Financial regulation: Going from potholes to expressways

In India, we have an alphabet soup of financial regulators: RBI, SEBI, FMC, IRDA, PFRDA, the Dept. Company Affairs. In 1997, all financial regulation in the UK was merged into the FSA. From an Indian perspective, the notion of merging all finance into a single agency sounds daunting. Why concentrate so much power into one agency? How will that agency be accountable? (I had written about this in 1997).

In 1997, everyone was curious about whether the FSA would succeed. I think by 2006, it is quite clear that it's worked well. The FSA has managed to steer clear of the three kinds of problems: the populist regulator who likes to play to the gallery by currying favour with ordinary citizens, the conservative regulator where the answer to all policy questions is "no", and the US-style approach of introducing enormous lawyer-overheads on the production of financial services.

I wrote a piece in Business Standard today where I try to understand how the FSA succeeded. One essential idea seems to be the notion of "light-touch regulation". This is much like a civil law vs. common law question (Jayanth Varma blogged about this yesterday). Do you write down every product and market mechanism in fine detail? Or do you articulate broad principles, and leave individuals in the market to continually innovate on details? The FSA has chosen the latter path. The second essential idea seems to be an elaborate safety net of mechanisms for accountability.

From an Indian perspective, I have two elements of intuition on understanding the FSA. The reforms to trade & industry of the early 1990s had one recurring theme: to get CEOs of companies to worry about competition and the market, and to get them to spend less time dealing with government. When I see the FSA in operation, it feels like the same idea applied to finance. The FSA approach unleashes competition by getting CEOs to focus on innovation instead of being tied down by detailed rules which define every corner of what they can do.

My second piece of intuition is about our endemically low standards in India about what we expect from public goods. We were used to pothole-filled roads, and it took decades for us to set our sights higher and get to the State capacity required to build expressways. In similar fashion, I think that most people in Indian finance can't imagine the idea of a regulator that does not write down every detail about their business, where the innovator is not burdened by the task of lobbying the regulator to change detailed rules, etc. I see the establishment of sound judiciary and regulators as being the `soft infrastructure' that lies below a well functioning market economy. It's as important as the `hard infrastructure' and much harder to achieve owing to problems of verifiability.

In the case of infrastructure, the removal of trade barriers was critical to shifting the private sector from a complacent acceptance of low quality public goods. In a world of global competition, it didn't work for the Indian firm to be handicapped with potholes. In similar fashion, I think removing barriers to trade in finance - capital controls, FDI limits, etc - will be critical for getting Indian firms to not accept the existing control raj in finance.

Update: Jayanth Varma has posted a followup on his blog.