not gotten along with each other. But is that a reason to merge some organizations and break up others, perhaps ensuring dysfunctionality along many other dimensions? After all, there is no single regulatory architecture that has emerged with distinction from the crisis. Instead, different regulatory architectures have succeeded or failed based on the circumstances of the country and the quality of the regulator. Undoubtedly, we have also had occasions when regulators have exceeded their remit or been high-handed. But is that a reason to subject their every action to judicial second-guessing? Is there a reason we need more checks and balances, or are we trying to solve a problem that does not exist," Dr Rajan asked.