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Monday, September 28, 2015

Is India a hospitable environment for India-related finance

by Anjali Sharma, Kanwalpreet Singh, Rajat Tayal, Rohini Grover, Susan Thomas.

Competition in finance

There is an assumption in India that financial services and products connected with India can only exist through the aegis of financial firms and markets in India. As a consequence, there tends to be little discussion on international competition for India-related finance.

There are, indeed, elements of finance which are not amenable to international competition. For example, setting up bank branches in Nagpur is something which can only take place in Nagpur. However, for a growing class of situations, Indian customers of finance, or non-resident customers of India-related finance, now have choices:

  • Indian firms can choose between raising equity or debt capital within India or abroad.
  • Non-residents have a choice of buying the equity of Indian companies by coming to Indian exchanges (NSE or BSE), or by sending orders go to overseas venues (e.g. London Stock Exchange or the New York Stock Exchange) when Indian companies list abroad.
  • Derivatives settled in cash can trade anywhere. Outside India, exchanges and the OTC market  trade derivatives on the rupee, on Nifty, on Indian interest rates, on India-related credit risk, etc. This gives non-residents a choice about whether orders go to India or to overseas rivals.

These developments have taken place over the last decade, changing the dynamics of what is possible for domestic and foreign investors. This has brought international competition to confront Indian financial institutions and systems.

This competition is good for the Indian economy. When an Indian firm is able to access debt overseas, it overcomes the limitations of the Indian credit market. This is good for India. Similarly, when an Indian firm is able to obtain equity capital overseas, overcoming the problems of the Indian primary market for equity, access to capital for India goes up. This is good for India.

When non-resident investors take exposure in Indian assets, they face financial risks such as the rupee risk, Nifty and single stock price risk. To the extent that they are able to reduce risk, this is good for India. For example, a non-resident investor who has given a dollar-denominated loan to an Indian firm, or a foreign firm who has FDI in India, should be able to reduce their risk by trading in derivatives. These include sovereign Indian credit default swaps (CDS), single stock CDS, rupee derivatives, Nifty derivatives, Indian interest rate derivatives, etc. Whether these are available in domestic markets or in competing markets off-shore, the presence of these markets encourages higher foreign participation in Indian assets.

Hence, the emergence of greater competition against Indian financial producers, which gives reduced prices and higher quality, is good for India.

Expected and actual outcomes

India has a natural edge in global competition for India-related finance. As an example, consider trading in Nifty derivatives. The information is formed in India. The most liquid market is in India, created by the trading of hundreds of thousands of thinkers, and decision makers in India. Once India is the most liquid market, this would suck in all order flow, which would help further increase the liquidity. The most reasonable outcome is one where India owns one hundred percent of the market share. However, the outcome that has come about over the last decade is starkly different.

Precise estimates of turnover are difficult to obtain. But most estimates suggest that it is reasonable to think that roughly half of the global trading in the rupee and in Nifty is now taking place outside India. In 2008, the share of the overseas market was roughly 0%. Since then, this share has gone up to roughly 50%. There is a possibility that the share of the overseas market could further increase in the days to come.

Implications: Loss of revenues in India

An order that comes to the Indian financial system induces export of financial services. A basket of revenues comes with the basic order. This includes securities broking, legal services, research, accounting and travel. All these revenues are lost when the order goes to an off-shore market such as Dubai or Singapore.

We believe that a conservative estimate of the total services revenues associated with each order is approximately 0.25%. As there is a buyer and a seller for each unit of turnover, this implies a total revenue stream associated with turnover of 0.5%. Given the extent of international competition that Indian finance faces, what is the size of the revenue at stake?

If turnover is \$1 billion per day, or \$250 billion per year, this would imply a revenue stream of \$1.25 billion per year. This is Rs.83.75 billion per year. In other words, each \$1 billion per day of overseas activity is a loss of financial services exports revenue for India of Rs.83.75 billion per year.

But how much turnover is taking place outside India? This is hard to estimate and there is no unambiguous answer. We believe the answer lies between \$10 billion to \$50 billion per day. If all this business came to India, it would yield additional financial services export revenues of between Rs.83.75 billion per year to Rs.4.18 trillion per year.

Implications: Loss of domestic market liquidity

If an order flow of between \$10 billion/day and \$50 billion/day were added to domestic financial markets, this would yield a quantum leap in market liquidity and market efficiency. The reduced capabilities of domestic financial markets is the second consequence of the loss of market share. This may have an adverse impact for India that is even greater than the headline grabbing figure for the loss of export revenues.

Tackling the problem of the loss of market share

In June 2013, in recognition of the importance of the problem as one requiring research analysis and policy responses, the Ministry of Finance setup a `Standing Council of International Competitiveness of the Indian Financial Sector'. The Standing Council is chaired by the Secretary of the Department of Economic Affairs. IGIDR FRG has been the technical team for the Standing Council.

