SEBI, IRDA & ULIPs: Hurried solutions lead to poor law

by Bikku Kuruvila and Shubho Roy.

On 18th June, the President signed an ordinance that would settle the recent spat between SEBI and IRDA over unit linked insurance plans ("ULIPs"). The ordinance makes it clear that ULIPs cannot be regulated by SEBI and places them within the jurisdiction of IRDA. The ordinance also tries to prevent further disputes by setting up a joint committee to address future conflicts. But this is not all there is to the matter. The ordinance also amends 4 major acts of parliament governing financial markets in the country (the RBI Act, the Insurance Act, the Securities Contract Regulation Act and the SEBI Act) with minimal consultation. The language of the ordinance also raises a wide range of questions about regulatory arbitrage, misselling, what issues the joint committee would actually consider, the very effectiveness of the proposed solutions, good governance and the structure of financial sector regulation. This is not a small list.

Looking at these matters in turn, the ordinance raises serious concerns about regulatory arbitrage. Today, ULIPs act as 'endowment policies' where the premium paid by the insured on a what is nominally a life insurance contract is invested in the stock market. Under these contracts, if the insured dies before the maturity of the policy, there is an insurance payout. After a fixed period or maturity, the investments in the stock market are liquidated and returned to the insured minus charges. Under these conditions, insurance companies cover the risk of premature death for only a short period of time (between entering into a contract and maturity). As such, the insurance component of these policies (the money which the insurance company must keep with itself to meet its contingent liability) is very low. The rest of the money can easily be invested and payouts depend upon the stock market.

Mutual funds are similar in all aspects to ULIPs except for the small component of insurance that an ULIP carries. However, mutual funds must comply with tough regulations imposed by SEBI and are severely limited in the forms of fees they can charge. Financial firms faced with the choice of registering as a mutual fund and complying with SEBIs regulatory framework or providing a small component of insurance in their product structures, registering as a ULIP, and charging open-ended fees, will rationally choose the latter.

Second, as many others have commented, the ordinance does not address misselling. (See recent articles by Monika Halan, Deepak Shenoy and Jayant Thakur). The ordinance does not include any provisions to deal with misselling. The ordinance also does not address IRDAs lack of enforcement capabilities vis a vis SEBI. The ordinance does active harm and removes provisions that previously protected investors. By amending the Securities Contract Regulation Act, insurance instruments are now not considered securities for the purposes of the Act. Section 27 A and B were one of the few statutes in the country addressing misselling. These two sections gave investors in collective investment schemes and mutual funds limited investment protection, namely rights to income under collective investment scheme. These small provisions will now not apply to insurance products, weakening investor protection for the time being.

Third, the provisions of the ordinance raise concerns about what matters the joint committee would actually consider. The dispute settlement mechanism in the ordinance specifies the securities which can be referred to the joint committee. We wonder: could the ULIP controversy have been the first matter submitted to the joint committee? In any case, since new types of securities are constantly being developed by financial firms, the joint committee would need frequent legislative interventions to be operable. For example, the joint committee in its current form, does not include the Forwards Markets Commission (FMC). If a product were to be launched which consisted of a hybrid of steel futures and steel companies futures (not an absurd proposition to the extent that steel prices play a significant role in the profits of the steel industry), the FMC would not be allowed to approach the joint committee as the Commission is not a recognised regulator under the ordinance.

To take up a different example, the joint committee is also limited in its jurisdiction to ``hybrid" or ``composite" instruments. Certainly many disputes could arise between regulators that do not involve an underlying hybrid or composite instrument. An instrument governed by one regulator that has a negative effect on the market regulated by another regulator, as with the regulatory arbitrage hypothesis suggested above, could not be referred to the joint committee. Neither could issues which bring instability to multiple markets, unless, of course the underlying instrument is hybrid or composite.

Fourth, the structure of the joint committee points to problems of institutional design. The ordinance is largely silent about the procedures the joint committee would follow. This is not simply a technical matter. How would differences of opinion in the board be settled? By majority vote? Consensus? Would there be staffing? Who would be responsible for expenses? No doubt, to a significant extent disputes would be settled by reference to soft norms and existing hierarchies in government. The culture of deference by IAS officers to other IAS officers of a senior class provides one example. The unlikely possibility of agency regulators going against the deeply held preferences of a strong finance minister provide another. Yet these are not simply mundane questions and impact, materially, how extensively the committee could study and resolve matters before it.

Fifth, the process by which the ordinance was passed is worrisome. As suggested by the Economic Times, regulators were not consulted on a ordinance that amends 4 major acts of parliament. What does this say for consultativeness and democratic process? What does this say for the legitimacy of the proposed solution? Is the failure to consult and rush to promulgate this solution reflected in the drafting and policy flaws of the instrument suggested above?

