The draft Indian Financial Code: From ideas to action

The IFC: A bridge too far?

Transformative change of the Indian State takes place through big projects. We seem to combine stasis in government, with ground-up rethinking in big projects. Six big projects are now in the fray:

1. Goods and Services Tax (GST)
2. Direct Tax Code (DTC)
3. Indian Financial Code (IFC)
4. National Pension System (NPS)
5. Delhi Mumbai Industrial Corridor (DMIC)
6. Unique Identity Authority of India (UIDAI)

Everyone agrees these big projects should be done. The story of Indian State capacity and trend GDP growth is one of conceiving and executing a series of such ground-up redesigns of the State. With this shelf of 6 big projects, the bottleneck lies in execution. We cannot help but anxiously look back at the Companies Act. Could we have gone faster? Could we have achieved a better law when compared with the outcome we got there, the Companies Act of 2013? Similarly, while the NPS project has made great progress, there are important concerns about where the NPS has come. How should we work, in translating these big projects from ideas to action, and get to a pretty good thing at the end?

When the Financial Sector Legislative Reforms Commission (FSLRC) released the draft Indian Financial Code (IFC) in March 2013, many people were concerned that India lacked commensurate implementation capability. To some critics, it felt like an alien spaceship had landed, embedding knowledge that was too far ahead of the landscape. For a sense of the zeitgeist, see this blog post from 19 June 2013 which is roughly 3 months after the IFC. Reasonable men were asking: Was the IFC a bridge too far?

T+7 months: A three-pronged strategy was visible

The first signs of implementation came from the Financial Stability and Development Council (FSDC), which consists of the Ministry of Finance and the five financial agencies (RBI, SEBI, FMC, PFRDA, IRDA). A press release reporting on the Eighth meeting of the FSDC on 24 October, seven months after the IFC, contained this text:

Based on the deliberations made today, it has been decided that all the financial sector regulators (including FMC) will finalise an action plan for implementation of all the FSLRC principles relating to regulatory governance, transparency and improved operational efficiency that do not require legislative action. As regards legislative recommendations, it was decided to analyze the public comments and feedback to further fine tune the draft Indian Financial Code. It was also decided that action should be taken for finalizing the roadmap for creation of new institutions such as Resolution Corporation, PDMA, FSAT and FDMC. 

This suggests a three-pronged implementation strategy for the IFC: (a) An action plan of the things we can do now, (b) A consultative process that will lead to an improved IFC and (c) Creation of new institutions.

T+9 months: the `action plan' is a Handbook

Roughly two months after this meeting, and 9 months after the IFC, the Ministry of Finance has released the Handbook on adoption of governance enhancing and non-legislative elements of the draft Indian Financial Code. Here is the press release. The Handbook has four components:

• Chapters 2 and 3 are a good chunk of consumer protection from the IFC.
• Chapters 4 to 12 are a good subset of the regulatory governance process and the Rule of law from the IFC.
• Chapter 13 is on capacity building.
• Chapter 14 pulls together all the implementation activities that flow from Chapter 2 to Chapter 13.

With this in hand, we get a fair sense of the first prong of the implementation of the IFC, which is an action plan for right now. The three key documents connected with the IFC are now : The IFC itself, the report of the FSLRC and the Handbook.  They are collected together at http://macrofinance.nipfp.org.in/fslrc . Everyone interested in Indian economics should read all three documents.

Next steps

The adoption of the IFC now runs on three tracks:

1. Implementation of the Handbook by FMC, IRDA, PFRDA, RBI, SEBI.
2. Consultative process leading to an improved IFC, led by MOF, and then the hazards of the legislative process after the next elections.
3. Construction of new institutions. We may assume some actions will get announced in coming weeks.

Implications of the Handbook

How big is this? I have been in the field of financial regulation in India for 20 years and I think the adoption of the Handbook is the biggest event of this period. Trend GDP growth in India will go up when the members of FSDC implement the Handbook as they have resolved to implement it. Very crudely, and assuming technically sound follow through, I think this adds up to 66% of the consumer protection and 66% of the regulatory governance from the IFC. A properly implemented Handbook is perhaps 33% of the goodness of the IFC. While a lot remains in that 66%, to build 33% of the IFC is a big deal.

How much work will it take to implement this? I think the Handbook is a big deal because there is a big gap between what we see there, and present practices. All five financial agencies will require a significant scale of reorganisation, recruitment and reskilling in implementing the Handbook. SEBI is a bit ahead of the others, but for SEBI also, the changes required are substantial.

