Y V Reddy: Issues in choosing between single and multiple regulators of
financial system
Address by Dr Y V Reddy, Deputy Governor of the Reserve Bank of India, at the Public Policy
Workshop, at ICRIER, New Delhi on 22 May 2001.
* * *
Respected Chairman, Dr. Patel, Dr. Isher Ahluwalia and distinguished participants.
I am here in fulfillment of a promise made to Mrs Isher Ahluwalia some time back to make a
presentation at this prestigious institute. Needless to say it is a privilege to be here; and I am thankful
to the organizers for giving me freedom to choose the subject of the day. My fascination for this
subject is only about four yours old. Dr. Rangarajan, the then Governor deputed me to attend the
fourth Central Bank Governors Symposium in London on my way to the annual meeting of Bank for
International Settlements at Basle. The broader issue of financial regulation and the contemporary
issue of single regulator had then just been decided upon in United Kingdom. In view of recent interest
in the subject in India, I thought that I should share my thoughts on the choice between single and
multiple regulators for our financial system. It is a great personal honour to me that Dr. I.G. Patel is
presiding over this session as his scholarship, statesmanship, sage counsel, and outstanding
leadership are admired by all of us.
I have divided this presentation into five parts. First, the institutional structure for regulation needs to
be considered with an initial broad understanding of the rationale for regulation, regulatory coverage,
policy frame and the operational aspects. Second, the structural aspects of regulation are presented
encompassing the reasons for recent interest in the subject, pros and cons of single versus multiple
regulators, the international experience and the developing countries' perspective. Third, the current
status of the regulatory structure. Fourth, the contours of the current debate on the subject. Fifth part,
the issues for consideration. It is argued that the historical context, the state of development of
financial markets and the level of skills available should be considered in making a choice. It is also
argued that apart from single and multiple regulators, hybrid arrangements can be explored to suit the
requirements of our country. While change from the current status appears desirable, the issue is not
only one of choosing an appropriate model, but also one of managing the process of change and
sensitizing all participants to the changing circumstances. In any case, an ideal structure by itself does
not guarantee optimal regulation, and in any structure, coordination among all wings involved,
including the Government, is critical.
Financial regulation
There are several theories that attempt to explain regulation in general and financial sector regulation
in particular. These include theory of competition for regulation and theory of regulatory capture on the
one hand and public interest theory aimed at correcting market failures on the other. Since there are
virtually no takers for frontier capitalism, the rationale for regulation lies in the search for a public policy
that makes markets work better, while avoiding the dangers of excessive burden by treating regulation
as a free good and the scope for regulatory capture by the few suppliers compared to the large
dispersed consumers. More generally, the objectives of regulation are to avoid monopoly power, foster
competition and protect the consumer's interest.
In regard to financial regulation, however, there is a slight change in emphasis in the objectives of
regulation in the sense that the focus is on maintaining systemic stability and protecting the interest of
the customer. Maintaining systemic stability is important because social costs of financial distress are
high in the form of the contagion effect. A wholesale customer, such as a corporate or large net worth
individual, should be in a position to have the capacity and resources to make informed choices. But, a
retail customer, such as small saver or small borrower, cannot incur the cost of getting information,
acquire or employ skills to analyse, have large enough volumes to learn from experience, big enough
portfolio to spread risks, and as such will be unequal in relation to the financial intermediary. Above all,
economies of scale are likely in monitoring of information on a collective basis. In brief, the why of
financial regulation should be considered essentially in the light of the primary objectives, namely,
maintaining systemic stability and giving an impression of protecting interests of the retail customer;
and implicitly other objectives will have to be secondary.
In India the regulation of financial sector has evolved as an instrument of planned development. In
such a situation the objectives are mobilisation of savings, and allocation of investible resources
mainly through public sector and or administered prices of financial products. There has been an
implicit sovereign guarantee of maintaining systemic stability and in the process giving an impression
of protecting interests of all participants. The management of the financial sector, therefore, contained
a variety of objectives and to this end many financial institutions were nationalised (banks) or created
(Industrial Development Bank of India or Unit Trust of India) to subserve ends of planned
development, thus relegating the role of competition as an instrument of efficiency to a secondary
position. Furthermore, co-ordination among the financial institutions took precedence over arms length
relationships or checks and balances, thus introducing what may be called a joint-family approach to
financial transactions, which undermined both the degree of transparency and the extent of
accountability.
