Occam's razor of public policy

by Ajay Shah.

Occam's razor is the idea that when two rival theories explain a phenomenon, the simpler theory is to be preferred. Aristotle's epicycles fit the data as well as Kepler's ellipses, and a pure empiricist could have been agnostic between the two. Occam's razor guides us in preferring Kepler's ellipses on the grounds that this is a simpler explanation.

In the world of public policy, a useful principle is:

When two alternative tools yield the same outcome, we should prefer the one which uses the least coercion.

Example: Punishment

When we want to drive the incidence of a certain crime to the desired rate, we want to find out the lowest possible punishment that gets the job done. You can reduce theft to desired levels by promising to cut off the hand of the thief. We would much rather achieve the objective using a reduced use of the coercive power of the State, with mere imprisonment.

The purpose of punishment is deterrence, not vengeance. And, in the class of deterrents, we seek to find the smallest possible use of the coercive power of the State that gets the job done.

Suppose 4 years of imprisonment and 2 years of imprisonment are equally able to get the incidence of a particular crime down to the desired level. Suppose a person says: I am not a liberal; I am not squeamish about using the coercive power of the State; I hate the people who commit such crimes; I don't care whether they get 2 years or 4 years in jail. But an $\alpha$ fraction of all convictions are in error. In these cases, we are inflicting the punishment upon an innocent. The harm is minimised when we have deployed the lowest possible punishment.

Example: Spending on government programs

All government spending is grounded in taxation, present or future. All taxation is grounded in the coercive power of the State. If there are two different spending programs that get the job done, we should favour the one which spends less.

Example: Infrastructure bonds

When the market for infrastructure bonds in India does not work, too often, solutions are proposed which use extreme force. Some people propose tax breaks. Some people propose harsh interventions such as forcing every bank to buy infrastructure bonds or forcing every bidder to NHAI to issue infrastructure bonds. As an example, we in India force insurance companies to buy infrastructure bonds.

If, on the other hand, we trace the failures of financial sector policy which have held back the market for infrastructure bonds, this would show how to get the job done while actually reducing State coercion (i.e. getting the State out of inappropiate coercion).

Example: The journey to cashless

Cash is an abomination and we should have a thousand flowers of electronic payments blossoming. India is one of the most backward places in the world in the domination of cash.

Tax breaks for electronic payments or high taxes for cash transaction or outright bans of cash transactions: these are all ways that get the job done using a lot of force.

If, instead, we understand the failures of financial sector policy which have hobbled the sophistication of payments in India, we will get the job done while actually reducing the use of the coercive power of the State. We would have less cash in India if RBI did not use the coercive power of the State to block the clever Uber cashless transaction.

Example: Family welfare

A government which runs counselling services on family welfare is using less coercion when compared with forcible sterilisation or a one-child policy.

How to reduce the use of coercion: go to the root cause of a market failure

Market failures can be addressed in many ways. When we go to the source, with well understood causal claims about the source of the market failure, we will find ways to address the market failure using the smallest use of the coercive power of the State.

If we don't have a deep understanding of the sources of the market failure, we may often end up hitting a symptom rather than the disease. Getting the job done may then require the use of a lot of coercion.

As an example, for some market failures that are rooted in information asymmetry, if an intervention can be found which rearranges the structure of information, this can get the job done using the least coercion.

Why are big punishments often favoured in India?

A person who thinks of violating a law to obtain an ill gotten gain $G$ faces a probability $p$ of being caught and the fine imposed upon him will be $F$. Standard economic arguments suggest that we must set $F = G(1-p)/p$. In this case, the expected gain from violating the law is 0, and a risk averse person will favour the certainty of compliance over the lottery of breaking the law.

In India, too often, the executive works poorly and $p$ is quite low. This creates a bias in favour of driving up $F$. This is giving us very large penalties. This induces its own problems. We are inflicting terrible harm on the $\alpha$ fraction of innocents who are wrongly convicted. We are giving great power to front-line investigators and judges at a time when institutional capacity is low.

If we are able to build institutional capacity for enforcement, and $p$ goes up, we will then be able to come back to lower punishments that generate adequate deterrence.

Why does Occam's Razor of Public Policy make sense?

1. It is consistent with the liberal philosophy that desires that humans should be free to pursue their own life with the minimum interference.
2. At best, governments work badly. The information available to policy makers is limited, many wrong decisions are taken, many decisions are poorly implemented. Governments do not know the preferences of citizens. Politicians and officials are self-interested actors and work for themselves. The Lucas critique comes in the way: rational actors change their behaviour when policy changes take place in ways that confound the original policy analysis. Many government actions fail to achieve the desired outcome, but they always have unintended consequences.
   
   It's good to be humble, and swing the smallest stick that would get the job done.

Limitations

All this, of course, presupposes that all use of coercive power of the State is a purposive activity aimed towards achieving a certain well specified objective. This is not always the case. As an example, the objectives of exchange rate policy or capital controls are hard to decipher. Before we get to discussion of more coercion vs. less coercion, it would be a great step forward if all government intervention were fully articulated in terms of market failure, objective of the intervention, demonstration of the causal impact of the intervention upon the objective, and cost-benefit analysis.

The examples above have featured comparisons where more versus less coercion is easy to identify. Amputation of the hand $>$ imprisonment for 4 years $>$ imprisonment for 2 years. Forcing banks to give out 40% of their loans into priority sector lending is more coercion than information interventions which make the credit market work for poor people. Opening up to private and foreign telecom companies is a way to get phones to everyone with less use of State coercion when compared with forcing banks to open accounts for everyone.

In many situations, however, it is not easy to identify which of two alternative policy pathways involves more coercion. A government program which educated parents that their kids should get immunised seems to involve lower coercion when compared with a forced immunisation program, but this is perhaps not the case when we envision an education program that must generate eradication of polio. A government program to educate young people about saving for old age involves less coercion than forcible participation in the NPS.

Conclusion

The State has a monopoly on violence and is the only actor who can coerce citizens to do things against their will. All public policy initiatives involve the use of the coercive power of the State. In the field of public policy, we should be humble about our lack of knowledge, respectful of the freedom of others, and use this power as little as possible.

