Y V Reddy: Legal Aspects of International Financial Standards - National Law
Perspective
Paper circulated by Dr Y V Reddy, Deputy Governor of the Reserve Bank of India, at the International
Seminar on Legal and Regulatory Aspects of Financial Stability sponsored by the World Bank, the
International Monetary Fund, the Bank for International Settlements and the Financial Stability Forum
at BIS, Basel, Switzerland on 23 January 2002. Dr Reddy is thankful to Mr N V Deshpande, Principal
Legal Adviser of the Reserve Bank of India, who was associated with parts of the work; for presenting
the paper in the Seminar on his behalf.
The references for the speech can be found on the Reserve Bank of India's website.
* * *
Professor Giovanoli and friends,
I am thankful to the Bank for International Settlements for giving me opportunity to make this
presentation on the national law perspective, though a large number of presentations in the Seminar
relate to international law. The presentation is based on Indian approach and Indian experience and
focus is on processes and current status of various legislative changes that evolve in the consideration
of international standards and codes. Some generalisations are attempted on the link between
domestic law and international law. The first section captures general observations in regard to
international financial standards and codes with particular reference to Indian approach. The second
section attempts some generalisations on the domestic legal framework in this regard. The third
section describes the processes of consideration in India while the fourth narrates the changes in legal
and policy framework that are addressed in the processes. The daunting agenda for legal reform
arising out of the process is covered in the fifth section. The penultimate section deals with the current
legislative processes and responsibilities for implementation. The final section attempts some
generalisations on national law perspective and international law.
Indian Approach to International Financial Standards and Codes
The development of international standards and codes in the current context has five important
features, viz., it is part of the reform of the international financial architecture; it represents a
consolidated view of several interrelated standards and codes; it is a collaborative effort involving
different groups of countries, markets and international financial institutions and standard setting
agencies and bodies; it has elements of both external and internal assessments of degree of
compliance; and, finally there is an assumption of linkage between the implementation of standards
and codes and financial stability.
There are several reasons for the widespread interest in international financial standards and codes.
Among them, the most notable are the increasing cross-border flows; improvements in technology
making such capital flows faster thereby enhancing both efficiency and hard behaviour; large private
corporate entities operating significant resources, particularly, highly leveraged institutions impacting
on both efficiency and stability, and the large institutional funds such as pension funds and mutual
funds replacing to some extent the severely supervised banks' dominance in the financial
intermediation in a relatively closed economy. In such a situation, public policy has every reason to
minimise systemic risks by encouraging, to the extent desirable, transparency of operations and
uniformity in definitions to minimise risks of misunderstandings among the participants.
The extent of relevance of international financial standards and codes, the task of implementation and
the legal as well as other processes by which these standards are implemented would necessarily
depend on the country concerned. For example, in India, the major challenge in designing and
implementing the standards has been to chart a course of financial sector related reform in the
domestic arena, which ties up closely with the overall economic reform. At the same time, the need for
gradual harmonising with international standards has to be kept in view. Further, in taking a global
view and charting domestic reforms, there is need for built-in flexibility. The implementation of
international standards involves a virtual paradigm shift say, from a strong centralised planning system
(where the objectives are pre-determined and Fabian socialism dominated along with suspicion of
markets) to a system where contracts, prices and well defined inter-institutional relationships work.
The legal framework built on the socialist principles is being reformed and standards and codes
become a part of such changes.
While there is a strong case for considering international best practices, to the extent they exist and
are perceivable, there are several reasons to be circumspect about the role of standards and codes as
primary instruments of enhancing international financial stability. The recent efforts have focussed on
measures mainly designed to discipline debtor countries. While it is conceded that all the reforms that
are being prescribed have their merits, there is an overriding presumption in the prescriptions that the
causes of the crisis rests primarily with policy and institutional weaknesses in the debtor countries and
hence place the onus of responsibility of reform on the debtors. The obligations contained in the
standards and codes seem to reflect the view that the main flaws in the system for international capital
movements are to be found in recipient countries which should thus bear the burden of adjustment
needed to prevent or contain financial crisis. The UNCTAD Report (2001) states: "the reform process
rather than focussing on international action to address systemic instability and risks has placed
emphasis on what should be done by national institutions and mechanisms. Even in this regard, it has
failed to adopt an even-handed approach between debtors and creditors. Thus, it seems as if
standards and codes are being pressed upon developing countries to improve transparency and
disclosure without corresponding obligations for disclosure by financial institutions and hedge funds".