The next question is, what constitutes regulation. Regulation in its broadest sense includes
establishing specific rules of behaviour, or regulatory aspect per se, monitoring or tracking observance
of behaviour; and supervision or oversight of the compliance with specific rules in the overall
behaviour along with disincentives and penal provisions for non-compliance. There are some
arguments in favour of formally separating the regulatory aspects from supervisory aspects but the
current international practice favours the two functions being viewed together. In this presentation, the
functions are not viewed differently, and the terms regulation and supervision are used
interchangeably to cover all three functions, unless otherwise indicated. The Reserve Bank of India
(RBI) is generally looked at inter alia through three angles, viz., (i) monetary authority (ii) regulatory
authority (iii) supervisory authority. It is clearly possible to separate the monetary function from the
other two though such a separation between regulation and supervision could pose problems. The
impression that the supervisory function needs to be segregated from the regulatory responsibility has
been reinforced by the recommendations of the Narasimham Committee (1998) to the effect that the
supervisory function be removed from the central bank and be made autonomous. In operational
terms, however, supervision is an integral part of the regulatory framework. In India, in some
instances, regulation, monitoring and supervision are combined with business or commercial
relationship as in the case of National Bank for Agriculture and Development (NABARD) or Small
Industries Development Bank of India (SIDBI). It is not uncommon to find such apex supervisory
institutions competing or jointly financing with the institutions that they regulate and refinance some of
them as in the case of state-level industrial corporations. Thus developmental objectives are pursued
jointly by national and state-level public-sector financial intermediaries, some of which, like Industrial
Development Bank of India (IDBI) have private-shareholding also, and in the process, the distinction
between regulator and participant in the business gets blurred.
The objective of regulation may be institution based or function based or even product or market
oriented. In other words, a regulator may regulate banks though banks may involve themselves in
other activities such as being an intermediary in capital markets. Alternatively, the capital market
regulator may regulate all activities relating to public issue or trading in securities whether those
functions are performed by banks or non-banks. Similarly, all institutions which take public deposits
may be regulated by one regulator. Yet another approach is to consider regulation in terms of markets
say government securities, or money market or forex. In India, capital markets and insurance activities
were regulated by Ministry of Finance till the Securities Exchange Board of India (SEBI) and Insurance
Regulatory and Development Authority (IRDA) were set up recently while Development Financial
Institutions (DFIs) have recently begun to be regulated / supervised by RBI. While most banks are
regulated by the RBI, some are under dual control of government and RBI. Department of Company
Affairs (DCA) regulates deposit taking activities of corporates other than banks and non-banking
financial companies registered under companies Act, but not those which are under separate statutes.
Thus, the object of regulation itself is susceptible to some overlap, but the major issue in this regard
relates to the regulation of banks, namely whether banks should be necessarily treated as a separate
and special group of institution for regulatory purposes.
There has been significant debate on whether banks are special, and should be treated as such. The
rapid development of capital markets, increasing importance of non-bank sources of financial
intermediation and the emergence of universal banking have led to the erosion of importance as well
as uniqueness of banks as financial institutions. There are, however, three major reasons adduced for
treating them as special. First, they are participants in the payments system and hence are the
backbone of the financial system. The systemic risks of any one bank being affected either on account
of its banking operations or on account of non-banking operations are high. Second, the banks
contract for liquid deposits to acquire illiquid assets and hence are vulnerable to liquidity crisis. This
would underline the need for a lender of last resort. Third, the banks are the major service providers
for retail customers and are, therefore, on a separate footing in terms of consumer protection,
especially since the customers of a bank are typically risk-averse. In other words, while retaining
incentive for banks to be always solvent, there is constructive ambiguity in extending liquidity by lender
of last resort. Thus, banks, particularly those with access to payments system are generally treated as
a separate class in a regulatory framework - particularly in developing countries. In India, all banks
are subject to RBI's regulation but the framework is not uniform in the sense that public sector banks,
cooperative banks, and private banks are governed by significant differences and not all of them have
access to the payments system. The RBI is a regulator of banks but is also the dominant owner of the
largest commercial bank. Such close links were considered essential for effective coordination in
financial sector as part of the early endeavours of planned development and the channeling of credit.