Acknowledgements

I am grateful to Jeff Hammer, Shubho Roy and Renuka Sane for useful conversations.

Land market reform is an important enabler of bankruptcy reform

By K.P. Krishnan, Venkatesh Panchapagesan and Madalasa Venkataraman

In India, it seems easy to lend money, but it is difficult to get it back. Just ask our banks. New law, and associated institutional infrastructure, for bankruptcy is in the pipeline, with the draft Insolvency and Bankruptcy Code by the T. K. Vishwanathan Committee. Will it work? What can the impediments be that could limit its effectiveness?

One of the key weapons in a lender's armoury is the collateral (or security) from the borrower. The quality of the collateral - how easy it is to collect, store, value and dispose of - determines the type and extent of credit that a lender is willing to provide. Land and associated real estate constitute a large part of collateral in India. More than 50 percent of corporate loans and 60 percent of retail loans have land and real estate as collateral. It is hence important to understand the complex nature of land markets to determine whether they would facilitate or undermine the effectiveness of these new laws. We examine this issue in a recent paper titled Distortions in Land Markets and Their Implications to Credit Generation in India.

The land market in India is not a homogenous national market but a heterogeneous collection of various State markets with variation in laws and regulations. This is because land related issues fall under the State and Concurrent List under our Constitution. This poses the first big problem: it is not easy to provide credit across state boundaries unless lenders have local presence or partners to count on. Even when land is accepted as collateral, several factors exist that could raise costs and risks for lenders. Let's run through the list of challenges faced by the lender.

Challenge 1: Does the land belong to the borrower?

It is hard to say because titles are not guaranteed by the State (like the Torrens system used in countries like Australia). Hence, all evidence of title is merely presumptive and can be challenged at any point by a person claiming to have better title to the land.

To mitigate the risk of future challenges to title, lenders spend considerable resources, including legal help, to conduct title searches, to protect themselves. A title search can be a fairly complex and expensive exercise in the Indian setting. This is because:

1. Indian law does not mandate the registration of every single transaction that affects rights in or the enjoyment of, property. Hence, records of some transactions that affect title or enjoyment of property will not be found in any public office.
   
   
2. Land records in India are spread across three offices - the Sub-Registrar's office, the revenue offices and the offices of the survey department. Time lags between these offices in updation of land records, often lead to inconsistencies in information obtained from these three offices.
   
   
3. Title related disputes in courts require a search process in the courts, as the status of the dispute may not be reflected in the records in the Sub-Registrar's office or the revenue offices.
   
   
4. A title search is necessarily a local exercise, as land records are maintained in local offices in local languages. The contents of land records across States are not standardised. Several State laws have restrictions on the transferability of land, depending on the land classification. For instance, in most States, agricultural land cannot be transferred to a non-agriculturist. The localisation of the title investigation process adds to transaction costs.
   
   

Lenders do not have recourse to a private title insurance industry in India. Interestingly, even in countries that follow Torrens system of state guaranteed titles, there is an increasing trend for lenders to seek private title insurance (Zasloff, 2011). Hence, lenders in India have to rely on title searches conducted by independent title investigators. This raises transactions costs and particularly hampers small loans.

Challenge 2: Has the land been already pledged with other lenders?

There is no single point of information on all the processes and transactions that can encumber land. Again, some transactions which create encumbrances on land (such as the mortgage by deposit of title deeds) are not required to be registered. Consequently, the records of such mortgages cannot be found in any public office.

The Central Registry of Securitisation Asset Reconstruction and Security Interest of India, or CERSAI, was set up to consolidate information about mortgages against property. However, its scope is limited: it does not include reconstruction loans outside the purview of the SARFAESI Act or loans given out by entities other than banks. Nor does it have information about all loans issued prior to 2011 when CERSAI was set up. Further, since the registry requires identification of land clearly, the importance of accurately mapping land boundaries becomes critical for its success. Accurate mapping of land boundaries has its own set of problems as described next.

Challenge 3: Is the land properly identifiable in classified records?

Land parcel identification is a challenge since cadastral maps are outdated and rarely reflect the reality on the ground. As mentioned above, record-keeping of various related aspects of land - titles and registrations, encumbrances, geographic information sources, revenue and taxation - is done in silos by various departments, often leading to conflicting information on the same land parcel. The problem is more acute in rural areas, where use of technology is still limited. The use of different units (acres, hectares etc.), terms (like Khata in Karnataka and Patta in Tamil Nadu) and bookkeeping standards across states present their own set of difficulties in identifying land across States, thus hampering the economies of scale of running a nationwide lending business.

Challenge 4: Do the constructions/settlements on the land adhere to local laws, and have all dues been properly paid?

Important attributes such as flood plain, seismic zone, lake encroachments, easements and rights of way etc. also cannot be conclusively established given the siloed nature of record keeping. If not properly accounted for through pricing, these attributes could pose significant risk to lenders. The recent announcement in Bengaluru that several lake beds have been encroached by entities including the Bangalore Development Authority - the agency obligated to protect lake beds - shows the extent of risk to lenders who have financed development activity on such land.

The problem is exacerbated where the collateral is built-up property. In the case of built-up collateral, the lender is also required to verify whether the building complies with city-level zoning regulations and has the requisite building permissions. This is to avoid the possibility of the future demolition of the collateralised property which is not compliant with the local laws. The value of the collateral may also change depending on issues such as the area on the land, if any, earmarked for municipal road widening, changes in town planning norms, etc. This requires searches in the local municipal offices.

Challenge 5: Is the value of land sufficient enough to cover the loan in case of distress?

Land valuation is done by lenders at the time of loan origination, and after the borrower has exhibited distress. Empanelled valuers use a combination of recent transactions and government estimates (called guidance values or circle rates) to derive land values that are used by lenders. Given the significant presence of black money in land transactions, getting true market values is more an art than science. Issues such as defective land title and illegal developments, mentioned above, impede land values but are hard to account for at the time of origination of the loan.

Challenge 6: If there is default, can the land be sold to recover dues owed easily?

