Effective regulation is key to banking reforms

It is the season for banking reforms. Finance minister (FM) Nirmala Sitharaman’s announcements on the policy for privatisation in banking, insurance and financial services indicate that there will be bare minimum presence of public sector enterprises. The privatisation of a general insurance company and two State-owned banks are to be “taken up” in the year 2021-22. The FM has also proposed to set up an asset reconstruction and management company. While thin on details, the message appears to be strong on commitment. Indeed, the desire to change matters earlier thought to be non-negotiable seems to extend beyond the finance ministry.

An internal working group of the Reserve Bank of India (RBI) recently recommended that corporate/industrial houses should be allowed to promote commercial banks, subject to “necessary amendments” to the banking legislation to address the risks related to the proposal. The RBI governor has clarified that this was the view of the internal working group and not RBI’s official view.

Few will disagree that the financial sector is in dire need of reform. While there should be a robust debate on the merits of these proposals, it is equally important to consider how these will be implemented in the context of the existing regulatory framework. Regulatory governance involves elements of standard-setting, supervision and monitoring, and enforcement.

First, standard-setting.

Legislating standards requires a delicate balance between issuing rules to help industry understand the regulatory expectation clearly, and providing discretion to the regulator to reel in rogue players who abuse the rules. For instance, the simple principle that banks should not unfairly lend to people related to its owners, when translated into legal rules, will require a definition of the term “related”. The owners/promoters of the bank would, of course, be covered and, if they are individuals, their immediate relatives. But what about lending to a cousin? Similarly, if the promoter is a company, a subsidiary and holding company would be covered, but what about a company in which the promoter holds 10% shareholding and has largely similar key management personnel?

To address such attempts to circumvent the law, the rules should allow some discretion for the regulator to act if the objectives of the regulation are sought to be circumvented — for instance, if the promoter, in fact, exercises control or influence even while keeping up appearances of unrelated parties on paper.

While there cannot be a universally applicable test to determine whether someone is exercising control or influence — indeed, that would defeat the purpose of providing flexibility to the regulator — a well-developed set of principles to provide guidance on how such factual matters will be determined is required for such amorphous concepts to be effective and fair. Such context-sensitive tests to determine control or influence to guide regulatory officials are still evolving in India and, accordingly, any proposal that hinges on the regulation of related-party lending should tread carefully.

Second, supervision and monitoring. Even when the goals and the legislation are clear, supervision and monitoring are critical to ensure the effectiveness of the regulation. For instance, merely transferring the ownership of public sector banks from the government to private hands will not automatically solve the issues plaguing them. While RBI may have greater powers to monitor and supervise these banks once privatised, there are recent examples of privately owned banks that have also had serious challenges and have had to be rescued. RBI conducts regular inspections of banks and can call for information and records. But any comment on its supervisory capacity is bound to be anecdotal given the limited information available publicly in this regard. Greater transparency on the supervisory process, and knowing why and how recent crises in private banks occurred, will help in objectively analysing what needs to change.

Similarly, the proposal to set up new entities to deal with stressed assets also requires careful thought, particularly because RBI may be required to regulate them. RBI is already required to supervise and monitor, among others, commercial banks, non-banking financial companies, cooperative banks, small finance banks, payment banks, and housing finance companies (in addition to its other responsibilities including in respect of monetary policy, foreign exchange, and currency).

Supervision and monitoring, of course, require assessments of systemic risk and prudential norms, but usually go further and involve closer involvement of RBI in each company — from governance (for example, approving appointments to the board of directors and salaries of chief executives) to operations (for example, priority sector lending and verifying KYC compliance). A frank and open debate is required as to whether there is regulatory capacity to implement these proposals if the reforms are to be meaningful.

And, finally, enforcement.

Even with the best efforts at standard-setting and supervision, there are bound to be rogue actors. Accordingly, robust enforcement when failures are identified is needed, especially with regard to individual accountability for regulatory non-compliance. The Central Bureau of Investigation (CBI) inquiries and criminal action are notoriously unreliable and slow. A small fine for the organisations may not send the right signal for individual actors to comply with regulations. A quick and efficient mechanism for individual accountability is, therefore, essential to complement standards-setting and supervision. With increasing complexity and potential disputes in management of stressed assets, a framework for dispute resolution among stakeholders (whether or not the regulator is involved in the dispute), may also be required.

The need of the hour is effective regulation. Transferring ownership or setting up a new entity will not automatically solve issues for the industry or the regulator. This requires us to ask tough questions on transparency, supervisory capacity, and accountability. S Vivek leads the Regulatory Governance Project at the National Law School of India University, Bengaluru and was formerly a partner of a law firm in Mumbai The views expressed are personal