Regulation policy should recognize and admit that the fact of regulation does not guarantee that there
will be no risk of failure or insolvency of a regulated unit. In fact, a zero failure system is likely to be
sub-optimal. There is always a danger that people perceive that mere act of an entity being regulated
provides a guarantee from the regulator that it is risk free to transact business with the unit. The risks
arise due to several problems, mainly related to lack of information. First, it is difficult to precisely
assess even for the regulator how good the internal controls in a regulated entity are on an on-going
basis. Frauds that occur in connivance with the management of the bank are even more difficult to
detect if they occur between two inspections as the offsite surveillance may not throw up this
information. Second, there is no way of perfect and continuous assessment of adherence to the
external rules imposed by the regulator. Third, even under most prudent circumstances, there is a
residual risk.
Regulation is often perceived to be a free good, available at no cost, but it is not so. There are costs of
administering regulation; of compliance; and there are also structural costs. Excessive or inappropriate
regulation can stifle efficiency, and invite problems of what are known as moral hazard and adverse
selection. It may even provide incentives for the over regulated business overtly or covertly depending
on the nature of the business to move to entities which are not so regulated. Moreover, there are
savers who are willing to have a portfolio with different degrees of risk and return and correspondingly
there are investment avenues. An efficient regulatory policy should provide avenues for a spectrum of
risks and rewards, make it clear that regulation by itself does not guarantee risk-free transaction and
ensure that overall benefits to the system are commensurate with the overall costs incurred. All
failures of a regulated unit do not represent failure of regulation and a regulator cannot guarantee
compensation for those affected by failures other than those covered by deposit insurance. But, a
regulator has to maintain the credibility in terms of assurance of systemic stability and consumer
protection, especially in terms of information availability in a timely and transparent manner particularly
to retail customers. "Public policy arrangements should never eliminate the incentive for consumers of
financial services to exercise due care" (Charles Goodhart, 1998).
It is useful to refer to some operational aspects of financial regulation, which impinge on effectiveness
of regulation. First, how much of regulation through supervisory arm should be externally imposed by
regulator and how much should be left to market discipline so as to make the behaviour of the
regulated unit consistent with regulators intent. Second, whether intensity of regulation is such that it is
considered to be the minimum with incentive for better behaviour by the regulated unit or is regulation
such as to ensure mere compliance and no more. Third, how much of regulation should be off-site and
how much on-site. Fourth, how much of regulation should be incentive based, which would include
disincentives. Fifth, how far do consultations with market participants help enhanced efficiency and
when does such consultation end up as capture of regulator by the regulated. Sixth, how much of
findings of supervisory oversight be put in public domain and how much kept for communication
between the regulator and the regulated. Seventh, how much of the supervisory oversight should be
strictly rule based and how much of judgment of overall compliance acceptable. Briefly stated, the
answer to all these questions lies in seeking and striking a right balance. These are several issues
which need to be addressed irrespective of the structure of regulation. Of particular relevance to
Indian conditions is the need to appreciate the difference between administering law or public welfare
and regulation of financial entities and also not mixing up issues between the two roles. Similarly,
process of deregulation or rationalization of regulation should not imply dilution in supervision and, in
fact, should be complemented by close monitoring and effective supervision, especially adequate and
timely penal action as appropriate.
Finally an optimal regulatory framework ensures both autonomy and accountability of the regulator. To
ensure these, regulatory objectives need to be spelt out clearly and full operational freedom granted to
achieve the objectives through exercise of powers granted to the regulator over the regulated entities.
At the same time, the regulators should be as transparent as possible and fully accountable.