On 7 September 2015, the Standing Council released Volume 1 of its Report. There is likely to be a Volume 2 that follows shortly after. The Standing Council is likely to establish a rhythm of work where it is continuously watching the space of international competitiveness of the Indian financial system, and making recommendations with remedial actions to the Ministry of Finance.

The Standing Council has diagnosed four classes of problems which have generated this loss of market share of the onshore market.

  1. Problems in domestic financial regulation. In many situations, there are flaws in domestic financial regulation which are harming the onshore financial system.

  2. Taxation. The global financial system sends orders to financial centres which have `residence-based taxation', where non-residents are not part of the tax base as seen by the local authorities. Apart from the Mauritius treaty, this is not how India works.

  3. Capital controls. The global financial system sends orders to financial centres where the frictions are minimal. India's capital controls actively introduce friction which deters financial services exports.

  4. Unpredictability of policy changes. In a mature market economy, there is a consistent economic policy philosophy shaping policy pathways. In a mature market economy, rule of law procedures are used when changing laws or regulations. These two features create predictability about changes in policy. India suffers from flaws in both respects. As a consequence, market participants are frequently suprised by unexpected changes in policy. This enhanced political/regulatory risk deters investments in building organisational capital. It is safer for a global financial firm to build an INR derivatives business in a place like Singapore or London, rather than committing resources to build that same organisational capital in Bombay.

Looking forward

The ongoing process adopted by the Standing Council is to render policy advice to the Ministry of Finance, through which these four classes of problems can be addressed. This line of thinking constitutes one more impulse to undertake deeper reform of Indian finance.

Wednesday, September 23, 2015

Regulatory governance problems in the legislative function at RBI and SEBI

by Arpita Pattanaik and Anjali Sharma.

The problem

Regulations which are issued by regulators, have the full status of law. A person who violates a regulation stands to be punished exactly like a person who violates a law. But regulations are written by unelected officials. Ordinarily, in liberal democracy, the power to make law is restricted to those who have won elections. How do we reconcile this contradiction? The answer adopted, the world over, is to establish a sound regulation-making process, through which unelected officials do not have arbitrary law-making power.

Under sound public administration, when unelected officials wish to draft regulations, they should articulate reasons. All regulatory actions result in both costs and benefits for regulated entities and the market. In a good system, only those interventions, for which the benefits exceed the costs, are implemented. This requires regulators' to carry out a formal cost-benefit analysis and engage with the public through a consultation process.

Such transparency in the regulation making process has many benefits. It anchors the financial system by providing legal certainty. It creates transparency and predictability about the values and goals of financial policy and regulation making, and accountability in regulatory actions. As an outcome, market participants are able to conduct their business with confidence. Das et. al. (2004) find that balanced degrees of transparency, accountability, integrity and independence of the regulator, result in a sound and improved financial system.

In the Indian landscape, financial sector regulators have been endowed with a surprising mix of powers by the Parliament. They can make laws, enforce them and punish regulated entities that violate these laws. Often regulatory actions enjoy protection from judicial review as they are deemed to be "actions taken in good faith". However, the regulation making process followed by financial sector regulators in India is nowhere close to these standards. Regulations are issued as unilateral pronouncements. Little or no detail is provided about the problem being solved or the reason for the regulatory action. Often, there is a real risk of a ban on products (example), a ban on participants (example), retroactive changes in tax policy (example), changes in margins (example), position limits (example 1, example 2) and trading lots (example) and changes in investment norms (example) being introduced without any warning or rationale.

These maladies are part of the problems faced in doing business in India. The Report of the Standing Council on International Competitiveness of the Indian Financial Sector finds that mistakes in financial regulation and regulatory uncertainty are important factors that hamper financial market development across market segments in India. In contrast, jurisdictions that are or seek to be centers for international finance, follow robust regulatory governance practices and ensure regulatory certainty.

Improving regulatory governance

A recent development towards obtaining better regulatory governance in the Indian financial sector is in the report of the Financial Sector Legislative Reforms Commission (FSLRC), headed by Justice Shri B. N. Srikrishna. The FSLRC has proposed the Indian Financial Code (IFC), a consolidated draft law for the financial sector. Non-legislative elements of the draft Code have been culled out into the Handbook on adoption of governance enhancing and non-legislative elements of the draft IFC (Handbook). The Handbook lays down international best practices on regulatory governance and lists the procedures that the Indian regulators should follow to achieve better governance in regulation making.

As part of the Financial Sector Development Council (FSDC) Resolution dated October 24, 2013, all financial sector regulators agreed to comply with the Handbook procedures on framing regulations for :
  • All regulations from 31st October, 2013, and
  • All subordinate legislation -- which includes circulars, notices, guidelines, letters -- from 31st December 2014.
In this article, we examine whether the regulation making procedures followed by RBI and SEBI comply with the standards defined in the Handbook.

