Rajeshwar Rao: Reflections - challenges in regulations
Remarks by Mr Rajeshwar Rao, Deputy Governor of the Reserve Bank of India, at the
Gatekeepers of Governance Summit, organised by "Excellence Enablers", Mumbai, 2
November 2023.
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Ladies, gentlemen and distinguished guests,
It is indeed a pleasure to be participating in this summit, a gathering that is engaged to
distill the essence of responsible stewardship in the corporate world. Keeping up with
the theme of this session, "The Challenge of Regulation", I will reflect a bit on the
dynamic landscape of regulations and regulation making, its evolving nature and on the
transformation underway in the financial sector. Later, I will also outline a few
challenges and dilemmas encountered by the regulators in framing appropriate
regulations to manage these transitions.
Do we need Regulations?
Many believe that minimal regulations, is the best way to foster growth of the enterprise.
But history is replete with the examples of how minimal regulation coupled with lenient
supervision and restrained enforcements have often led to financial crises. In fact, we
would all agree that nothing could be more damaging to sustainable growth than a
misfiring banking and financial sector. While in an ideal scenario, the 'invisible hand'
would ensure that the system functions flawlessly for the greater good with minimal
regulatory oversight, in reality it does not happen that way. As such, to control the
irrational exuberance in the financial sector, there is need for a regulator who sets the
boundaries and also enforces them for ensuring a sound and robust set of financial
institutions and there by promotes financial stability.
Regulations, usually, impose restrictions on the entry and operations of the entity while
controlling the what and how of the business that is undertaken. This 'process' imposes
opportunity cost on regulated entities to achieve the desired objectives. However, these
are distributable costs to deliver a collective good. Therefore, regulations ensure that
the overall financial system fulfils its supportive role to the real sector through efficient
financial intermediation and its remains stable, robust and responsive.
Moreover, financial sector and banking industry is special. The inherent ability of banks
to generate leverage and the potential to trigger a domino effect in the financial system
makes it unique. Further, banks are not just the custodians of the customer's
hardearned savings but also custodians of public trust. It is RBI's responsibility to ensure
that the trust reposed by the customers and depositors on banks is resolutely upheld.
Managing Transitions
As we look at the challenges in the financial sector today, it becomes important to
address the profound structural shifts that are transforming the shape of the financial
sector. These transitions encompass a myriad of factors, each with its own set of
unique challenges. These are also complex, multifaceted issues that demand nuanced,
adaptable solutions. Striking the right balance between encouraging innovation and
maintaining the stability and security of the financial sector is always a formidable task.
Let me elaborate on few of such transitions which we are engaged with.
Climate Transition
We are all aware of the global challenge that climate change poses to our planet and its
impact which is felt across the world. The transition to a more sustainable,
environmentally responsible financial sector is no longer an option but an imperative. As
societies demand greater commitment towards a cleaner greener environment,
regulators must undertake the task of integrating climate risks into the regulatory
frameworks. Ensuring that financial institutions consider the environmental impact of
their actions while simultaneously managing the flow of credit, demands a delicate
balancing act and requires collaborative solutions.
The moot question which the regulators have to deliberate on is whether climate risk is
a unique risk that need to be captured separately and thus requires a separate
framework on a standalone basis or whether it transverses across credit, market and
operational risks and can be captured as a part of the existing risk frameworks. Another
point of debate is whether these risks need to be captured as combination of pillar 2
(supervisory review) and pillar 3 (market discipline and disclosures) requirements or is it
better to capture the risk as part of pillar 1 (capital and liquidity) straight way.
Technology Transition
Technology is reshaping the landscape of finance at an unprecedented pace and has
emerged as a transformative force reshaping operations and customer experiences
alike. Digitalisation is helping to enlarge the options available to customers and lenders,
increase efficiency and competition in the provision of financial services, and, more
importantly, making these services available to larger segments of the population.
As we embrace these technological advancements, it is imperative that regulatory
frameworks evolve in tandem to ensure the security, privacy, and integrity of financial
system. In an era defined by data, the protection of personal and financial information
has come the fore. In India, the Digital Personal Data Protection Act, 2023 (DPDP Act)
has been recently enacted. Such a legislation was necessary for safeguarding
individuals' rights and ensuring responsible handling of personal data.
Banks and other financial institutions, as custodians of vast volumes of sensitive
customer data, must make the required efforts to adhere to the provisions of the Act
and related regulations. To manage this transition smoothly, financial institutions must
invest in robust data governance frameworks, ensuring that they and their data
processors collect, process, and store data in complete adherence to the law and the
regulations. Managing the transition to a more data-conscious and 'data cultured'
institution necessitates treading a delicate path.
The Digital Intermediation Transition
Post the pandemic, digital lending and emergence of digital platforms providing loans
has seen an exponential rise in various emerging economies, including India. While this
led to an increase in scale and velocity of credit in an increasingly digital environment, it
has raised a host of business conduct issues.