The battle to recover the collateral really begins after default. The SARFAESI Act has shortened the recovery process for banks and financial institutions. However, it leaves out creditors who are not banks and financial institutions such as creditors of firms which have borrowed through secured bond issuances. For such creditors, a mortgage foreclosure suit will, under current law, have to go through the delays associated with civil courts. Moreover, the implementation and interpretation of the SARFAESI Act has not been free of problems. For instance, proceedings under the SARFAESI Act are often delayed through writ petitions or simultaneous proceedings which are pending in other fora (Ravi, 2015). Similarly, the SARFAESI Act does not resolve the problems of already encumbered collateral or collateral with no marketable title. For example, a bank or a financial institution cannot evict tenants of collateralised property under SARFAESI. This proposition was recently upheld by the Supreme Court in Vishal Kalsaria v. Bank of India and Others, January 2016.

Conclusion

Bankruptcy reform is important and valuable in and of itself. Land market reform is important and valuable in and of itself. Given the prominence of land as collateral in the working of the Indian credit market, improved working of the land market is an important enabler of a better functioning credit market and improved working of the bankruptcy code. Parallel and simultaneous progress on both fronts will yield a magnified impact upon the economy.

While the Bankruptcy Code is expected to improve recovery proceedings, it will not help where the title to the collateral itself is challenged at the time of recovery. Unlike movable collateral, the ability of a creditor to monetise immovable collateral quickly is fettered. Indian lenders have, so far, rationally responded to these issues by protecting themselves through credit rationing and through solutions like personal guarantees. Also, due to the difficult process of establishing title and related encumbrances, urban lands - where recovery time and cost are high - are subject to higher loan to value ratios.

One part of the reforms agenda is structural, and involves significant fiscal outlays, for cleaning up land titles, improving the quality of land registry through digitisation, overhauling the land litigation system and creating efficient stamp duty and registration processes. In addition, in the paper, we propose many modest, feasible and less expensive reforms. To begin with, we must standardise land-related data capture across states and create a repository of valuers' data that can be shared across lenders. Similarly, States need to focus their energies on building capacity in land record offices to enable smooth and efficient updation of land records. While creating conclusive titles with state guarantees is a laudable and ultimate goal, there are numerous opportunities for front-loading gains by streamlining existing land records using modern technology, and facilitating private title insurance to mitigate risk from lending against land.

Most of the challenges described above relate to the structure of information. Modern technology -- computers, telecom networks, GPS, Aadhaar, ubiquitous digital cameras -- has created a new opportunity to build improved institutional infrastructure for creating, storing and disseminating information that would transform the land market.

References

Aparna Ravi, The Indian insolvency regime in practice -- an analysis of insolvency and debt recovery proceedings, Economic and Political Weekly, 2015.

J. Zasloff, India's Land Title Crisis: The Unanswered Questions, Jindal Global Law Review, 2011.


K. P. Krishnan is at the Department of Land Resources, Government of India. Venkatesh Panchapagesan and Madalasa Venkataraman are researchers at the Indian Institute of Management, Bangalore.

Draft IRDAI regulations on insurance commissions: Going back to the beginning

by Ashish Aggarwal and Renuka Sane

On 13 January 2016, the Insurance Regulatory and Development Authority of India (IRDAI) released the draft (Payment of commission or remuneration to insurance agents and insurance intermediaries) Regulations, 2016 and invited public comments. The regulations propose a substantial increase in commissions for life insurance distributors starting April 2016.

In their present form, the proposals will be detrimental to consumer interest, increase the regulatory arbitrage in favour of products regulated by the IRDAI and undermine the recent attempts by the government towards curbing mis-selling and rationalisation of incentives for financial product distribution.

The regulations are intended to govern payments by an insurance company to individual agents or intermediaries (which include corporate agents, insurance brokers, web aggregators, insurance marketing firms, and any other entity as may be recognised by the IRDAI) for soliciting and procuring an insurance policy. Payments may be in the form of a commission (paid to agents), remuneration (paid to intermediaries) or a reward (any direct or indirect benefit over and above the commission). The Bill proposes that the Board of every insurance company will approve the commissions and reward policy. The draft Regulations propose two big changes.

Big change 1: Raise the overall commission rates

For bundled products, such as ULIPs and traditional plans, with a tenure of twelve years or more, an insurance company would be able to pay intermediaries 49% of the first year premium as commission and reward. This cap is proposed at 42% for insurance agents (See Table). The commissions for subsequent years has been increased to 7.5% of premium for year 2 to 6. Earlier, the cap from year 4 onwards was 5%. The 5% cap is now applicable from year 6 onwards.

Pure risk cover, or term plans, will have a maximum first year commission rate of 50% for policies of tenure 12 years or more. For those between 5 and 11 years, commission will be capped at 40%. Subsequent year commissions will be capped at 10%. The addition of rewards to these implies that the maximum cost cap for term policies of duration 5 to 11 years will become 48% for agents and 56% for intermediaries. For policies more than 12 years, the caps will be 60% for agents and 70% for intermediaries.

First Year Life Insurance Commissions and Rewards
Category	Proposed	Existing
Policies with premium paying term of 5-11 year:	ULIP/ Traditional - 42% for intermediary and 36% for agent Term - 56% for intermediary and 48% for agent [Note 1]	15% to 33% based on premium paying tenure of the policy [Note 2]
Policies with premium paying term of 12 years and more:	ULIP/ Traditional - 49% for intermediary and 42% for agent Term - 70% for intermediary and 60% for agent [Note 3]	35%
Note 1: Commission:- 30% of premium (ULIP/Traditional), 40% of premium (Term), Reward - 20% of Commission for agent and 40% for intermediary.
Note 2: Tenure and Commission:- 5 year - 15%, 6 years - 18%, 7 years - 21%, 8 years - 24%, 9 years - 27%, 10 years - 30% and 11 years 33%.
Note 3: Commission:- 35% of premium (ULIP/Traditional), 50% of premium (Term), Reward - (20% of Commission for agent and 40% for intermediary).