Handbook procedure for "Regulation Framing"

The Handbook lays out the following procedure for regulation making:

  1. All regulation making should start with a proposal to the Board of the regulator. The Board must assess the necessity of the proposed regulation and initiate the process.
  2. The draft regulation must be accompanied by a jurisdiction clause, defining the legal provision under which the regulation is being proposed, a statement of objectives, the problem it seeks to solve and a cost benefit analysis of the proposed solution.
  3. The draft regulation must be made available to the public, inviting comments for a reasonable period of time. This can be done by publishing the draft regulation on the regulator's website.
  4. All comments should be published on the regulator's website.
  5. The Board of the regulator should take into account all reasonable comments received when approving the regulation.
  6. Once the Board approves, the regulation will become effective from the date of its notification.

Of the six steps in this list, numbers three to five are observable publicly. Information about Step 3 is available when the regulator places the draft regulation on its website for public comments. Information about Step 4 is available when public comments are published on the website, while information about Step 5 is available when the final regulation is notified or published on the website. From these, three things can be assessed:

  1. Whether a public consultation preceded regulation making,
  2. Whether the public consultation document had all the elements recommended by the Handbook, and,
  3. Whether the public consultation process caused any change in the final regulation.

We collected information for the three steps described above from the RBI and the SEBI website for the period June, 2014 to July 2015 to understand their respective compliance track record.

Regulatory instruments used by SEBI and RBI

An analysis of the collected information reveals the following facts.

  • SEBI uses several instruments for regulation making: regulations, circulars, general orders, rules and guidelines. However, regulations and circulars are the most frequently used.
    1. Regulations are issued under Section 30 of SEBI Act. Regulations need the approval of the SEBI Board. They are then placed before Parliament for sanction and subsequently notified in the Gazette. 27 regulations were issued during the analysis period.
    2. Circulars are issued under Section 11(1) of the SEBI Act. This Section allows SEBI broad powers to act in the interests of investors, promote market development and regulate securities' markets. Circulars do not need to be placed before Parliament and only require approval within SEBI. 23 circulars were issued during the analysis period.
    3. General orders, rules and guidelines are less used instruments. Only 1 guideline and 1 rule was issued in the analysis period. No general order was issued in this period.
  • RBI uses atleast three legal instruments for regulation-making: "circulars", "notifications" and "directions". The present state of transparency about law written by RBI makes it hard to analyse the laws written by RBI: citizens do not get access to a comprehensive statement of the law. In this article, we study some circulars. These are used for regulation making under a wide range of legal provisions: the Banking Regulation Act, 1949, the RBI Act, 1934, the Foreign Exchange Management Act, 1999, the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, the Prevention of Money laundering Act, 2002 and the Payment and Settlement Systems Act, 2007.

    Each year in July, the RBI issues master circulars which are compilations of all circulars in force for a particular area. During the selected period, we were able to identify 643 circulars and 221 master circulars. With the present state of transparency at RBI, we do not know whether this collection is exhaustive. For the present purposes, we treat this as a reasonable sample where we can study the attributes of the regulation-making process at RBI.

We focus our analysis on SEBI regulations and circulars and RBI circulars.

Compliance record on regulation making

The table below shows how well RBI and SEBI complied with the Handbook procedure for regulation framing in the one year period of analysis using two sets of two measures. The first measure captures in how many instances regulation was preceded by public consultation? The second measures capture the procedure followed for the public consultation. This includes understanding: (a) how many days were allowed for public comments, (b) whether public comments were published on the website, (c) whether the public consultation document had a cost-benefit analysis, and (d) what was the time lag between public consultation to the final regulation?

Table 1: Compliance summary


Circulars Regulations Circulars

Total issued 643 27 23
Public consultation done 21 12 4
Cost-benefit analysis done 0 1 0
Public comments published 0 0 0

Table 2: Time lags in regulation framing

Time taken (in days)

Consultation period allowed Consultation to regulation lag

Minimum Maximum Median Minimum Maximum Median

RBI Circulars 7 46 29 24 2,232 1,171
SEBI Regulations 10 43 23 55 1,709 331
SEBI Circulars 12 28 18 11 740 609

This data offers fascinating insights into the problems of regulation making in Indian finance:

  1. The regulatory track record of seeking public comments is poor. Public comments were sought only on 2.4% of RBI's circulars. SEBI sought public comments on 44.4% of its regulations and on 17.4% of its circulars.
  2. When they do seek public comments, there are gaps in the contents of the consultation document. RBI public consultation documents did not lay out the objective of the proposed regulation, the problem being addressed, the jurisdiction clause or the cost benefit analysis. These documents only proposed one solution. SEBI public consultation documents did present the objective of the regulation, the problem being addressed, a proposed solution and the jurisdiction clause. However, the cost benefit analysis was missing in all cases except one. The SEBI public consultation documents often carried sweeping statements of motivation such as in the interest of investors and to promote market development.
  3. Neither regulator allowed adequate time for receiving public comments. The median time allowed for public comments by RBI was 29 days and by SEBI was 23 days for regulations and 18 days for circulars. In the case of both regulators, there were cases where only 10 or 12 days were allowed.
  4. At both at RBI and SEBI, the time lag between the public consultation and the issue of final regulation is high. For RBI circulars the median lag is 3.2 years while for SEBI regulations and circulars it is 0.9 years and 1.7 years respectively. The relevance of the public comments or the regulatory intervention itself may be lost or altered if significant time elapses from the point of problem definition to implementation.