Sixth, the ULIP dispute has been presented as a contest between SEBI and IRDA. Implicitly, one regulator had to win, and the other, lose. This is misleading. One scenario would have each regulator govern the portion of ULIPs which fall within their domain. IRDA would govern the insurance component of these instruments and SEBI would govern the investment component. Some might suggest that this would lead to too much complexity. Yet, we are more used to dealing with complexity than we realize. A person driving a vehicle who causes damage to property could be liable for damages under rules of the Motor Vehicle Act, tort law and possibly the Indian Penal Code. That the net zone of freedom of action in driving a car would be limited to the conjunction of the areas prescribed by these laws seems hardly remarkable. The government would never declare that all motor vehicle drivers are immune from civil or criminal laws. The more complex the transaction, the more regulation might apply. Financial firms are as well-equipped as any actor in society to handle this complexity.

Another scenario would involve crafting a mechanism for joint regulation of ULIPs. As Monika Halan suggests, this proposal has precedent in the arrangements between the banking and capital markets regulators and could lead to the harmonisation of regulation to the benefit of investors and the marketplace.

Yet another scenario would involve actively fostering or allowing some measure of regulatory competition. The heightened regulation of ULIPs as a result of this controversy is itself a salutary case in point. We do not suggest that the government allow this issue to fester but feel confident that serious scholars and practitioners of administrative law and institutional design could develop interesting ways of promoting regulatory competition given time and a mandate.

Hurried solutions lead to poor law with implications that will be felt by investors and markets down the line. Ordinances are intended for use when Parliament is out of session and the President perceives a need for immediate legislation. Ordinances may be amended. The conflict between SEBI and IRDA is also only one small piece of a larger problem of financial sector legislation that is fragmented, at times duplicative and at times inadequate. We can only hope that Parliament revisits this matter in a more thorough fashion, either independently or through the efforts of the Financial Sector Legislative Reforms Commission (FSLRC) proposed in the Finance Ministers budget speech of 2010-11.

Hours of operation of Indian retail firms

Raghavendra Kamath has an article in the Business Standard today on experiments by Indian retailers at running stores for 24 hours a day.

I have often wondered about the costs and benefits of the 24-hour stores that one sees in the US. Two things come to mind. First, the response of demand to extended hours will only show up with a lag, when people reconfigure their lives to exploit the consistent availability of stores at all times of the day or night. This won't happen immediately.

Second, round the clock operation requires recruitment of multiple shifts of staff. The article (mentioned above) talks about the problems that the retailing firms are having in trying to stretch the existing staff into longer hours. This might even work for a sporadic weekend but it's not feasible in a sustained way. This is about the relative consumption of labour and capital. Once the store exists, the entire capital cost is paid: for the real estate, the inventory and the technology platform. The decision faced by the firm is whether, on the margin, it makes sense to add more labour cost so as to generate some sales from an additional shift. My first guess would be that if this is efficient in the West -- where wages are much higher than in India -- then it should surely make sense in India.

If modern Indian professional retailing firms are able to push into extended hours, then this will have two effects. First, this will increase the distance between them and the traditional mom-and-pop which cannot really function for more than 10-12 hours a day. Second, this will increase the employment that they generate.

The overall goods and services that households buy don't change when retailing formats change. But if one retailing firm moves into extended hours or to 24x7, then it will suck customers who value this convenience away from other firms. Once this starts happening, all or most stores will settle into the equilibrium with extended hours or round-the-clock operation.

The murder or departure of the Soviet Jews

Gal Backerman has this fascinating story about events from 1970 (40 years ago), where Soviet Jews started fighting for the ability to leave the USSR and go to Israel. By the end of 1971, 13,000 Soviet Jews were permitted to leave for Israel -- more than the number in the previous 10 years put together. In 1972, 32,000 people got the right to leave. The article ends with:

But the true solution was no less mortal a threat to the Soviets in the late 1980s than it had been in 1970. If they let the Jews leave, what would keep everyone else from doing the same? 

When Soviet Jews finally emigrated en masse -- nearly 1.5 million by the end of the 1990s -- it looked like just another happy side effect of the Soviet Union's collapse, another wall crumbling. Forgotten were the decades of pushing from the inside. The Soviet Union might have gone the way of China and had an economic liberalization that ignored human rights. But this option was not open, because the Soviet Jews made it clear that any change would need to include open borders. 

As a result, not only were hundreds of thousands of Soviet Jews able to build new lives, but forces were set in motion that would bring down the Berlin Wall and, eventually, an empire -- a world-shaking transformation born from the hopes once placed on a small airplane that never even left the ground.

This raises an empirical question: Was the departure of Jews important to the functioning of the USSR, or was it just a powerful political demonstration of the bankruptcy of the system? Does this kind of brain drain matter, or is it just a side show in the larger scheme of things? Does it matter to a country that its intellectual elite stays or leaves?