Big change 2: Bring in hereditary commissions

These are being reintroduced. Section 54 of the The Insurance Laws (Amendment Act), 2015 had removed section 44, according to which, if an insurance agent had served for more than 5 years, the commissions had to be paid to the heirs of the agent, even if the agent was no longer servicing the policy.

Problems with the draft regulations

Ignores all evidence on the perverse impact of high commissions

Research has shown that the incentive structure of agents has played a large part in the mis-sale of financial products. When agents get remunerated by the product provider, the incentive comes not from higher sales driven by customer satisfaction, but from commissions paid by the product provider. The product that pays the higher commission is the product that gets sold. This is not always in the interest of the customer. The world over, the response of regulators has been to ban conflicted remuneration structures, and/or impose requirements on ensuring the suitability of the product to the customer. Against such a background, the IRDAIs proposal to increase commissions, and also not impose any suitability requirements seems misplaced. This is particularly relevant as metrics of performance such as persistency and lapsation of policies have been steadily worsening.

Increases regulatory arbitrage

The same insurance distributor is likely to be selling other products like mutual funds and New Pension System which at their core are long term investment products. The commission structure for mutual funds is based on asset based trail fee. This results in relatively much lower commissions in initial years which could grow into substantial sums after say, 10-15 years, provided the customer stays into the scheme and invests regularly. The commission structure for NPS distributor provides for a nominal flat transaction fee and a 0.25% fee on amounts invested. A distributor is naturally incentivised to push insurance plans irrespective of suitability for the consumer. A consumer would be more likely sold a traditional insurance plan than a basket of NPS, mutual fund and term insurance. This makes selling difficult for the mutual funds and NPS. The proposed regulations are likely to further skew the markets.

Does not realign the pure term and bundled insurance products

It would be misleading to assume that the regulations incentivise sale of term insurance products by providing for higher commission rate as compared to ULIPs and traditional investment oriented plans. A term plan of Rs.1 crore for a 35 year old would cost Rs.13,000. At 70% of premium, Rs.9,100 should be a very attractive first year commission given that these products are apparently more difficult to sell as compared to investments. However, even if the initial commission rates on ULIPs and traditional plans were much lower, say 10%, these could still be more attractive for distributors to sell than term plans. For example, premium for ULIP/ traditional plan with a similar insurance cover would be about Rs 100,000 and even a 10% commission would fetch Rs.10,000. Of course, these are basically investment products with only a small portion of the premium going into insurance component. The raising of commissions on pure term along with that of bundled products does not alter the skew against the sale of pure term products.

Poor process

The draft regulations provide an approach which has gone into the formulation of the regulations. They do not, however, provide a rationale. How would these regulations benefit the consumers? In less than one year of the Insurance Laws (Amendment) Act omitting hereditary commissions, it is not evident why these are now proposed to be brought back through regulations? Regulators such as RBI, SEBI, have shown a poor track record in following regulation making processes. Regulations on fund management, and regulations on aggregators of the NPS, by the PFRDA have also raised similar concerns. The IRDAI draft regulations are yet another example of the failure of the attempts by the Government to encourage regulators to frame regulations as laid down in the Handbook on adoption of governance enhancing and non-legislative elements of the draft Indian Financial Code.

Another recent committee's recommendations on commissions

It would be useful to look at the recommendations on similar issues of another recent committee setup by the Government of India and headed by Sumit Bose, Former Union Finance Secretary. The report has recommended doing away with the practice of front loaded commissions. It noted that these created perverse incentives for distributors to push products with higher upfront/ first year commissions, increased regulatory arbitrage and proved expensive for the consumers. The committee's recommendations provided that:

1. There should be no up-fronts for the investment part of the premium. The investment part should attract only AUM based trail commissions. The trail commission treatment should be decided with consultations with the lead regulator in the market-linked investment space. These should be level or declining.
   
   
2. Upfront commissions should be allowed only on the mortality part of the premium.
   
   
3. Distributors should not be paid advance commissions by dipping into future expenses, their own profit or capital.
   
   
4. The illegal practice of rebating should be punished harshly by the regulator as it distorts the market.
   
   

In its present form, the IRDAI draft regulations ignore all the recommendations of the Bose Committee report.

Way forward

The disjointed approach as apparent in the draft IRDAI commission regulations is not in consumer interest. A useful approach would be to:

1. Fix the commission structure for the distributors based on the  recommendations of the Bose Committee.
   
   
2. Improve the regulation making process. Inviting public comments on draft regulations is a great step but mere existence of a public consultation process does not mean that the public will spend time and resources to comment and participate in the exercise. When the final regulations get released, the IRDAI should take care that these are accompanied with a proper explanation of (i) what exactly is being changed; (ii) evidence that has been relied upon to propose the changes and (iii) expected impact of the regulations on key stakeholders like consumers and sellers.

Ashish Aggarwal is a researcher at the National Institute for Public Finance. Renuka Sane is a researcher at the Indian Statistical Institute.

Concerns about compliance with IRDAI regulations by insurance companies

by Sumant Prashant and Renuka Sane

Before choosing to buy any product, we want to know what the product is actually offering for the price, and how it suits our requirement and taste. For this comparison to work, we need information that a) describes truthfully all the features, or at least the material features, of the product and b) allows us to compare similar features across competing products. As the Bose Committee Report pointed out, when a financial, and especially an insurance product advertises its product features, it is not clear that the advertisement correctly represents the product. Sometimes advertisements are blatantly misleading. Sometimes, they are just hard to decipher. This environment of opaque disclosures has contributed to episodes of mis-selling, and losses to customers.

To address the problem of misleading advertisements, IRDAI issued a Master Circular on advertisements on 13th August 2015. The Master Circular aims to achieve two objectives - (a) make advertisements/sales material more accurate, comprehensive and reliable for the benefit of insuring public and; (b) set out minimum standards to be followed by all insurance companies for advertising and soliciting insurance business. In this article we summarise the Circular, and evaluate compliance by five randomly picked advertisements.

The IRDAI Master Circular on Advertisements

The Master Circular divides advertisements into two categories based on their intended purpose:

• Institutional Advertisements are meant to promote the brand image of the insurer company.
  