As part of our analysis, we also checked whether public comments had resulted in any changes in the proposed regulation. We do not find any case where there was a change in the final regulations in response to public comments.

More than eighteen months have elapsed since the FSDC resolution. RBI's compliance track record suggests an almost complete disregard for spirit of the resolution. Regulations continue to be issued unilaterally, without following the Handbook procedure. SEBI appears to be doing better, but it has a long way to go before its processes become state of the art.

An example of good regulatory governance in India: rule making at Airport Economic Regulatory Authority

The Ministry of Finance prides itself on having some of the best governance capabilities in India. However, better regulatory governance procedures are now found in some agencies outside the Ministry of Finance. As an example, consider the rule making process at the Airport Economic Regulatory Authority (AERA).

AERA, established in 2008, has been following a regulation making process that displays a level of transparency and organisation rarely seen in Indian financial sector regulators.

  • All orders issued by AERA are preceded by a two stage stakeholder process.
  • In the first stage a consultation paper is placed on the AERA's website seeking feedback, comments and suggestions. All feedback received, along with the names of parties giving the feedback and their detailed submission, is published on the regulator's website.
  • In the second stage, a consultation meeting is held, where stakeholders present and discuss their concerns and suggestions. The minutes of this meeting are also published on AERA's website.
  • If any subsequent communication takes place between AERA and any stakeholders, such as additional clarifications sought, these too are published on the website.
  • Only after the stakeholder process is completed, AERA issues the final order.

Further, the regulator's website transparently displays the list of consultation papers issued, the time given for public comments, the status of the stakeholder process and the status of the final order. The uniqueness of the AERA process is in the level of transparency and documentation that it provides. The entire process is available publicly, even those suggestions and comments that are contrary to the regulator's proposal. The volume of comments and level of detail contained in them, shows that the market participants are engaged in the regulatory process.

International best practices in regulation making

Financial sector regulators in jurisdictions such as the U.S. and Singapore define the standards of best practice in regulatory governance:

  • Monetary Authority of Singapore (MAS): For all proposed changes in regulations, a consultation paper is placed on the MAS website for public comments. The consultation document includes: (1) The rationale for the proposed regulation and the objectives of the measures being proposed, (2) A standard template for providing feedback, which allows respondents to indicate if they would like parts of their response to be kept confidential, and (3) The proposed regulation. A minimum of 30 days are allowed for public comments. After closure of the consultation process, MAS aggregates all public comments and responds to them. This document, published on MAS website, also indicates where MAS has agreed to change the proposed regulation based on public feedback or agreed to review it at a later date.

  • The U.S. Securities and Exchange Commission (SEC): The SEC rule making process starts with a public notice regarding its intent to consider regulatory proposals. This is followed by the release of the draft rules for public consultation. The proposed rule is accompanied by supplementary information which includes the rationale, the impact of the changes being proposed, an economic analysis and a compliance schedule. A minimum of 30 days are allowed for public comments, though, in most cases the period ranges from 60 to 75 days. All public comments and details of meetings held with SEC officials regarding the proposal are made available on the SEC website. The approval order for the proposed rule also shows SEC's consideration of the comments received, and an explanation, in plain and clear language, of what the rules would do.


There is a lot of interest in `good governance' that will `reduce the cost of doing business' in India. Where the rubber hits the road, in Indian finance, is the arbitrary power that is exercised by persons in financial agencies.

Good governance standards are critical to ensure confident participation in financial markets. When such standards are applied to the regulation making process, there is an overall increase in clarity and transparency. Participants become informed about the motivation and thinking at the regulatory agencies and also become prepared for the changes to come.

The process of seeking public comments engages the regulated entities, and the public at large in the regulatory process. It gives them a channel through which they can influence regulation framing. Publishing comments on regulators' website creates two way communication. It informs market participants whether their feedback is taken into account by regulators. Over time, if participant find that their comments are not considered, the volume of comments will decline. All these, over time, improve the effectiveness of the regulation making mechanisms. They place checks on the discretionary power in the hands of regulatory staff. They reduce regulatory mistakes, that may arise either through ignorance or corruption.

In adhering to good governance practices, the regulators also have an additional incentive to lead by example. Their adoption of such good governance standards improves their legitimacy when they seek similar compliance from their regulated entities.