The link between implementation of standards and codes and financial stability by itself is neither
theoretically established nor backed by sufficient empirical evidence though on the basis of first
principles and judgement, the linkage between the two elements is apparent. Despite the apparent
emphasis on their voluntary adoption, there is a danger that incentives and sanctions linked to
standard setting will become features of IMF surveillance and conditionality. In such a scenario,
publication of information on the compliance status, particularly the information presented in the ROSC
reports, is fraught with the danger of classifying the countries into performers and non-performers.
Even when the international agencies associated with the work on standards and codes may not
intend so, once the information is disseminated, it is possible that credit rating agencies may assign
country ratings on the basis of the levels of achievement of standards.
Briefly stated, the recent international initiatives in regard to standards and codes provide at best a
partial solution to the problems of existing international financial architecture. Furthermore, in the
context of a crisis, they provide solutions at domestic level for issues that may often originate outside
the country. Finally, they do not assure international financial stability although they may contribute to
it. Yet, there are several reasons why public policy and national authorities need to focus on the
international standards and codes and these reasons centre around both efficiency and stability of
financial sector in the country. In this context, a desirable approach to the consideration of
international standards and codes can be explored in national interest.
Although the standards have evolved in the context of international stability, they have enormous
efficiency-enhancing value by themselves. Standards by themselves may be presumed to be, prima
facie, desirable, and it is, therefore, in the national interest to develop institutional mechanisms for
consideration of international standards. Thus, the implementation of standards needs to be given a
domestic focus with the objectives of market development and enhancing market efficiency. Often,
there are significant differences among the standards adopted, as in the case of accounting, and in
any case, mere existence of a set of codes does not guarantee either transparency or integrity of the
institutions concerned and transactions - a matter amply illustrated by the recent events involving
Enron and Arthur Anderson. Many standards keep evolving and it is important to keep a close track of
development in these areas. It also needs to be recognised that the process is evolutionary and say
two years down the line, present standards themselves can change, in degree and detail though not in
kind.
Role of Domestic Legal Framework
It may be possible to classify the standards in a conceptual framework under three broad elements,
viz., technical, policy and socio-cultural. Standards like SDDS, accounting and auditing, and
supervision may be classified as purely technical and, therefore, easily amenable to implementation.
Standards on monetary and financial policies, fiscal transparency and securities regulation have
certain policy implications and would form an integral part of the economic reform process in many
developing countries. The changes in these areas depend on timing, sequencing and complementarity
in related areas and availability of institutional, technological and legal infrastructure. Nevertheless,
while it is desirable to adopt these standards as soon as possible, it actually boils down to an issue of
managing policy reforms in a non-disruptive fashion. Finally, standards in the areas of corporate
governance, insurance and to a certain extent, insolvency and bankruptcy practices take a
sociocultural dimension and pose challenges of design, adoption and implementation.
It would thus follow that the scope and need for reviewing legal framework will vary depending on
whether it is technical, policy- oriented or socio-cultural. In technical issues, legal framework should
not be prohibiting appropriate standards, while policy should enable, and procedures ensure their
adaptation. The policy-oriented standards have significant link with conduct of policy and legal
framework may either enable or even assure policies that are consistent with international standard.
Those with predominant socio-cultural dimension would need significant legal backing, policy and
procedural elements. In other words, legal framework is of significance in varying degrees among
different standards and codes.
It is also possible to attempt a construct of the link between transparency and macroeconomic policy.
Good macroeconomic policy and good standards is perhaps an ideal situation for a country. Good
macroeconomic policy and poor transparency though not ideal is perhaps not risky by itself. Bad
macroeconomic policy and good transparency has large elements of risk and warrants change in
policy before launching into transparency. The most risky combination perhaps is bad macroeconomic
policy and bad standards. In a more dynamic sense, it can be argued that transparency provides
incentives to adopt good macroeconomic policies.