Accountability should no doubt be with reference to overall objectives and effectiveness. If individual
actions of a regulator are subjected to external scrutiny, there may be a preference for regulatory
inaction, just as, if individual case of inaction is subjected to such a scrutiny, there may be superfluous
or even obnoxious regulatory actions. In brief, the credibility of a regulatory framework is enhanced by
making it accountable for the overall performance in terms of well defined objectives. In India, many of
the joint family approaches are not consistent with some of these principles. For example, the
regulator has a nominee on the board of the regulated. The Government to whom a regulator is
accountable has dominant presence on the board of a regulator, who has to exercise operational
autonomy. These arrangements may give some advantages of coordination but have also
disadvantages of role-conflict leading to inadequate regulatory focus and diffused accountability.
Structural aspects of financial regulation
Recently, there has been significant attention to structural aspects of regulation. Thus, a unified
regulator was announced in UK in 1997; changes have been considered in Australia and reform has
been brought about in Japan. Further, legislative changes in the USA have to some extent diluted the
compartmentalization of financial activities and regulatory framework, which had been described as
"hotchpotch of different regulators for different bits of financial services industry, mainly for reasons of
history rather than deliberate strategy" (The Economist, May 5, 2001). Irrespective of the actual policy
preferences or reforms across the globe, the structural issue of financial regulation has recently
gained attention for several reasons.
First, the growth of financial sector is characterised by the blurring of distinction between banking,
securities and insurance activities.
Secondly, even if these institutions and activities are treated with a compartmental approach and even
if risks are considered separable, the linkages are such that the contagion cannot be avoided.
Thirdly, globalisation has resulted in multifunctional global conglomerates warranting appropriate
changes in structural aspects of domestic regulation.
Finally, it is argued that banks can still be treated separately for purposes of prudential requirements
without necessarily linking them with the central bank, whose primary responsibility should be price
stability.
In considering the pros and cons of single regulator or unified regulation and multiple regulators, a
major issue that needs to be addressed is: should banks be supervised by central banks? A case for
keeping supervision with the central bank is generally made out on the following grounds.
First, in order to assess the creditworthiness of the participants in the payments systems, the central
bank needs to form a judgment on aspects of liquidity and solvency and prudent conduct of banks.
Secondly, supervision complements the central bank's market intelligence system with a detailed
knowledge of the strengths and weaknesses of individual banks and, therefore, of the banking system
as a whole.
Thirdly, knowledge of developments in the banks' balance sheets can be important in assessment of
macroeconomic conditions.
Fourthly, lender of last resort function has a potential for moral hazard in the system and may cause
banks to gamble for resurrection, requiring the central bank to ensure that banks are well supervised.
Fifthly, there are substantial economies of scale, especially when there is scarcity of skilled
professionals in the area of finance.
Sixthly, independence of bank supervision is automatically provided if the central bank enjoys
autonomy, thus avoiding politcisation of bank regulation. In other words, central banks do enjoy a
tradition of independence and lesser politicisation.
There are, however, strong advocates of separation of monetary policy function and of banking
supervision too. It is said that monetary policy independence would be compromised due to possible
conflict between monetary policy and banking regulation/supervision. For example, the central bank
may relax monetary policy in times of extreme weaknesses in the banking system rather than for
macroeconomic reasons. In fact, Dr.Rangarajan had stated "Therefore I feel that the responsibility of
banking supervision being carried on to the central bank might make it more difficult in my opinion to
gain the kind of independence that we are talking about". Further, bank failures or weaknesses may
undermine the credibility of the central bank.
Assuming that one has an open mind on the issue mentioned above, the arguments in favour of a
single regulator can be summarized as follows:
First, there are economies of scale for the regulator since unification may permit cost savings on the
basis of shared infrastructure, administration and support systems.
Secondly, the regulated units also benefit since unification mitigates the costs which supervised firms
with diverse activities (i.e. financial conglomerates) bear for dealing with multiple regulators.
Thirdly, accountability is enhanced since complexity of the multiple supervisory system could lead to
lack of clarity of roles and consequently lack of accountability.
Fourthly, regulatory arbitrage can be avoided in the case of a single regulator. In a multiple regulatory
regime, fragmentation of supervision could lead to competitive inequalities as different units, possibly
offering similar products or services, are supervised differently.
Fifthly, reducing the number of regulators could allow scarce supervisory resources especially in
specialist areas to be pooled.