In India, the lack of such regulatory governance practices is cited by both domestic and foreign participants as a reason for not increasing their use of the Indian financial system. The FSDC resolution was a first step where the regulators agreed, in principle, to adhere to good governance practices in regulation making. However, their actions over the last eighteen months belie their intent. In comparison to home grown entities like AERA, as well as in comparison to the Handbook and the international best practices for regulatory governance, both the RBI and SEBI fall short. Regulatory reform and capacity take time to develop and get fully entrenched, specially in an emerging economy such as ours. When both these regulators have fully built the capacity and systems to comply with sound procedures of regulatory governance, this will strengthen confidence and participation in the Indian financial system.

Wednesday, September 09, 2015

Bose committee on mis-selling

The policy discourse in personal finance in India has been shaped by two concerns. The first is that of the limited participation of households in finance. The second is the increasing evidence of mis-selling of financial products. At present financial products are regulated by multiple regulators who do not coordinate strategies. The sales channel sees different incentive structures emanating from different regulators for identical products. Product disclosures are often not transparent. Returns are not comparable, and costs get hidden. The standards of disclosures are different across regulators. This makes it difficult for customers to evaluate products. All of these contribute to mis-selling.

Mis-selling not only causes losses to customers, but also is likely to impact low participation. Consumer protection in finance has therefore become an important objective. The Ministry of Finance decided to set up a Committee, led by Sumit Bose, to go into these questions in detail. The Report of the Committee to recommend measures for curbing mis-selling and rationalising distribution incentives in financial products was released on 3 September 2015.

What the report says

The Report seems to have identified some core areas of concern, and made recommendations addressing each of them. These include:

Regulatory arbitrage
The key recommendation of the Committee is that regulation of financial products must be seen in terms of the product function and not form. These functions are Insurance, Investment and Annuity. The lead regulator, according to function, should fix the rules. In bundled products, the rules of each component should be set by the lead regulator. For example, in a bundled insurance product, the rules on the investment component should be set by the investment regulator, while the rules on insurance should be set by the insurance regulator. This will help remove distortions that result in investment oriented products from insurance being relatively expensive and opaque. The committee has suggested specific steps to create a level-playing field between all products, steps that are essential to curb mis-selling.
Improved disclosure
The Committee recommends that the way in which returns is computed should be standardised and should be a function of the amount invested. Returns in bundled products should be shown on the invested amount, and not on a third number such as sum-assured. Ongoing disclosure should show historical returns as an average annual number based on the IRR of the product. An average customer should be able to understand what the product costs, what the benefits are and for how long the product should be held. The norms of this disclosure for investment products should follow the rules set by the lead regulator. All disclosures should be machine readable. These measures are designed to help consumers compare products objectively and make appropriate choices.
Commissions and charges
Investment products and investment components of bundled products should have no upfront commissions. All investment products, and investment portions of bundled products, should move to an AUM based trail model. Upfront commissions on pure insurance products and pure risk portions of bundled products should be allowed, and should be decided by the lead regulator since pure risk is a difficult product to sell. Financial products should have flexible exit options. The cost of exit must be limited. The costs of surrender for each product should be reasonable. After deduction of costs, the remaining money should belong to the exiting investors. Lapsation profits, or profits from exit charges, if any, should not accrue or be booked by product providers. These measures will help align the interest of intermediaries with those of the consumers as the commissions will grow based on customer's tenure of investment, investment size and the returns earned.
Common distributor regulation
Regulators should create a common distributor (including employees of corporate agents) regulation. Each regulator may add rules specific to products regulated by them. Regulators should create a single registry of all distributors. Anybody facing the customer should be registered. The registry should identify each individual distributor with a unique number. The registry should have the past history of regulator actions and awards for each individual distributor. Strict penalties should be defined for distributors who are not registered. These steps will enable tracking of distributor actions across products and improve enforcement actions.

What is missing?

The report makes some important recommendations that should have a significant impact on the disclosures of product features, as well as incentive alignment between distributors and customers. Both these are fundamental to any regime that desires consumer protection in finance. There are, however, a few areas where the report falls short of going the full distance.

First, while the report recognises that regulation of products, and not of function, has led to regulatory arbitrage, and recommends regulations by the "lead" regulator, it does not go as far as to recommend moving away from product regulation. The only way to carry the thought process of the report through is to break with the present financial regulatory architecture, of having RBI/IRDA/SEBI as presently constructed.

Second, the report makes only cursory mention of the design of penalties on financial firms if they are found guilty of dubious sales practices. Regulation in India has focused on prevention, and largely ignored enforcement. This philosophy seems to have been carried over to the report as well. Only when bad behaviour is costly, will financial firms re-design their policies towards "good behaviour". Penalties designed by regulators are usually far too small compared to the benefits gained by firms and distributors through mis-selling. In addition, regulators are mostly reactive and impose penalties only after consumers complain. Regulators must establish mystery shopping programmes to find out the behaviour of regulated entities. Penalties should not only disgorge all potential profit from mis-behaviour but include some penal component which removes the incentive to repeat the behaviour. This component should be based on probabilistic models of getting caught and not on vague standards of "strict penalties." To implement such systems, regulators need to write detailed penalties regulations which consider the nature of the violation, the illegitimate gain and the probability of getting caught.