In this background, it is necessary to make it clear that a legal framework can address the issue of
transparency, and for that matter codes, in a variety of ways. First, it may be possible to ensure
adoption of such standards and codes within the existing legal framework. The issue would be
whether such compliance be made mandatory by law or the disclosure of the extent and nature of
compliance be mandated by law. Second, legal framework may have to be put in place to enable
compliance as and when considered appropriate. Third, legal framework could mandate compliance
but from a date to be specified. In fact, role of delegated legislation in the legal framework needs to be
explored in the context of standards and codes that keep evolving and need adoption. Fourth, legal
framework could provide for institutional arrangements that would assure a continuous basis for
compliance. Finally, legal framework may enable or mandate independent regulatory bodies that
happen to be relevant for the purpose to ensure compliance.
While transparency and financial stability appear fundamentally complementary, there could be a
trade-off at some point. Therefore, codes should be treated as milestones and the exact manner and
timing of dissemination of information including the structure of reporting should depend not only on
constitutional, legal and institutional mechanisms but also the likely impact of dissemination on the
financial sector soundness and stability in a given context.
Many codes emphasise legislative provisions in a concrete manner and legislation provides the shield
or back up for such actions. The emphasis should be to promote a general effort to improve legislative
provisions and it is necessary to recognise that the process of legislation is time consuming and
complex. While it is essential to recognise the importance of legislation, given its complexity, it is
essential to appreciate that sound practices also could be as satisfactory. For example, in India,
several regulatory prescriptions in respect of banks' investment in Commercial Paper brought about
changes in the money market though legal framework did not provide for mandating such prescriptions
on all the participants. Broadly speaking, the legal framework is one element of set of actions that
should be considered in regard to public policy on the issues of adoption of transparency and codes.
The others relate to actual conduct of policy and detailed procedures. In fact, apart from critical roles
for different regulations, there is a significant role for self-regulatory bodies in matters relating to
documentation, common procedures and promoting market discipline in favour of best practices. In
brief, the need for, scope of, and limits to the legal framework should be explicitly and continuously
appreciated.
The emphasis on the implementation of standards and codes and accountability thereof is still heavily
concentrated in the official sector. An optimal balance between regulation and competitive efficiency in
the financial system and markets can be achieved only with equal emphasis on responsibility and
accountability of the private sector. The focus of IMF is also with regard to codes mostly in respect of
regulators and not so much with private sector. International accounting standards and standards set
by securities market associations are, no doubt, expected to cover issues relating to private sector
market participants. Every effort should be made to recognise and correct the asymmetry in
considering legal framework.
Processes
Inspired by own reflection on the subject and the likely gains from implementation of international
financial standards, the Reserve Bank, in consultation with the Government, constituted a high level
Standing Committee on International Financial Standards and Codes in December 1999. The terms of
reference of the Committee entrusted it with the task of monitoring developments in global standards
and codes and assessing aspects of their applicability to the Indian financial system. The Committee
was, inter alia, required to reach out its Reports to a wide range of audience including relevant public
and financial sector organisations and institutions to sensitise public opinion and create awareness in
different subject areas. The approach of the Committee, therefore, was unique as it recognised public
consensus and concord as essential precursors to facilitate a voluntary adoption rather than merely
mechanical compliance.
The Standing Committee formed Advisory Groups in ten different subject areas in the financial system
by drawing intellectual resources in the form of groupings of eminent non-official experts. The Advisory
Groups were entrusted with the task of studying, in detail, (a) the present status of applicability,
relevance and compliance of standards and codes, (b) reviewing the feasibility of compliance and the
time-frame over which it could be achieved, given the prevailing legal and institutional practices,
comparing levels of adherence in India, vis-à-vis in industrial countries and emerging economies, and
(c) to chalk out a course of action for achieving the best practices.
The ten different core subjects areas identified by the Standing Committee corresponds to the official
list of codes suggested by the Financial Stability Forum (FSF) for implementation. These were :
Transparency in Monetary and Financial Policies, Data Dissemination, Payments and Settlement
Systems, Banking Supervision, Securities Market Regulation, Accounting and Auditing, Fiscal
Transparency, Insurance Regulation, Bankruptcy Laws and Corporate Governance. At this juncture,
the Committee, however, did not consider the set of codes on market integrity as fortified in the
40 recommendations of the Financial Action Task Force (FATF), though a technical report
commissioned on the subject has been finalised presently.