  
• Insurance Advertisements are meant to solicit insurance business and therefore provide more details about the product, such as name and benefits of the product and financial performance of the insurer company. Insurance Advertisements are further divided as
  
  
  • Invitation to Inquire advertisements, which only provide basic information about the product and advise the customer to refer to a more detailed brochure.
    
    
  • Invitation to contract advertisements, which contain detailed information about insurance products and induces prospective or existing consumers to purchase them.
    
    

Of these, Insurance Advertisements are critical in influencing the purchase decision of a customer. They also have the potential of being misused by insurance companies through projection of exaggerated benefits or non-disclosure of important terms and conditions of a product. The Master Circular, therefore, provides detailed do's and dont's for Insurance Advertisements. Some of the requirements for an advertisement are:

1. The product should be identifiable as an insurance product, disclose risks, limitations and exclusions of the product.
   
   
2. The benefits of a guarantee, when advertised, should also mention the cost and charges of the guarantee. If conditions of guarantee are elaborate, the advertisement should be accompanied by conditions applicable to the guarantee in specific font size.
   
   
3. If promise, projection or past performance are mentioned, this should be accompanied by assumptions, sources of information and the statement that past performance is not an indication of future performance.
   
   
4. If tax benefits are mentioned, this should be accompanied by statement that tax laws are subject to change.
   
   
5. If a ranking or award is advertised, this should have been awarded by an agency independent of the insurance company which is advertising.
   
   
6. Viewers of Internet advertisements should be able to view all the key features of the product.
   
   
7. Insurer's website should flash a cautionary notice about spurious calls and fictitious offers.
   
   
8. In case of ULIPs, the asset mix of various underlying funds, approved asset composition and pattern should be placed on website on half yearly basis.
   
   
9. In promoting product combinations, all particulars of each product should be disclosed with an advice to refer to the sales brochure.
   
   

Evaluating Compliance

We examined 5 advertisements posted recently on the Facebook pages of leading insurance companies that fall into invitation to inquire category of advertisements, to ascertain the effectiveness of the Master Circular. Though these advertisements provide a weblink through which more details about the products can be accessed, they still have to comply with requirements of the invitation to inquire category of advertisements. The requirements placed by IRDA of these advertisements is less demanding, relative to the invitation to contract category of advertisements. We also focus on those aspects of the Master Circular that are clearly written and leave no ambiguity regarding their interpretation. The Table below shows how well the five advertisements we studied comply with the Master Circular. We find that:

1. Some of the requirements which seem easy to implement, like mentioning the registration and UIN number have not been satisfied.
   
   
2. Some advertisements did not mention that the product is an insurance product.
   
   
3. Some advertisements did not publish an unique identifiable reference number.
   
   
4. Some of advertisements did not follow the font and appearance requirement provided in the Master Circular.
   
   
5. Some advertisements did not include the disclaimer mandatorily required by regulations.
   

Here is the summary of the analysis of five advertisements:

	AD 1	AD 2	AD 3	AD 4	AD 5
Registration number	No	No	No	No	Yes
Product identified as insurance product	Yes	Yes	No	Yes	Yes
Unique Identifiable reference number	Yes	No	No	No	Yes
Mandatory disclaimer	No	No	No	No	Yes
Font	N.A.	N.A.	N.A.	No	Yes

N.A. means "Not Applicable"

Conclusion

Many insurance companies appear to be violating the IRDAI Master Circular on Advertisements.

Assessing RBI's medium-term debt management strategy

by Radhika Pandey and Smriti Parsheera.

The international community has long highlighted the importance of a sound and transparent public debt management (DeM) strategy. Its objective being to set out the plan for achieving an optimal debt portfolio that minimises costs while accounting for associated risk factors. The Reserve Bank of India (RBI) has made a welcome move in this direction by publicly articulating the medium term debt management strategy for the three year period from 2015-18. Some key features of the strategy include adherence to a transparent debt issuance calender, elongating the maturity of the debt portfolio, undertaking buybacks and switches for effective liability management and taking steps to improve the liquidity of the government securities market.

The World Bank's Debt Management Performance Assessment Tool (DeMPA), which consists of a comprehensive set of indicators used to assess the strengths and weaknesses in government DeM practises, is a useful starting point in thinking about this issue. The DeMPA identifies the DeM strategy document as being an important component of the assessment toolkit and advocates that it should meet the following requirements:

1. Description of the market risks being managed (currency, interest rate, and refinancing or rollover risks) and historical context for the debt portfolio;
   
   
2. Description of the future environment for DeM, including fiscal and debt projections; assumptions about interest and exchange rates; and constraints on portfolio choice, including those relating to market development and the implementation of monetary policy;
   
   
3. Description of the analysis undertaken to support the recommended DeM strategy, clarifying the assumptions used and limitations of the analysis;
   
   
4. Recommended strategy and its rationale.
   
   

The RBI's strategy document also tries to base itself on these parameters. For instance, it begins with an assessment of the current debt profile of the government and then sets out the future strategy adopting the three broad pillars of low cost, risk mitigation and market development. The document however falls short of achieving a level of analysis that would meet the highest quality standards contemplated in the DeMPA. For this, the DeMPA requires that the strategy should ensure that the target ranges for the risk indicators are based on a comprehensive analysis of costs and risks - identifying the vulnerability of the debt portfolio to shocks in market rates - and these analyses are clearly described, clarifying the assumptions used and limitations of the analyses.

Analysed against this background we find that the strategy document in its current form suffers from certain flaws.


Scope limited to internal debt: The strategy is incomplete in that it has been prepared only for the country's internal debt and within that for the marketable debt of the Central Government. It is missing on two key components that are a part of the government's overall liability position: external debt and liabilities in the public account (i.e. National Small Saving Fund). The strategy also does not take into account contingent liabilities. There are close inter-connections between contingent liabilities and debt management. The government may guarantee a loan, but it will only be liable to make the payment if the recipient of the loan defaults. In such situations the government will have to assume the responsibility of paying the outstanding debt. Invoking of guarantees can therefore have an important bearing on the risk assessment of the debt portfolio of the government. This problem is, in turn, related to the lack of a unified Public Debt Management Agency, which would be able to take a full view of India's debt management problem.