Third, the report does not adequately address the issue of composite products such as traditional insurance plans, which combine investment and insurance components. The management of assets of the pooled products make the product structure opaque. The way forward would have been for the assets of the investment portion of the product and the mortality portion of the product to be separately managed and kept independent of each other. This requires far-reaching change in the management of the investment pool for non-linked products. The report, sadly, has not been bold enough on this important aspect of the present retail market.

Fourth, the report should have placed a greater emphasis on requiring regulators and industry agencies to collect or create information in a way that supports downstream information processing and dissemination activities. While the report does require machine readable disclosures, it should have also stressed regulators to make publicly available disaggregated data to provide analysis to consumers and encourage creation of tools (mobile based apps etc) by third parties from the fintech industry, thus helping consumers make better choices.

Finally, the report leaves it to the regulators to frame a time-bound road map to implement the recommendations. This almost gives regulators a free pass at ignoring all that is in the consumers interest, as has been the case thus far. The report should have provided a road map with time lines for regulators to act upon.

The way forward

The report has attempted to address some of the basic issues and importantly has suggested specific measures that the government and the regulators need to take to address the same. These would be useful preparatory steps for the regulators and the industry as they gear up for the Indian Financial Code, which once enacted will provide for:

  1. A single financial agency to regulate securities markets, investments, insurance, pension, and all other financial services except banking and systemically important payments.

  2. A comprehensive framework of consumer protection to be implemented by financial service providers and the regulators. This framework would include rights and protections for all consumers, as well as some enhanced protections for individuals and small businesses. This consumer protection framework would seek to ensure adequate initial and continuing disclosures, minimising conflicts of interest, provision of suitable financial services, and protection against unfair conduct.

  3. A fully articulated rule of law framework for enforcing against violations and giving out punishments to financial firms.

  4. A single Financial Redress Authority to redress complaints of retail financial consumers in a speedy, inexpensive and predictable manner.

Tuesday, September 01, 2015

Payment bank entry process considered inconsistent with the rule of law

by Shubho Roy and Ajay Shah.

First best

Banking is the business of accepting deposits from the public with the promise of repaying such deposits on demand at an agreed rate of return. Payments is a distinct business from banking. A payment system is one which enables payment of funds to be effected between payer and a beneficiary. In the olden days, payments was primarily (though not entirely) the business of banks. In the modern world, banks should face competition from technology companies who will use modern telephony to do payments. These companies are bringing in a new business strategy of leveraging their client base and using analytical tools to provide a superior consumer experience.

The first best approach is to establish a regulatory strategy for payments which is not deferential to the business interests of banks,i.e. which has a level playing field between banks and non-banks.

Second best

The second best strategy is to invent the moniker `payments banks',which suggests some kind of entity which does payments and sounds like bank but isn't a bank. In this case, a mechanism is required through which new entrants will establish payments banks. Anything that we do in public policy in the Republic of India should be grounded in the rule of law. How would a rule-of-law entry mechanism work?

Under version1.1 of the draft Indian Financial Code, the legal process for considering an application for carrying out a new business is governed by Chapter 20. This induces the following procedure:

  1. The regulator has to make clear regulations on the criteria on which an application will be judged.
  2. Section 73(6) of the Code provides that before rejecting an application, the Regulator must provide a show cause notice to the applicant.
  3. Section 91 provides the details of how a show cause notice is issued and its contents.
  4. The Regulator must give an hearing, and provide all the material the Regulator relied on to come to its decision.
  5. The hearing will be before a staff member of the regulator, who is not involved in the actual evaluation of the proposal (separation between executive and and quasi-judicial functions)
  6. There will be detailed regulations on how the hearings will be carried out; the procedure will not be made up on the fly.
  7. If the applicant is unhappy with the decision of the regulator, the applicant may appeal to the Financial Sector Appellate Tribunal (FSAT).

This procedure yields the rule of law in entry of new firms.

Third best

The RBI recently announced that it has given "in principle" approval to 11 applicants for payments banks licenses. These were chosen from 41 applicants who wanted to start payment systems. The manner in which 11 payments banks were short-listed is inconsistent with the rule of law. It is not clear how the RBI came to the number of 11 payments banks, or why licenses were denied to the others.

Right at the outset of this process, it is not clear why RBI chose to use the Banking Regulation Act, 1949 to license "payments banks" when Parliament has made a separate law for governing payment systems under the Payments and Settlement Systems Act, 2007. Since paragraph iv of the payment bank guidelines do not allow such entities to undertake any lending activities, it is not even clear why RBI is classifying them as banks.