For people interested in public administration, and actually making the machinery of government work, this will be an exciting time. The people who built SEBI, NSE and NSDL over 1988-1996 had a disproportionate impact on the following twenty years. In similar fashion, the people who implement the Handbook, and build the new institutions of the IFC, will have a significant impact upon Indian finance of the next 50 years.

What is the impact of harmonisation on financial economic policy? At present, there are large differences between RBI, FMC, SEBI, IRDA and PFRDA. One achievement of the IFC is that it is one single law for the entire financial system. As a consequence, there is only one Handbook covering RBI, FMC, SEBI, IRDA and PFRDA. For the first time, we will be able to compare and contrast different agencies, and we will be able to carry good practices from one agency to others. We will achieve better outcomes with five agencies competing, with success stories getting transferred from one the others. On any question, a person in one agency will start by asking `How do the other four agencies do this? What worked and what didn't?'. There will be greater scrutiny as finance practitioners and the media will be able to compare and question practices and events across all the five agencies.

What is the impact of harmonisation on individuals in finance? There is one IFC and one Handbook: this gives greater transferability of individuals across the entire Indian financial system -- whether in government or in financial firms or their surrounding support system such as legal firms, consultants, etc. Breaking down silos increases competition in the labour market. For the staff of government agencies, we will see the beginnings of an Indian financial regulatory cadre, with individuals across all five agencies (and MOF) thinking in consistent ways, sharing experiences, and feeding off each other's work. While SEBI has a head start, it is quite possible that agencies like RBI or FMC could outperform in coming months.

What will be the impact for financial firms? The Handbook is really Consumer protection and a group of improvements in governance that emphasise the rule of law. The consumer protection component of the Handbook implies that financial firms have to emphasise business plans that are good for their customers. For an analogy, when health standards make it harder to sell sugar water, this is good for the people selling water. Consumer protection from the Handbook will make life more difficult for the messy things that financial firms in India do (example), and improve the market share and profit rate of financial products and services that are good for consumers such as index funds, NPS, KGFS, Quantum Mutual Fund, direct sales (link), more sensible insurance (link, link). CEOs will lean away from toxic business plans towards things that are good for consumers -- not because they are nice guys but because of modified behaviour of financial agencies.

The governance-enhancing features of the Handbook imply that there will be less arbitrariness in the hands of financial agencies, and greater consistency across financial agencies and across time. This will reduce legal risk.

The greater portability of individuals and knowledge across all five regulatory agencies will make it easier for all financial firms to think about business strategy across the entire Indian financial system, instead of living within one silo at a time. More firms will be willing to span silos, which will increase competition in finance.

It will become easier to identify and solve mistakes by regulators, which will foster rationality, competition and innovation. But this will require capacity building among financial firms, who will have to construct public policy teams that will engage with financial agencies through the formal mechanisms of the IFC, and in associated academic institutions and law firms.

How does this change the outlook for the remaining 66% of the IFC? Implementing the Handbook front-loads much of the pain, of reorganisation, recruitment and re-skilling by existing financial agencies. Once these problems are out of the way, there will be less of a disruption when the law is passed by Parliament. This is a wise strategy that will reduce fear of the changes required for the IFC.

Implementation of the Handbook by existing financial agencies will generate knowledge that will assist the construction of new institutions required under the IFC such as the Resolution Corporation or the Public Debt Management Agency, all of which will run on regulatory governance of the IFC.

Implementing the Handbook will make gains from the IFC tangible. Many in Indian finance will see long-standing points-of-pain get addressed by implementation of the Handbook. Improved working of financial agencies, and of consumer protection, will become palpably visible, will increase confidence in the IFC, and help go forward to enactment of the law.

What are the implications for the Indian State more broadly? The Indian State is fraught with meddling, laziness, incompetence and corruption. We fail to be guided by market failures when thinking about the use of the coercive power of the State, and we fail to be guided by public choice theory in thinking about the organisation of the State. The State is lost in a haze of populist redistribution, and fails on the hard work of producing public goods.

The IFC constitutes a fully articulated solution of constructing a sensible State in one field with an extensive State interface, namely, Finance. The IFC limits the intervention of the State to market failures, and it is fully cognisant of public choice theory. Some of the ideas about how FSLRC was done, and some of the ideas from the IFC, could be usefully transplanted into other areas.