All Advisory Groups of experts had the option of interacting amongst themselves on matters of
overlapping or common concerns to evolve a consensus approach. The Advisory Groups also had the
option to include officials from regulatory and Government organisations as special invitees to discuss
and understand the prevailing position in the relevant standards and codes, for bringing improvements
in the existing practices. They also had the benefit of deliberations with market participants, members
from professional bodies as well academics. The arrangement afforded the Advisory Groups an
independent or impartial status and prompted a critical evaluation of the relevance and compliance
with each of the aforesaid standards and codes. The work of the Advisory Groups in some cases
happened to continue alongside similar subjects addressed by groups constituted by the Government
or other regulatory bodies. In any case, the work of the Advisory Groups was considered unprejudiced
and non-intrusive to any such official or non-official initiatives taken by others. The Advisory Groups
were requested to take cognisance of these parallel efforts and to provide inputs, wherever necessary.
All ten Advisory Groups have already submitted their reports to the Standing Committee. The Standing
Committee has made efforts to disseminate these Reports as widely as possible including their
expeditious posting to the Reserve Bank website. The Committee has also requested the Advisory
Groups to organise seminars for creating awareness and concretising views on recommendations.
The Committee would also take up regular annual review of the status and progress regarding
compliance with, and implementation of standards and codes and submit it to the Ministry of Finance.
Changes in Legal and Policy Framework
The implementation of the recommendations of Advisory Groups in relevant sectors would require a
co-ordinated approach based on elements of consensus, incentives, technical support, resources and
encouragement to concerned institutions and regulatory bodies. Broadly speaking, the
recommendations of Advisory Groups can be categorised into three levels, viz., requiring (a)
constitutional, (b) legislative and (c) procedural and policy changes. Quite a number of
recommendations require new legislative enactments or amendments to existing laws, while several
others could be implemented by making appropriate changes in the existing policy and procedures
under the powers vested to relevant bodies under the law. A few recommendations could also require
changes in the Constitution of India. Some of the issues pertaining to the financial system are also
being addressed by the National Commission to Review the Constitution. Of these changes,
amendments to the legal framework of the country assume utmost importance as they institutionalise
changes as formal laws with parliamentary endorsement and, therefore, provide clear-cut mechanisms
for enforcement.
There are several overlaps in the recommendations of Advisory Groups with concomitant relevance
for legislative changes keeping in view such overlaps. Some of the notable overlaps are between (a)
Monetary and Financial Policies and Fiscal transparency; (b) Corporate Governance and Banking
Supervision; (c) Payment and Settlement System and Securities Market Regulation; (d) Accounting
and Auditing and Banking Supervision. The issues of regulatory overlap were highlighted by several
Advisory Groups which has a bearing on the policy and procedures though not on legal framework as
such.
Daunting Agenda for Legal Reform
The Reports of Advisory Groups have identified several areas requiring legislative actions to ensure
enhancement in standards and codes relating to financial sector. The agenda arising out of the reports
is daunting as will be clear from the description below.
First, the improvements suggested by the Advisory Group on Payment and Settlement System would
necessitate amendments to Reserve Bank of India Act and Banking Regulation Act. While a new
enactment viz. The Payment Systems Regulation Act may also be needed, the implementation of the
rest of the recommendations would require notification of Regulations under all the above enactments
as well as in the Information Technology Act and the Indian Contract Act.
Second, on matters covered by the Advisory Group on Banking Supervision, amendments and
appropriate notifications under Reserve Bank of India Act and Banking Regulation Act would suffice.
Third, in respect of Securities Market Regulation, amendments are needed in respect of Securities
Exchange Board of India Act; Unit Trust of India Act, and The Companies Act. It may also be desirable
to consider a new enactment to deal with financial frauds. Several policy and procedural changes
would, no doubt, be needed by the Securities Regulator. The self-regulatory bodies are also required
to enunciate Code of Conduct and best practices in securities transactions.
Fourth, in respect of the Report of Advisory Group on Transparency in Monetary and Financial
Policies, a possible amendment to Constitution of India was expressed in the context of an ongoing
review by a National Commission. More important, several amendments to Reserve Bank of India Act
and Banking Regulation Act supplemented by policy and procedural changes on the part of RBI and
Government of India would be essential.
