Financial regulation: Going from potholes to expressways

Business Standard, 18 July 2006

In May 1997, fundamental economic reforms were announced in the UK. The Bank of England was made an independent central bank which would set the short-term interest rate with accountability for hitting a publicly stated inflation target. All financial regulation was placed into a new agency called the Financial Services Authority (FSA) which was seeded with the 500 people from the Bank of England who used to do banking there, and the staff of all existing financial regulators.

From an Indian perspective, the notion of merging all finance into a single agency sounds daunting. Why concentrate so much power into one agency? How will that agency be accountable? However, by 2006, it is fairly clear that the FSA experiment has worked well in the UK. It has helped London establish itself as the number one financial centre of the world, and it is a model which has been emulated in over 20 countries. Hence, it is interesting to try to understand how the FSA works and why it works well.

The first innovation of the FSA is the mandate. The law gives FSA four equal objectives: "maintaining market confidence", "promoting public understanding of the financial system", "securing the appropriate degree of protection for consumers" and "fighting financial crime". The law writes down nothing about markets and products, and focuses on broad principles.

The FSA is tasked with making markets work effectively to deliver benefits to firms and consumers. It accepts that some failures neither can, nor should, be avoided. The mandate of the FSA is designed to avoid the loss of efficiency from the conservative instinct of setting up a license-permit raj, or the periodic heavy handed front-page-banner-headlines crackdown on finance which happens with populist regulators.

In India, we have seen problems with the flow of innovation from one part of finance to another, because of the rigid silos that are found with separate agencies such as SEBI or RBI. The integration at FSA makes it easier to carry success stories from one part of the FSA to another. Internationally, most banking regulators view the securities markets with suspicion or hostility. However, the world is increasing shifting away from banks towards a securities-dominated financial system. The merger of banking and securities into the FSA has ensured that FSA-regulated banks have no hindrance in achieving a deep integration with securities markets.

FSA has carried forward an approach called "principles-based regulation" which was originally thought up by the Bank of England prior to the reforms. The main insight here is that it is neither feasible nor desirable to write down detailed rules governing every market and every product.

The phrase one repeatedly hears in London is that the top management of a finance company must primarily look at markets and innovate, without worrying about the regulator. This is reminiscent of India's experience with control raj in manufacturing, where the reforms were about turning the gaze of the CEO away from the government towards the market. The FSA places a complex burden upon the finance company and upon its own staff: that of understanding broad principles and adhering to them in spirit. In return for this, the RBI or SEBI-style rules governing every minute activity in finance has been eliminated. CEOs in London innovate without needing to run to the regulator for permission.

Large firms are linked up to specialised relationship-management teams in the FSA which are a single point of contact. The team at FSA that deals with the large firm is given three tasks. Understanding the sources of profit of the firm, understanding that the business plan and processes are consistent with the principles of the FSA, and verifying that the processes of the firm are able to perform satisfactorily. The FSA team makes regular presentations to the board of the regulated company about their understanding of the areas of concern. This improves the pressure on the FSA team to talk sense.

This approach places a two-fold pressure on the FSA staff. First, they have to be smart enough to understand the regulated firm in a manner akin to a strategic management consultant. Second, they have to be empowered to act based on discretionary judgment. In contrast, in an Indian setting, it is all too easy to have rigid checkboxes that RBI or SEBI staff have to verify when they interact with a firm, so that they have plausible deniability when anything goes wrong.

The FSA approach requires top quality staff. In order to help achieve this, FSA wages are decoupled from civil service wages, and linked to median wages in the private sector. More than half of the staff comes from the industry, and there is a good two-way flow between the FSA and industry.

With the concentration of power at the FSA, there is enormous concern about accountability and checks on the power of FSA. This has been achieved through numerous devices. The first device is that of having staff who understand realworld finance, and don't fall back upon saying "no" when faced with any complex idea. A statutory "practitioner panel" watches the FSA and writes reports about areas where things are going wrong. There is a tribunal for appeal on enforcement matters, much like our Securities Appelate Tribunal (SAT). And when there are policy disputes between the industry and the FSA, the UK Treasury (the equivalent of our Ministry of Finance) plays tribunal. Finally, the finance industry produces 8% of UK GDP, and if FSA stifles the innovation or competitiveness of this industry, it directly impacts upon UK GDP growth.

When I have described these kinds of ideas to Indian finance professionals, they shake their heads in wonder, and are unable to even imagine such a world. I am reminded of how I felt when, as a child, I used to hear people talk about roads abroad where one could fall asleep driving at 120 kph. All of us used to accept pothole-filled roads as the norm in India. Over the years, we understood that the world builds eight-lane expressways, and learned how to setup the contracting and incentive structures so as to get roads like the Jaipur-Kishangarh highway. In similar fashion, we need to understand how to get away from populist and pothole-filled financial regulation, and build the eight-lane expressway that the FSA examplifies.

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