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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.


  1. Super important problem.
    I once filed a complaint against SEBI about an unjust regulation asking them to change it as it made no sense whatsoever. I also gave them the opportunity to explain why that regulation was in place (there was no information available). They asked for my broker details in response. I told them that the complaint was not about my broker but about them. They didn't understand, they forwarded the letter to my broker. The broker replied to them telling them that the customer (me) didn't have a problem with the broker but with the regulator. They still didn't get it. Their next reply was to ask for my account id. At that point, I gave up.

    SEBI and RBI really need to incorporate the public accountability measures outlined in this article asap. Very urgently needed. The ombudsman complaint systems need to accept complaints about the regulators too, not just the entities they regulate.

  2. Excellent piece. Well put. Highlights how broken the system is.

  3. Another enlightening post on Indian Financial System. These issues are hardly talked about. What a pity that that FSLRC/IFC has been reduced to constitution of MPC which s just gibberish in the overall schema of things..


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