Weak on forward looking analysis: A public debt management strategy must be set in a forward looking framework. The strategy document makes a point that external debt is being ignored on the ground that it forms a very small proportion of the total debt portfolio. This is a fallacious argument because if no analysis is made of the cost-risk trade-offs between external and domestic debt for the medium-long term then how can it be determined that the external debt will continue to remain "small". Similarly it has been stated that keeping currency risk low is a policy decision but the basis for this decision is not clear. It would have been desirable for such statements to be supported by an analysis of global interest rates versus domestic.


Inadequate description of underlying risks: The strategy falters in veering towards an over optimistic assessment of expected outcomes. For the baseline scenario it assumes that the "economy will record moderate to reasonable growth, a moderation in inflation as per the path projected by Reserve Bank and financial stability". It takes into account two alternate scenarios - a positive scenario in which the economy would grow at a higher pace than projected in the baseline and an adverse scenario where the reverse happens. However, the conclusion once again is that the stress tests "indicate a very low level of stress" and "the debt is stable, sustainable over medium to long run. Further, there are no short-term risks to the debt structure."

It assumes that the Government will follow its fiscal consolidation path i.e. a fiscal deficit of 3.9% by 2015-16, 3.5% by 2016-17 and 3.0% from 2017-18 onwards. It also assumes that the CPI inflation will follow the inflation targeting path adopted by the RBI. In the alternate scenario of fiscal slippage and high inflation it comes up with a higher debt-GDP and interest-GDP ratio. However, a clear analysis of the sources of fiscal and inflation shocks and the implication of deviation from the baseline scenario on the debt profile has not been demonstrated.

The strategy is weak in that it does not show a thorough analysis of the assumptions underlying its projections. For example: It says that the net market borrowing as a proportion of GDP is expected to fall from 33 per cent in 2014-15 to 31 per cent in 2017-18 reflecting fiscal consolidation. It does not explain how this will be impacted if there are deviations from the fiscal consolidation roadmap. The confidence of this statement also appears to be at odds with the Mid Year Economic Analysis which proposes a case for fiscal expansion to steer the economy on a higher growth path.


Mix of indicators for debt-sustainability and debt management: The strategy mixes debt sustainability and debt management indicators (See Table A3 of the strategy document). In a broader macroeconomic context there is merit in distinguishing between these two sets of indicators. The IMF's Guidelines for Public Debt Management emphasize that Governments should seek to ensure that both the level and rate of growth in their public debt is fundamentally sustainable, and can be serviced under a wide range of circumstances while meeting cost and risk objectives. Examples of debt sustainability indicators include debt service to revenue, debt service to exports, debt service to tax revenue in addition to what RBI has already calculated on debt to GDP and interest to GDP. In that same section the analysis of ATM (average time to maturity) is more of a debt management indicator, arising from the composition of the debt portfolio, and not of debt sustainability.


Time lag between the application of the strategy and its publication: The present strategy covers the period from 2015 to 2018 with a requirement of annual revisions. However, the RBI chose to publicly notify this strategy only on 31, December 2015, i.e. three quarters after its commencement. Going forward, if the objectives of transparency are to be met, it is essential that any revisions in the strategy for the coming period should be notified prior to its commencement.


The articulation of a medium term DeM strategy is a welcome step. The notified strategy has positive features like listing out measures to develop the domestic debt market and trying to conform with international best practices. However, it needs to be strengthened on its analytical foundations. In its present form the strategy is at best a description of the actions required to achieve a desired debt profile. Improving the analytical foundations will go a long way in improving the quality of the document to enable it to become a guidepost for achieving an optimal debt portfolio.



The authors are researchers at the National Institute for Public Finance and Policy.

Understanding heterogeneity in tax compliance

On 14 January 2016, we had a talk by Raymond Duch of the Nuffield Centre for Experimental Social Sciences (CESS). The title was Why we Cheat: Experimental Evidence on Tax Compliance [paper, video]. In an experimental setting, they find that high performance ("rich") experimental subjects are more likely to cheat on tax payments.

Understanding the results

I felt a key problem of the setup was the absence of coercion and punishment. Paying taxes is, at heart, about the coercive power of the State. Nobody wants to pay taxes; it is only the fear of punishment which makes you pay taxes.

I would interpret his results as saying: In a cooperative, high performance people are more likely to not pay in a fraction of their output to the common pool. The paper is about the behaviour of people in voluntary arrangements, and not tax compliance.

It perhaps suggests that a poll tax comes more naturally to humans as compared with a tax which is a fraction of the income. Imagine that you were in a cooperative: it's easier to think of everyone in the cooperative putting up Rs.X, rather than of everyone putting in x% of their income.

Heterogeneity in tax compliance

Turning to tax compliance, let's think of a simple setup where there is income $y_i$, a flat tax rate $\tau$, actual tax payment $T_i$, a $p$ probability of getting caught and a punishment $\lambda$ times larger than the tax shortfall $\tau y_i - T_i$. In this setup, the key parameter which will shape compliance is risk aversion. People who are more risk averse will comply more.

In countries where $p$ is high, the outcome will have high compliance. As $p$ becomes higher, the distribution of compliance will collapse into a point mass. When $p$ is low, and for certain kinds of distributions of risk aversion, we will get economically significant heterogeneity in tax compliance.

Low risk aversion is likely to be correlated with high performance. So we may endup with a simple correlation where high performance people are more likely to cheat on taxes. This is perhaps less spicy than meets the eye.

Tax compliance by firms in India

Consider the Indian operations of a multinational corporation versus an Indian family business. There is evidence that tax compliance by multinationals is superior. In my understanding, two things are going on.

The first is that $\lambda$ is not a constant; it is lower for Indian firms, as they are better able to manage the non-rule-of-law environment in the tax administration.

The second issue is risk aversion. MNCs tend to be very risk averse and look for safe interpretations of law. This may be related to multiple layers of bureaucracy and the principal-agent problems between the shareholder and the manager. Global compliance teams have a cover-your-ass attitude and force the local operations to play very safe. In contrast, Indian business houses tend to be take more aggressive interpretations of the law. They know this is risky and they walk into it with their eyes open.