In India, for many decades, some of the brightest people left. Vikram Pandit and Anshu Jain now lead two of the top 10 financial firms of the world. Conversely, from the 1990s onwards, there has been an increasing phenomenon of India being able to pull back some of the brightest ones back into the country. So it's interesting to ask what are the consequences of elite flight or its reversal. Are these few who leave just a drop in the ocean or does it matter in the larger scheme of things?

Daron Acemoglu, Tarek A. Hassan and James A. Robinson have a recent NBER paper analysing a related story titled Social Structure and Development: A Legacy of the Holocaust in Russia where the abstract reads:

We document a statistical association between the severity of the persecution and mass murder of Jews (the Holocaust) by the Nazis during World War II and long-run economic and political outcomes within Russia. Cities that experienced the Holocaust most intensely have grown less, and cities as well as administrative districts (oblasts) where the Holocaust had the largest impact have worse economic and political outcomes since the collapse of the Soviet Union. Although we cannot rule out the possibility that these statistical relationships are caused by other factors, the overall patterns appear generally robust. We provide evidence on one possible mechanism that we hypothesize may link the Holocaust to the present --- the change it induced in the social structure, in particular the size of the middle class, across different regions of Russia. Before World War II, Russian Jews were predominantly in white collar (middle class) occupations and the Holocaust appears to have had a large negative effect on the size of the middle class after the war.

Interesting readings

The Budget Speech of February 2010 had announced a `Technical Advisory Group for Unique Projects' (TAGUP). The press release about creation of this group is out.

Giles Kepel has a great article in the National Interest on the concept of secularism and assimilation in France and the UK. It makes you think about how we're approaching the puzzle of forging an Indian identity - and the contrast between the damage caused by State policy as opposed to the interesting quiet changes taking place every day on the ground.

Anil Padmanabhan looks back at year 6 of the UPA.

Heather Timmons and Hari Kumar in the New York Times on the carnage on India's roads.

NSE does Fix.

SEBI's order on front-running at HDFC AMC. Bhave's SEBI is a new world of enforcement in Indian finance.

Somasekhar Sundaresan in the Business Standard on the mess in India's capital controls.

Bibek Debroy in the Indian Express, and an editorial in the Business Standard, on India's problem with land titles. Most of us in India don't know about how far back this story goes in other countries : to the Domesday book of 1086 AD, or 924 years ago, in the UK.

Jayanth Varma in the Financial Express on the new world of exchanges. Roughly a decade ago, I had started using intra-day data from NSE and at the time had checked that their trading system clocks were synchronised by NTP -- they were.

Ila Patnaik in the Indian Express on the importance of the BSST countries instead of the BRIC countries.

Vikas Bajaj in the New York Times on the difficulties of rail transportation in India.

Gary Schmitt, in the American, worries about the finlandisation of Taiwan.

Nixon's Nose by Xiaoda Xiao, in Guernica and Angel factories by Anne Applebaum in the New Republic.

Ali Sethi in the New York Times with a piece titled One myth, many Pakistans.

Adam Ridley in the Financial Times on the challenge before London.

Sebastian Mallaby in the Atlantic on Paul Romer's work on `charter cities'.

Scott Sumner has an interesting take on the performance of neoliberal policies worldwide.

Rent a white guy.

Scott Adams guide to investment.

Structural change in the Indian exchange rate regime

The rupee/dollar rate has gained in flexibility. In order to visualise what has changed, it's useful to look at a graph of the time-series of weekly percentage changes, expressed in absolute terms. That is, a change of -3% or +3% is shown as a bar of height 3 in this graph:

The vertical blue lines show the dates of structural change in the exchange rate regime. These are taken from our recent paper The Exchange Rate Regime in Asia: From Crisis to Crisis, which is forthcoming in International Review of Economics and Finance, and is part of our work on measurement of the de facto exchange rate regime. As an aside, a recent article in The Economist about Asian currency flexibility talks about this in a larger context.

The vertical blue lines break the overall experience into six distinct periods: a first period of high flexibility, then the shift to a nearly fixed rate in April 1994, then the higher flexibility at the time of the Asian crisis followed by a return to very low flexibility, and then two moves of increasing flexibility.

These movements towards flexibility -- and away from administered prices -- require corresponding adjustments on the part of the economy. If firms are coddled with an administered price and thus think that currency risk does not exist, or if exporters are coddled with a distorted exchange rate, then this generates the wrong behaviour on their part. See Ila Patnaik in the Indian Express on learning to live with a genuinely market determined exchange rate. Also see T. B. Kapali, of the Shriram Group of Companies, in the Hindu Business Line arguing in favour of greater flexibility for corporations in hedging currency risk.