The RBI states that an external evaluation committee chose the 11. The RBI claims that the committee determined its own procedure and analysed the applications. Without casting any aspersions on the members of the committee, this is, sadly, not a due process of law.

The RBI notification claims that the committee screened the applicants for financial soundness, fit and proper criteria, physical outreach, business model innovation, capability of volumes of transactions and money and their proposed business plan. Additional data was also requested from the applicants. While this may satisfy a casual reader, these phrases are vague and empty. There is no explanation on how the committee evaluated each criterion mentioned in the paragraph. Were marks given for each criteria? Was there a pre-decided cut off marks below which licenses would be denied? What was the basis/system of providing marks or comparative ranking? How was innovation adjudged and comparatively scored/ranked between the 41 applicants?

In addition to these process failures described above, the RBI guidelines provide no review or appeal provision for rejected applicants. This is also a violation of the rule of law.

Compare and contrast this with examples for the existing legal process for selection/short-listing in the government. If you apply for a driving license and it gets rejected, you get a specific reason for the rejection. The Motor Vehicles Rules specify what the department tests. The Motor Vehicles department does not state "the driving instructor will formulate his/her own procedure for determining the competence of the driver". Giving out licenses to payments banks is more important than giving out driving licenses; the quality of procedure at RBI should be even more thorough than what is done by Motor Vehicles departments all across India.

Look at the UPSC exams which select the senior most officials for all of Government of India and State Governments. There is a set syllabus. The rules about how marking is done are stated before the exam. There is a clear system of assigning ranks. After the examination, the answers are also published for examinees to determine their scores independently and more importantly to understand where they went wrong. The process has a subjective part of interviews; but that forms a smaller component of the overall evaluation which is predominantly objective.

The process used for the entry of payments banks is strikingly different from the quality of governance seen in main line government. It is, however, disturbingly similar to the process of allocating coal blocks through a Screening Committee, which the Supreme Court has held unconstitutional on the grounds that:

  1. The allocation procedure followed by the Screening Committee was arbitrary.
  2. No objective criterion was used to determine the selection of companies.

The Supreme Court found:

The approach had been ad-hoc and casual. There was no fair and transparent procedure,...

The Supreme Court judgment gives much insight into the governance problems of RBI, and the concepts that drive the draft Indian Financial Code. It should be noted that the much criticised procedure of the coal ministry was ahead of RBI on good governance procedures in that they released the minutes of the meetings of the Screening Committee while RBI did not.

So far, we have discussed how RBI has run the licensing process. Now we turn to the RBI concept of a scarce number of licenses. Entry problems in public policy fall into two kinds:

  1. Allocation problems: Where the resource is a limited resource and the number of claimants are more. The system preferred by governments in these types of situations is usually auctions with allocation to the highest bidder. This is used for situations like coal mines or spectrum allocation.
  2. Licensing problems: These are activities where the entity carrying out the activity needs to have certain minimum qualifications. If such qualifications are absent then there is a risk that the activity may generate substantial negative externalities. As an example, an untrained driver may kill innocent bystanders.

Some problems are combination of the two, like the UPSC exams where you need skilled civil servants and the number of positions are limited. In those circumstances, scoring plus comparative ranking is the standard method.

The payments bank licenses are not an allocation problem. There would be no problem if there were 30 payment banks instead of 11. It would have promoted more competition and reduced costs to consumers. The arbitrary setting of numbers of payment banks harks back to the days of the Aluminium Control Order or Steel Control Order or the other Control Orders and Industrial Licenses which plagued the Indian economy before 1992. These laws set arbitrary production quotas and licenses for manufacturing without any rationale. A crucial part of our reforms of 1992 was removing the quotas and industrial licenses. Anyone can start a steel mill now or produce aluminium. there is no limit to the number of steel mills the government will allow.

Even if you were to consider the entry of payments banks as an allocation problem, there is an important governance failure right at the outset. Nowhere in the guidelines for payments banks (or any document that we could find in the public domain) is there any mention of the magic number 11. This is akin to the UPSC deciding on the number of students to take in after the exam. The arbitrariness of the decision is inconsistent with the rule of law.

A climate of fear

One may wonder why no one stands up against these violations of the rule of law. The problem is, without a statutory or regulatory right to appeal, it is dangerous to go against a regulator in India. Even if you win in court, you would then be under the regulation of the same entity you vanquished in the High Court. In a non-rule-of-law situation, where the financial agency has wide and arbitrary powers, that is not a condition you would enjoy. Unlike other regulators (SEBI, IRDA, PFRDA) there are no statutory appeals under the RBI Act against the decisions of the RBI. Regulated persons feel safe dragging SEBI to SAT as SEBI operates in a rule of law environment and is not able to exact retribution through devious methods.