There isn't much of a low-compliance-correlates-with-performance story here, as some of the best run companies in India (the MNCs) have the highest tax compliance. The empirical regularity actually runs in the reverse direction.

Participatory governance in regulation making: How to make it work?

by Bhargavi Zaveri.

In December 2015, SEBI issued five discussion papers. Decisions on three of the five discussion papers were taken at the board meeting of SEBI held on January 11, 2016. As of today, SEBI has not published the responses received from the public or its responses to the public consultation process.¹ This problem is present more broadly in the regulation-making process in Indian finance (Pattanaik and Sharma, 2015).

In recent years, there has been a great emphasis on strengthening the regulation-making process used by regulators in India. One element of this is a formal public consultation process. Effective public consultation processes are a powerful tool for reducing mistakes in the regulation-making process, and in reducing the dislocation caused by the sudden introduction of new law. However, the mere existence of a public consultation process does not, in and of itself, mean that the public will spend time and resources to comment and participate in the consultation exercise. A full ecosystem has to develop involving sophisticated private parties, who commit resources into the consultation process, and sophisticated persons in government, who utilise this effectively.

The extent and quality of public participation in a consultation process depends on four conditions.

Condition 1: Effective notice of the proposed regulation

The public cannot comment on a proposed regulation if they do not know about it. Barriers to information access can be blatant or subtle. Not making information available in an open format is an example of a blatant barrier. Examples of subtle barriers include cases where outdated information is not archived or the information is organised in a manner which makes it difficult for a user to access that information.

For example, an Indian regulator can initiate a public consultation process by publishing the proposed regulations in the official gazette. While the Indian official gazette has been recently digitalised and is therefore relatively more accessible, the chances that the public (or even stakeholders) will browse through the official gazette to respond to it, range from slim to none. On the other hand, if there is a concerted process whereby all financial regulators consistently put out notices on the gazette, and gave the gazette the role for which it was intended, then the public will make it a practice to look regularly at the gazette. This will be assisted by technological improvements such as RSS feeds and open APIs by the Gazette of India.

Some Indian regulators have made considerable progress on giving easy access to information about proposed initiatives. For instance, the website of Airport Economic Regulatory Authority (AERA) has a Consultations segment displaying all the active consultation papers in one place. The archives page of AERA's website too has a consultations segment which displays:

1. All the consultation papers ever issued by AERA together with the dates on which the consultation opened and closed for each paper;
   
2. Responses recieved and minutes of stakeholder consultation meetings, if any; and
   
3. Orders issued pursuant to each consultation exercise.
   

Similarly, the website of Telecom Regulatory Authority of India (TRAI) has a dedicated section on Consultations, which organises all the consultation papers ever issued by TRAI subjectwise, shows the status of the consultation paper (whether it is ongoing or closed) and displays the responses received.

Condition 2: Institutional mechanisms outside the State

While information dissemination exercises are the responsibility of the regulatory agencies seeking public participation, they need not be limited to initiatives of the State alone. For instance, researchers at a US university have developed a platform called Regulation Room. The program collaborates with certain federal agencies whose rules are put up on the platform for discussion, aggregates comments and submits a detailed summary of the comments recieved to the regulators it has tied up with.

What is remarkable is not just that the program was concieved and is running, but that Federal agencies in the US actively encourage and collaborate with it, in addition to spreading information about proposed rules through other methods for dissemination of information mandated by law. We wonder how financial agencies in India might respond if an academic institution initiated such a platform.

Condition 3: Stakeholder resourcing

Easy access to information does not automatically translate to effective public comment:

1. Effective public comment requires reasoned arguments supporting it. Depending on the field of regulation, comments may require to be supported by research, collection and analysis of data and legal arguments. This requires the public to expend time and resources toward understanding the subject or if they are experts, putting together their research and experience in a coherent form for processing by the regulator.
   
2. The kind and volume of stakeholders who are likely to respond also entirely depends on the field of regulation. Therefore, while a discussion paper on net neutrality has elicited close to 2.4 million comments, a discussion paper on the proposed regulatory framework for convertible securities will likely not attract as much attention. In other words, the breadth and technical nature of the proposed regulation will influence the extent of participation.
   
3. Some elements of stakeholders' responsiveness are a direct function of what the regulator does. For instance, the time given for responding to proposed regulations, the quality of the information published in the public domain, the readability of the discussion paper, etc. will influence the decision to participate or otherwise. If the regulator displays sound intellectual capabilities, it is more likely to elicit responses from the best people, as has happened with the TRAI document on net neutrality.

Condition 4: Responsiveness of regulatory agencies

The last stage of participatory governance - that of the regulator publishing comments recieved from the public and responding to them - is perhaps the most crucial. It is important that the regulator completes the loop on public consultations because:

1. It enhances the transparency of the consultation process. It is important that people know what motivated changes from the draft that was published for their comments.
   
2. If the regulator persistently rejects public comments without assigning reasons, it leads to a breakdown in conversation between the regulator, the regulated and the beneficiaries of the regulation. There is no incentive left for responding to documents put out by the regulator.
   
3. The exercise of responding to public comments brings clarity on the objective of the proposed regulation and the reason for preferring a selected policy tool over others. This helps the regulator and also answers future challenges to a selected policy tool.
   

While several empirical and qualitative analyses have been done on the the extent of influence of public comments on draft regulations (West 2005, Kerwin 2003 and Golden 1998), the methodologies have been open to criticism because it is nearly impossible to identify what prompted a change in a regulation. However, where, over a period of time, the outcome of a series of discussion papers or draft regulations have been identical or largely similar to the draft proposed by the regulator, it is safe to infer that public comments have not influenced regulation-making at all.

Some examples of good State responsiveness

Regulators in developed countries spend considerable time and resources in bothering to respond to public comments on proposed rules.

For instance, recently, the SEC issued a regulation which seeks to strengthen the technology infrastructure of participants in the US securities markets and enhance SEC oversight of such infrastructure. The text of the regulation is 11 pages. However, the press release containing the text of the regulation runs into 200 pages. The first 189 pages of the press release are dedicated to the comments received from the public on the proposal which was put up for public comments and SEC's response to those proposals. This is standard practice with all rules made by the SEC.