Sixthly, a single regulator can respond more effectively to market innovation and development as
there would be no regulatory gray areas.
Finally, unification aids in international cooperation as there is a single contact point for all regulatory
issues. In developing countries where banks dominate in banking insurance and securities business,
there may be a case for unified regulation.
Not surprisingly, the arguments against the idea of a single regulator are equally strong.
First, unification could lead to lack of clarity in functioning as multiple regulators tend to have different
objectives. This objective may be depositor protection for banks vs investor protection for capital
markets vs consumer protection for other financial firms.
Second, concentration of power could vitiate democratic policies.
Third, there may actually be diseconomies of scale since monopolistic organizations can be more rigid
and bureaucratic than specialist agencies because they would typically be large and too broad based
structures for effective regulation of the entire system.
Fourth, there may be unintended consequence of public tending to assume that all creditors of
supervised institutions will receive equal protection.
Finally, the focus of banks, securities and insurance supervisors being different, pooling of skills and
objectives, pooling of resources may not produce the synergy that is expected.
One way of reconciling the idea of a single regulator with keeping bank supervision as a part of central
bank is to have the central bank itself as a super regulator. A clear example of this unified supervision
is the Monetary Authority of Singapore.
In USA, there are multiple regulators even for banks who are accountable to Federal Reserve, FDIC
and State authorities.
In India, there is a separate agency for each main sector but there are examples of a variety of
combinations such as combined securities and insurance regulators (Chile, South Africa); combined
banking and securities regulators (Germany, France); and combined banking and insurance regulators
(Australia, Canada). Currently, examples of unified regulator outside the central bank are UK. Japan,
Korea and Sweden.
It is also necessary to recognize that several arrangements are possible whereby the single or multiple
regulators can function while ensuring appropriate coordination, sharing of facilities, and where
appropriate establishing clear cut division of responsibilities. It is possible to readily identify four of
them: (1) Unified Oversight Board which leaves the existing structure in place but overlay it with a
newly established oversight board comprising heads of different agencies (South Africa). (2)
Unification of support services which keeps agencies as separate legal entities but provides shared
infrastructure and support services. (3) Shared facilities with central bank which establishes unified
supervisory agencies as a separate agency, but have it share the support services with the central
bank (Finland). (4) Memorandum of Understanding (MoU) which establishes framework of cooperation
between government, central bank and single regulator (Memorandum of Understanding of UK 2001).
The guiding principles of the MoU are accountability, transparency, no duplication and information
exchange.
The international status in regard to the regulatory structures has been reviewed by the International
Monetary Fund (IMF, December 2000). The study notes that in approximately half of the countries
examined in a recent study, the revealed preference is for a regulatory structure based on specialised
agencies. The study shows that 35 countries have separate agencies for each main sector, 3 have
combined securities and insurance regulators, 9 have combined banking and securities regulators, 13
have central banking and insurance regulators, 3 have unified supervision (in central bank) and 10
have unified supervision (outside central bank).
It will be interesting to explore further the countries that adopted the unified model. The ten countries
classified as having adopted this organizational form are Australia, Canada, Denmark, Iceland, Japan,
Norway, the Republic of Korea, Singapore, Sweden, and the United Kingdom. In at least two cases -
Australia and Canada - the regulatory structure is not fully unified, as securities regulation is
conducted separately from banking and insurance regulation. As mentioned already, in Singapore's
case, regulation has been unified within the central bank. This leaves only seven countries that have
fully unified regulatory agencies separate from the central bank. Over half these are in Nordic
countries. In brief, while there is a significant global interest in examining the desirability of unified
financial sector supervision - combining banking, insurance and securities regulation, the practitioners
continue to be very few so far.