The questions for any regulator to consider are whether they should try to be ahead of
the curve to ensure that financial innovations are enabled only after putting in place an
appropriate regulatory and supervisory framework; or to follow a relaxed approach of
allowing the markets to develop on its own? By being more accommodating, do the
regulators then run the risk of having to deal with unanticipated business conduct
concerns and in extreme cases, confront and deal with potential events that could
trigger systemic risks which may lead to outcomes that are difficult to anticipate and
manage?
Nonetheless, for a regulator, inaction can never be an option. The pace with which
newer business models, players and products are coming up, with such entities often
exploiting the gaps in existing regulations or conducting business operations that fall in
a regulatory grey area, continues to be a challenge. The business models that are built
to challenge the regulatory perimeters, aggressive marketing strategies, and those that
are engaged in exploitation of gullible customers makes it clear that such issues need
intervention. But, the dilemma lies in deciding the extent of regulatory intervention which
will contain and restrict the customer abuse without significantly altering the nature of
FinTech led innovation.
For example, in the beginning of 2020, the lending activities of the new technology
driven platforms involved small ticket size loans granted to a large number of
borrowers, mostly falling in the lower income strata of the society such as students,
retail businesses, gig workers, etc. For these borrowers, taking a loan at an exorbitant
interest rate meant falling into a vicious debt trap. What made the situation worse was
the fact that borrowers were not even aware of such high interest rate or charges before
taking the loan as these were not disclosed upfront, there was no interface except the
mobile app to raise their grievances and the recovery practices were harsh and
unorthodox.
We had also observed that right from credit underwriting to recovery, every activity was
being outsourced with scant regard to customer privacy and protection. Digital Lending
was operating on a 'rent an RE' model, where the FinTech platform was undertaking all
the lending activities on behalf of the regulated entity by posing itself as principal. In
many cases, the customers were not even aware of the name of the bank or NBFC
which had sanctioned the loan.
To tackle this issue, the regulatory stance has converged on regulating the digital
lending activity and the arrangements between regulated entities and FinTechs
providing specified services to REs (which were rechristened as Lending Service
Proivers or LSPs). RBI's digital lending regulations have laid down a broad regulatory
framework under which FinTechs can become enabling partners with regulated entities.
These guidelines are a mix of reiteration of the extant guidelines like reporting to CICs,
conducting due diligence before engaging LSPs, etc. and some fresh ones, with REs
being the fulcrum around which digital lending activities are required to operate with the
regulatory compliance being made their responsibility.
The Social Media Transition
Social media has revolutionized the speed and scope of dissemination of information.
Information sharing has never been so quick and unhindered thus far. But this also
means that unsubstantiated rumors and false news can also spread equally quickly and
can adversely affect financial institutions, especially banks. The recent banking turmoil
in USA has jolted some of the widely held views regarding principles of liquidity
management and nature and speed of bank runs.
The banking turmoil in the United States and Europe in early March 2023 has had a
significant impact on the global financial system. This episode has highlighted the need
for a reassessment of global standards in financial sector regulations. This episode has
offered two important lessons: First, the trust is vulnerable to perceptions of
weaknesses and misinformed social media commentary.
Second, that in an age of social media and internet banking, the speed with which bank
runs occur is unprecedented and therefore, the response time to handle any such crisis
has telescoped to a fraction of what was hitherto considered acceptable. To address
these challenges, constant and effective supervision, complemented by ability of the
bank concerned to monitor and prevent spread of misinformation over social media, has
become vital.
How is RBI Managing these Transitions?
RBI's approach has always been to foster and support innovations and dynamism while
balancing it with financial stability considerations. Therefore, let me elaborate what are
we doing to manage these transitions.
Simplifying Regulations
The regulatory instructions have evolved over a period of time in consonance with the
developmental trajectory of the financial system and institutions. The regulatory
perimeter has also expanded as the Indian financial system has ventured into newer
business models, product lines and geographical territories. Over time, this may have
led to certain regulations becoming complex with concomitant increase in compliance
burden. Therefore, a periodic stocktake is useful to review the regulatory instructions
and compliance procedures with a view to streamlining/ rationalising them and making
them more effective.
The RBI had set-up Regulations Review Authority 2.0 (RRA) in 2021 (following the RRA
1 set up in 1999) to undertake this task and ensuring simplicity of regulations that has
become a priority for us. In my view, future regulations must be responsive to the
evolving need of the financial system. For this to happen, we have adopted a five-pillar
strategy -
1. First, we are making sure that future regulations are forward looking and proactive.
2. Second, we have become nimble in our approach. This is critical as the pace of
change has accelerated.
3. Third, our approach to regulation making has become more data driven and
impact assessment oriented. This, in turns, has led to a more analytical decision
making process and is helping in making provision for a suitable path for
transition, wherever warranted.