Similarly, the Australian Prudential Regulatory Authority generally issues a separate document dedicated to its response to comments received from the public on consultation papers that it puts up for discussions. For instance, see here.

As discussed above, TRAI and AERA also have dedicated sections reflecting the public comments received in the course of the consultation exercise.

While AERA reflects its response to the public comments in its orders, none of the other Indian regulatory agencies have transitioned to a rulemaking framework where the regulator responds to public comments. However, the examples of AERA and TRAI show that some Indian regulators are ahead of financial agencies on issues of participatory governance.

Some examples of bad State responsiveness

Recent research on the regulations and circulars issued by SEBI from June 2014 to July 2015 (Sharma and Pattanaik, 2015) found:

1. An analysis of 27 regulations issued by SEBI showed

1. It conducted a public consultation on 12 of them; and
   
2. It did not publish the public comments recieved in any of the 12 public consultation processes.
   

2. An analysis of 23 circulars issued by SEBI showed:

1. It conducted a public consultation on four of them; and
   
2. It did not publish the public comments recieved in any of the four public consultation processes.
   

3. There was no case where there was a change in the final regulations in response to public comments.

While the above study is silent on whether SEBI published its response to the responses recieved from the public, the website indicates that no response was published.

The trend seems to be continuing even after July 2015. For instance, we, at NIPFP, responded to two of the five discussion papers published by SEBI in December 2015 [link, link]. We resourced this work with two teams of four people each, which spent an effective working time of three full days, researching on the subject, looking up international precedents and consulting with external experts, so that we could collate our responses and submit them within the indicated timelines. The cost to make these responses was 24 man-days each.

While it is the absolute prerogative of the State to accept or reject comments received from the public,  the people who spend time and resources on preparing a response expect that their comments are considered. Today, we have no way of verifying whether our comments were considered and whether we should similarly galvanise resources the next time a regulator initiates a consultation process. This is precisely the kind of break-down that lack of State-responsiveness can lead to.

An ecosystem for participatory governance

A takeaway from this discussion is that the extent of public participation in a State-initiated consultation process is a function of various elements. While some of these elements (such as the technical nature of the regulation) are not within the control of the State, most of them are. This begs the question of how does one go about fostering an ecosystem which enhances public participation in consultation exercises.

Many countries have taken the approach of fostering this eco-system through the primary law. For instance, the Administrative Procedure Act, 1946, a US federal statute, requires Federal agencies to subject delegated legislation to a public notice and comment process. Delegated legislation which does not go through the entire notice and comment process has been struck down by US courts by applying an 'arbitrary and capricious' standard.

Subsequent agency-specific legislation and executive orders have led US Federal agencies to disseminate information in a user-friendly manner. For instance, the Open Government Directive² issued by the President's Office requires Federal agencies, amongst other things, to:

1. Publish information online in an open format that can be retrieved, downloaded, indexed, and searched by commonly used web search applications;
   
2. Create an Open Government Webpage which enables people to give feedback on and assessment of the quality of published information.

Indian examples

A couple of recent Indian legislations have an in-built overarching legislative mandate of transparency. For example , the Airports Economic Regulatory Act, 2008 mandates the airports regulator to `ensure transparency in exercising its powers and discharging its functions' by holding consultations with stakeholders, allowing them to make submissions to the authority and documenting and explaining all decisions taken by it. Perhaps, the existence of this principle in the primary law has led to AERA being a relatively far more responsive regulator. Similarly, the Electricity Act, 2003 requires that all delegated legislation under the act be subject to `previous publication'.

The absence of similar principles in the Indian financial legislative framework is glaring. A first attempt of this kind can be found in the Indian Financial Code (IFC) which was the outcome of the recommendations of the Financial Sector Legislative Reforms Commission led by Justice B.N. Srikrishna. IFC1.1 (which is a refined version of IFC) codifies a comprehensive process to be followed by financial regulators when making delegated legislation. This process entails the (a) publication of a proposed regulation with a statement of objectives, (b) a cost-benefit analysis of the proposed regulation, (c) a notice and comment process, (d) publishing the responses received and a general account of the regulator's counter-responses to the feedback recieved in the consultation exercise, and (e) approval of the regulation at the highest level within the regulator.

In December 2013, the Finance Ministry released a Handbook which serves as a guide towards the improving the regulatory governance of financial sector regulators.³  The Handbook requires the financial sector regulators to:

1. Consider all comments while framing the final regulations;
2. Publish all comments received; and
3. Publish a general account of the response to the representations along with the final regulations.

Thus, while attempts to foster an eco-system for participatory governance have been taken by the Indian Government, RBI and SEBI have not implemented this. Owing to this, Ministry of Finance regulators now lag the practices found in AERA, TRAI, and WDRA.

References

West, William (2005), "Administrative Rulemaking: An Old and Emerging Literature", Public Administration Review, Vol.65, No.6.

Kerwin, Cornelius M. (2003), "Rulemaking: How Government Agencies Write Law and Make Policy.", Washington, DC: Congressional Quarterly Press.

Golden, Marissa Martino (1998), "Interest Groups in the Rule- Making Process:Who Participates? Who Gets Heard?", Journal of Public Administration Research and Theory, Vol. 8(2).

Pattanaik, Arpita and Sharma, Anjali, Regulatory governance problems in the legislative functions at RBI and SEBI, Ajay Shah's blog, 23 September 2015.

Footnotes

1. Disclosure: NIPFP has responded to two of the discussion papers published by SEBI in 2015. Back
2. Memorandum on the Open Government Directive dated December 8, 2009 issued by the President's Office to the heads of executive departments and agencies. Back
3. The Handbook was issued as a follow-up document to a resolution passed by the Financial Stability and Development Council in October 2013, which requires financial sector regulators to adopt the recommendations of the Financial Sector Legislative Reforms Commission, which do not require legislative changes. Back

The author is a researcher at the National Institute for Public Finance and Policy.