While there are only a few practitioners of unified model, it is noteworthy that almost all of them are
developed economies. In examining this issue, it may be useful to consider the organizational status
of banking supervision since banking is more special in developing countries. The Financial Stability
Institute's publication on the subject (Occasional Paper 1), makes interesting observations: "The
evidence appears to be that the weight of argument is moving towards the adoption of a separate
unified supervisory body within more developed economies. But does that same balance hold for
emerging and transitional countries?" The publication notes that in view of the Asian crisis, "it is
possible that international pressures, e.g. through the IMF, will interact with domestic forces to lead
towards better funded, more skilled and more independent supervisory bodies irrespective of how
these are structurally organized". The conclusion is instructive : "If so, then structure may come not to
be an important issue for the conduct of banking supervision. Perhaps, but for the time being, the
balance of argument would suggest that in less developed and transitional economies it would be
safer and better to integrate banking supervision into the ambit of the Central Bank".
Mr.Howard Davies, in the Tenth C.D.Deshmukh Memorial Lecture "International Financial Regulation:
The Quiet Revolution" makes a valid point of relevance to India: "in countries where the central bank is
well established as an independent institution, and where the interplay between the banking system
and the government's finances, perhaps because of state ownership, or state run programmes of
lending, is close, then one can see a stronger argument for central bank involvement in banking
supervision".
The reasons for caution in advocating unified model for developing countries have been articulated
very well by Professor Charles Goodhart in the Eleventh C.D.Deshmukh Memorial Lecture "Whither
Central Banking?": "I doubt whether the pressures to establish a unified, specialist, supervisory
agency are quite so strong in most developing countries. The financial system is less complex, and
dividing lines less blurred. Commercial banks remain the key players. Moreover, the Central Bank in
most developing countries is relatively well placed for funding, is a centre of technical excellence, and
can maintain greater independence from the lobbying of commercial and political interests on behalf of
certain favoured institutions. If the supervisory agency is placed under the aegis of the Central Bank, it
should share in these benefits of better funding, technical skills and independence. There are too
many cases of supervisory bodies, outside Central Banks, failing in such respects. For such reasons I
do not believe that the case for separation, which has become stronger in developed countries, should
be transposed also to developing countries". It is, however, necessary to recognize that there may be
a variety of systems, even among developing countries. However, in most cases, systems are
underdeveloped in terms of coping mechanisms (such as good governance practices), which makes
them fragile and more vulnerable. Besides, in developing economies, there is concentration of
economic activity with few economic players. To deal with situations from such scenario, therefore,
function specific supervision may be necessary but not adequate unless there is an institutional
framework for effective overall coordination.
Perhaps, one should also examine the possibility of unified supervision under central bank itself in the
case of developing countries. On this, Dr Chandavarkar, who made an outstanding analysis of Central
Banking in Developing Countries (1996) has this to state: "Although the case for the central bank's
supervisory role is, on balance, stronger, this does not imply that there is necessarily a case for
merger of existing autonomous supervisory agencies with central banks, which can continue, provided
there is effective coordination between the agency and the central bank".
Current status in India
In India, as in the case of many other countries, there are several agencies entrusted with the task of
regulation and supervision of different institutions and market participants in the financial sector. While
the specific objective may vary from depositor protection and investor protection to market regulation,
their common concern is maintaining financial stability. The RBI regulates and supervises the major
part of the financial system through its various departments. The supervisory role covers Commercial
Banks, Non-Banking Financial Companies (NBFCs), Urban Cooperative Banks (UCBs) and some
AllIndia Financial Institutions (AIFIs). Some of these AIFIs in turn regulate and/or supervise other
institutions in the financial sector, viz., Regional Rural Banks (RRBs) and Central and State
Cooperative Banks are supervised by the RBI through National Bank for Agriculture and Rural
Development (NABARD); State Financial Corporations (SFCs) by Industrial Development Bank of
India (IDBI) (to be transferred to SIDBI) and Housing Finance Companies by National Housing Bank
(NHB).
The Board for Financial Supervision, which operates as a Committee of the Central Board of Directors
of the RBI functions as an oversight supervisory body in respect of banks, NBFCs and AIFIs. It may be
noted that while NBFCs have been brought under a firm regulatory framework through legal
enactments, supervisory role in respect of AIFIs is of more recent origin. The AIFIs continue to be
large in size but with significant direct links with the Ministry of Finance. The RBI-NABARD relationship
has many different facets. On behalf of the RBI, NABARD supervises the banks in the rural
cooperative segment, viz., the State and Central Co