4. Fourth, we have been adopting a more consultative approach to regulation
making. Prior consultation with stakeholders enables us to gather diverse
viewpoints and incorporate them in the regulations. This also makes
implementation of regulations better.
5. The fifth and last pillar is collaboration. We are engaging more and more with
stakeholders, government and with other regulators and industry to evolve a safe
and resilient financial sector.
The Reserve Bank has been conferred upon the powers to make subordinate
legislation under a wide spectrum of statutes. This casts a responsibility upon RBI to
ensure that its instructions are within the perimeters set by the statutory mandate, clear
in language, appropriate and proportional. Therefore, we have increased our focus on
providing suitable training and skills to our officers so that the regulations can be written
in simple language and there is better clarity on the regulatory intent.
Bringing customer conduct into focus
In whole scheme of things, the 'customer' should and must remain the centre. The two
primary objectives of regulation viz. ensuring financial stability and protecting customer
interest leads to two broad categories of regulations - prudential regulations and
conduct regulations. Prudential regulation builds foundation for financial stability, while
conduct regulation lays the ethical foundation for maintaining customer trust, together
help in safeguarding the integrity of our financial system.
Accordingly, our endeavour has been to inculcate responsible conduct on the part of
the regulated entities. We have asked banks to design suitability and performance
requirements for financial products and financial services keeping in mind the interests
of its customers. This includes Board level oversight arrangements that a bank must put
in place in order to meet these objectives. As we further strengthen our approach
towards addressing the concerns in the area of conduct based regulations, the guiding
philosophy would be to set certain minimum regulatory expectations, with the option for
entities to adopt higher standards depending upon their size, proportionality and
customer focus. The ultimate message is that the regulated entities should treat all
customers - big or small, urban or rural, educated or less educated, in a transparent
and ethical manner.
Principle Based vs Rule Based Regulations
There is an ongoing debate of whether a principle based approach is preferable or
whether a rule-based approach to regulations is the better option. At different points in
time, one approach has influenced the policymakers more than the other.
The benefit of rules-based regulations is that it provides certainty and firm guidance on
what regulated entities are required to do, and from the regulator's point of view, the
measurable and explainable regulatory targets and responsibilities that can be easily
monitored and enforced. But in a prescriptive approach to regulation, the rules might
end up becoming more important than the intended outcome for which they were
designed, leading to a culture of "box ticking" compliance.
In contrast, principle-based regulation is more like a compass, providing regulated
entities with a general direction, without specifying the precise route to be taken. The
principles are crafted to be suitable for a wide array of situations and emphasize on
desired outcomes. They grant regulated entities the flexibility to adapt to evolving
circumstances and to innovate; however, it also requires them to exercise prudent
judgment and make responsible decisions. But, often, to make the regulatory
expectations clear, principle-based regulations are required to be supplemented with
clarifications, illustrations and guidance notes.
So where do we stand in the continuum of rule-based and principle-based regulatory
approach? The Reserve Bank, as a matter of policy, has been gradually giving banks
greater operational freedom to conduct their business operations within the overarching
regulatory framework. We are thus moving at a good pace towards making our
regulations increasingly principle-based.
Maintaining a Level Playing Field
A level playing field ensures that all participants operate within a fair and consistent
regulatory framework where the potential risks and rewards of the financial system are
evenly balanced. There is widespread agreement that a level playing field is a key
condition for a competitive financial sector. As a regulator, we are following the principle
of "same activity, same risk, same regulation". This approach can be seen in the case
of our guidelines on Digital lending, first loss default guarantee (FLDG) and
microfinance sector.
However, maintaining a level playing field has to be counter balanced by ensuring
regulations that are proportionate to the risks posed by the firm to the financial system.
We are quite mindful of the need to ensure that the regulatory burden on an entity
should be proportionate to the risks posed by it to the financial system and to the size of
its operation. This thought has underscored our revised scale-based regulatory
approach to NBFCs and revised regulatory framework for UCBs.
It, however, must also be appreciated that limiting the potential for regulatory arbitrage
and establishing a level playing field for market participants is an important objective for
regulators, but it is not the overriding one. To ensure efficient market functioning and,
more broadly, to safeguard the public interest, policymakers may, at times, need to treat
different players differently.
Conclusion
Let me conclude.
Framing regulations in today's dynamic and interconnected world is a challenging task,
but it is a challenge that we are fully committed to overcoming. As a regulator, our most
important contribution to the society is that we do our job - by making forward looking,
risk-based and proportionate regulations and implement them in a consistent manner.
At the same time, we are conscious that process of regulation making must yield a net
surplus for the financial system. Even as we move forward on these lines, we need to
remain steadfast in our dedication to maintaining stability, fostering growth, and
safeguarding the interests of customers.
The inputs provided by Deepak Rana, Vishal Kumar Prasad, Pramanshu Rajput and
Pradeep Kumar are sincerely acknowledged.