On this subject, see the recent article The rule of law in the regulatory state by John Cochrane. For an example of better governance found within India, consider SEBI. When a person applies to become a stock broker SEBI grants the broker a hearing before rejecting the application and even allows the broker to apply for a reconsideration (See Regulation 8 here). After that, the broker can appeal to the Securities Appellate Tribunal.

Subjects versus citizens

RBI gives hope to the industry through the following paragraph in the notification on approvals:

Going forward, the Reserve Bank intends to use the learning from this licensing round to appropriately revise the Guidelines and move to giving licences more regularly, that is, virtually "on tap". The Reserve Bank believes that some of the entities who did not qualify in this round, could well be successful in future rounds.

This has two shortcomings:

  1. The minimum standard of objectivity required under Article 14 of the Constitution is not dependent on the convenience of RBI. A regulator has to meet a minimum level of objectivity under the Constitution. It may improve upon it, but that does not allow it to deny it to the applicants at the present.
  2. The consolation to the "failed" participants is in itself an admission of the lack of faith of RBI in the process. A more inclusive and consultative mechanism may have developed a more objective criteria for selection. Even RBI itself seems not to be sure about the legality of the present process when it says that the failed entities may be successful in the future. It seems unsure about the reasons why these entities were rejected.

For an analogy, we would not accept a Coal Ministry which first gave out 11 coal mines through a clubby process, which violates the rule of law, and said that in the future it will adhere to the Constitution.

The promise of future "success" is clouded by dangers for the 30 unsuccessful aspirants. The first set of 11 may rapidly develop their business. In network industries, subsequent entrants face an uphill task of competing against the entrenched incumbents. In addition, RBI makes no promises about when the next round of licenses will be awarded. From 1949 till 2015, RBI was not able to learn how to do on-tap licenses for banks. Hence, there is no telling how many decades of a head start these 11 payments banks will get. The harm imposed upon the unsuccessful applicants could be arbitrarily large. Under the rule of law, State actors can only inflict harm after following certain sound processes.

The problem of learning

As emphasised above, the Constitution of India does not give rope to any part of the State to violate the rule of law while it is learning.

It is hard to see what was difficult about developing a sound rule of law framework. The steps required are quite elementary:

  1. RBI staff could have read the Indian Financial Code and used the procedure there.
  2. SEBI has long had sound entry procedures. RBI staff could have just studied SEBI and emulated them.
  3. These procedures could have been validated against ample international experience which is on the web. UK regulations are available here, in the U.S. it is usually governed under state laws and the New York regulation process is available here. Australia regulates some payment systems under deposit taking regulations which can be seen here.

Saving capitalism from the capitalists

A nimble new set of technology companies want to challenge an inefficient incumbent: the existing sleepy world of payments as done by banks. Both industries have one regulator -- RBI -- which is captured by the interests of incumbents. It has not permitted the new players to compete with the incumbents. In an age of great concern about crony capitalism, uncomfortable questions are raised when six out of 11 new entrants are big business houses, and the competitive energy of technology companies has been largely shut out. Many names in the list of 11 which appear new to this field have partnerships with incumbent banks -- e.g. Reliance with SBI, Fino with ICICI Bank, Airtel with Kotak Bank, etc.

How do we save capitalism from the capitalists? The rule of law is a necessary, though not sufficient, condition for a competitive economy where rich families and dominant firms face vigorous competitive pressure. The Constitution of India is a great tool for addressing our problems of cronyism.

At the same time, mere emphasis on rule of law procedures is not a sufficient condition for doing sound economic policy. A great deal of thought and care needs to go into the work, so as to ensure that good outcomes are obtained. E.g. it's easy to do a formal rule of law process which insists that any applicant for a payments bank must be a software company with over Rs.1 trillion a year of revenue. All the formal processes can be easily run with this criterion. But it will give us the wrong outcome. The rule of law is a necessary, but not sufficient, condition to get sound outcomes.

While the RBI Act, 1934, predates free India, in 1949, the Constitution of India established the rule of law in India. SEBI has long had a more evolved system on the entry of mutual funds. In 2013, the draft IFC was released, and offered a substantial step forward where the rule of law was integrally brought into all aspects of financial economic policy. Sound entry procedures are in Chapter 9 of the FSLRC Handbook. In 2014, this critique of RBI permitting two persons to start a bank came out. In this backdrop, the process failures with payments banks constitute an avoidable failure.


It is better to have 11 new payments banks than to have none. However, there are important intellectual failures in what was done, on questions of economics and on questions of law.


Supreme Court of India, Manohar Lal Sharma vs The Principle Secretary & Others, judgment dated 25th August, 2014

Ministry of Finance, Revised Draft Indian Financial Code for Public Comments

John Cochrane, The Rule of Law in the Regulatory State, The Grumpy Economist, 1 August 2015.

Ajay Shah, Rule of law and competition in banking, Economic Times, 9 January 2014.