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PJ Nayak’s dissent note

Gautam Chikermane’s tweets


While the Commission’s Report strives to break fresh ground in several directions, and particularly in respect of Consumer Protection and Resolution, there are two approaches adopted with which I disagree, while otherwise being supportive of the Commission’s recommendations. As both approaches affect significantly the structure and conclusions of the Report, I believe their importance necessitates this Note of Dissent.

18.3.1. The Finance Ministry as a Financial Sector Regulator

The last 25 years of the evolution of financial sector regulation in India has seen a continual empowerment of regulatory agencies. This began with the transfer of powers for capital markets regulation from the Government to a new regulator, SEBI; led subsequently to the establishment of other regulators for commodities, insurance and pension funds; and has coincided with the increasing empowerment of the two principal regulators, RBI and SEBI, through periodic amendments to Acts of Parliament under which they draw their powers. This directional thrust in the empowerment of regulators established outside of the Government has brought expertise into financial regulation. It is also now generally accepted that when the Government did regulate directly, as it did for the primary capital market through the Controller of Capital Issues, or the secondary capital market through the stock exchange division of the Finance Ministry, the consequences were sometimes unfortunate: new capital issues were continually grossly mis-priced, and malpractices in the functioning of brokerage firms were commonplace.

The Commission now arrests and partly reverses this directional movement, and it is with apprehension that one must view the very substantial statutory powers recommended to be moved from the regulators (primarily RBI) to the Finance Ministry and to a statutory FSDC, the latter being chaired by the Finance Minister. The Commission has recommended that direct statutory powers be vested in the Government in matters of (i) Capital Controls and (ii) Development. The statutory empowerment of the FSDC encompasses (iii) Inter-Regulatory Co-Ordination; (iv) Identification and Monitoring of SIFIS; and (v) Crisis Management.

This transfer of powers collectively constitutes a profound shift in the exercise of regulatory powers away from (primarily) RBI to the Finance Ministry. The Finance Ministry thereby becomes a new dominant regulator. To rearrange the regulatory architecture in this manner, requiring new institution-building while emasculating the existing tradition of regulators working independently of the Government, appears unwise. There is no convincing evidence which confirms that regulatory agencies have under performed on account of their very distance from the Government; indeed, many would argue that this distance is desirable and has helped to bring skills (and a fluctuating level of independence) into financial regulation.

The concept of a statutory FSDC, and the functions sought to be vested in it, are sensible provisions and will provide much needed co-ordination between regulators, as also the ability to steer the financial sector through periods of systemic risk. What is worrisome is that the chairmanship of FSDC is with the Finance Ministry, as this could lead to a government creep into the micro-prudential powers of other regulators. At present, without statutory powers, such a creep is difficult. As an uneasy compromise, the Commission has recommended (in Table 9.3) that an Executive Committee of the board of FSDC be constituted which will be chaired by the regulator for banking and payments [read Governor RBI], with managerial and administrative control, which will refer decisions to the board of FSDC when the Committee is unable to reach a consensus. It is unlikely that this would constitute an adequate buffer against Government creep. A superior way of combining the needs of efficient co-ordination, the management of systemic risk and regulatory independence, would be to have the Governor RBI (as the senior of the two micro-prudential regulators) chair the FSDC, with Finance Ministry officials also being represented on its board. The Chairmanship of FSDC is therefore critical. In any case, with the Commission proposing just two micro-prudential regulators, co-ordination becomes easier, and the case for the Finance Ministry exercising FSDC leadership weakens.

The Commission’s recommendation (Chapter 8.3) of transferring from RBI to the Central Government rule-making powers on capital account transactions for all inward flows has even more alarming implications. Regulations influencing the quantity and structure of India’s external liabilities, the management of the balance of payments, and the conduct of monetary policy have a close and intricate synergy. For the Commission to recommend regulatory scatter, wherein capital controls regulation is with the Government, monetary policy is conducted by RBI and the balance of payments is wedged in between the conduct of monetary policy and the impact of capital controls regulation is likely to prove damaging to the conduct of monetary policy and of fluent macroeconomic co-ordination.

The present law under FEMA vests powers of capital account regulation with RBI. It is true that since the economic reforms of 1991, FDI Policy governing inward equity investments has been authored by the Central Government, on the argument that it constitutes an adjunct of Industrial Policy. ECB policy has however evolved through consultation between the Finance Ministry and RBI, and has invariably required the assent of RBI, even where it may have been initiated by the Government. At best this de facto position could be formalised as de jure, with regulations on inward equity and equity-related investment being authored by the Central Government, and with external debt regulation vested in RBI. To move formal regulatory powers governing external debt policy away from RBI would be damaging to the maintenance of macroeconomic balances.

18.3.2. Principles as the Basis of Financial Sector Law

The Commission strives to choose an imaginative and bold approach in adopting a principles-based approach towards formulating law for the financial sector. It is necessary however to also put this approach to the test of pragmatism in the Indian context, particularly as most financial sector law has hitherto been rules-based.

Rules-based legislation brings greater certainty to financial sector participants in the understanding of whether a financial product or sales behaviour are legal, but this understanding is necessarily contextual. Rules therefore need to be elaborate in order to cover a plurality of situations which could arise in practice and, where there are gaps in these, participants could potentially exploit these to their advantage. Where rules-based law has achieved adequate comprehensiveness, it provides greater certainty to financial sector participants in understanding whether contracts and behaviour are lawful. Principles based law does not provide such certainty, but by focusing on more generalised principles, covers the gaps by providing meaning to situations not presently contemplated but which could arise in future.

There are two difficulties which a principles-based approach could create. The first, recognised in the Commission’s Report, is that participants are more reliant on courts in interpreting the law in a specific context. As the Commission’s Report notes (See Chapter 2.2) “Central to common law is the role of judges. When laws are written in terms of principles, there would be legitimate disagreements about the interpretation of principles. These are resolved by judges who build up the jurisprudence that clarifies what a principle means in the light of the continuous evolution of finance and technology”.

Such an approach works well when court processes are speedy and decisions of courts are dispensed quickly. In the Indian context, with an accumulating backlog of cases, the position is more problematic.

A second difficulty arises on account of the specific principles adopted for the legislative law. In the case of micro-prudential regulation, for instance, 11 principles are listed in Table 6.9 and constitute principles of administrative and economic rationality. The resulting law, applicable to the entire financial sector and embodying these 11 principles, is proposed in Section 141 of the draft Indian Financial Code. If the legislative basis of a micro-prudential law for banking (for instance) is to be restricted to these 11 principles, the burden on regulatory law to bring greater specificity in respect of banking increases very substantially. A mammoth superstructure of regulatory law will thus sit atop a slender base of legislative law. Aside from the issue of whether Parliament would be comfortable with this balance between legislative and regulatory law, such a legal structure imposes a high burden on the quality of regulation-writing. As each regulation can be challenged on grounds of being in violation of the principles, uncertainty about regulatory law will persist until the courts have ruled.

This double whammy of uncertainty will be detrimental to financial contracting, including new product design and sales behaviour across the financial sector. Financial sector contracts gain in strength when the interpretation of contracts is understood by general consensus ex-ante, before the contract is entered into, rather than ex-post, after interpretation by courts. While it may be true that a principles-based system will settle into its own equilibrium over a period of years, the likely travails associated with that until then appear disproportionate to the benefits. A more rules-based approach to the writing of financial sector law would have been preferable.


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