Fifth, the Report of Advisory Group on Corporate Governance covers a wide spectrum of institutions
and practices warranting actions in three broad areas. Amendments in Companies Act accompanied
by stipulations in regard to listing agreements of Stock Exchanges by securities regulators would
address the set of issues governing private shareholders in corporates in general. Amendments in
Banking Regulation Act and other statutorily established but Government-owned financial
intermediaries, especially public sector banks would be needed to bring entities in financial sector
under the overall best practices for corporate governance, especially in financial sector. In regard to
several other government owned enterprises also, there may be need for amendments in
Memorandum and Articles of Association, and in some cases the special laws that may govern their
establishment and functioning. In any case, substantial changes would also be needed in the
management practices and relationship between Government and the entities concerned where both
Government and private shareholders co-exist.
Sixth, the Advisory Group on Fiscal Transparency took account of the ongoing efforts to enact a Fiscal
Responsibility and Budget Management Bill, and expressed that such an enactment would fulfil most
of the requirements of transparency, when supplemented by appropriate rules and regulations, under
the proposed legislation. There is also a reference to proposed amendments to Reserve Bank of India
Act and Banking Regulations Act, which would, inter alia, address the issue of quasi-fiscal deficits.
Seventh, in regard to insurance, the Advisory Group found the legal framework to be upto international
standards though a couple of amendments are suggested. However, several of the recommendations
relate to the issuance of regulations by the Insurance Regulatory Authority.
Eighth, on issues relating to auditing, amendments are needed in respect of Companies Act,
Income-tax Act and Chartered Accountants Act.
Ninth, the compliance with the Report on Data Dissemination needs no legislative change.
Finally, in regard to Bankruptcy Law, a new legislation on a comprehensive bankruptcy code is
advocated. In addition, repeal of Sick Industries Companies Act, substitution of the institution of official
liquidator with professional trustees, creation of dedicated bench of High Court etc. have been
recommended. A special chapter on cross-border insolvency in line with the UNCITRAL model law
has also been suggested. Similarly, in respect of market integrity, a new legislation relating to
terrorism is under consideration while legislation to prevent money laundering is at an advanced stage
of consideration. Procedural actions by Reserve Bank of India in regard to strengthening of
KnowYour-Customer are also contemplated. Amendments to Banking Regulation Act are also expected to
enhance the powers available to Reserve Bank in this regard.
Current Legislative Process and Responsibilities
It must be recognised that the legislative process is complex, particularly in a democratic polity. Many
of the proposals are at different stages of processing. Thus, while Fiscal Responsibility and Budget
Management Bill and Prevention of Money Laundering Bill have been returned to Government with
opinion of Parliamentary Standing Committee, the Prevention of Terrorism Ordinance is likely to be
re-promulgated in a modified form. Proposals for amendment of Reserve Bank of India Act; Banking
Regulations Act are already at final stages of consideration in Government. Matters relating to
amendments to Indian Contract Act are still in the drafting stage. Some of the amendments to
Companies Act are being processed in the Government, though some of them are not strictly in
consonance with the recommendations of the Advisory Groups on Bankruptcy and Corporate
Governance. Independent of this process, the Government had also created a Committee on law
relating to insolvency and winding up of Companies, and based on the Committee's
recommendations, the Government has introduced amendments to the Companies Act. On others,
particularly in regard to Income Tax Act, action has not been initiated. On several aspects such as
separation of debt management from monetary policy, policy decisions have been taken but the
legislative process is yet to be commenced. There are several recommendations relating to
transparency of monetary policy and publicly owned entities where consensus is yet to emerge.
It is interesting to note that the Reports on the Observance of Standards and Codes (ROSC) BY IMF,
World Bank etc. draw heavily from the work of the Advisory Groups. These include fiscal transparency,
monetary and financial policy transparency, banking supervision, securities market regulation,
payments system and corporate governance.
On the whole, much of the responsibility of implementing the standards and codes falls on authorities
charged with the responsibility of regulating various areas of the financial system such as the
Department of Company Affairs (DCA) of the Ministry of Finance, Reserve Bank, Securities and
Exchange Board of India (SEBI) and Insurance Regulatory and Development Authority (IRDA). A large
number of recommendations could be implemented by self regulatory organisations specific to market
segments such as the Indian Banks' Association (IBA), Fixed Income Money Market and Derivatives
Association of India (FIMMDA), Association of Merchant Bankers (AMBI), Association of Mutual Funds
of India (AMFI), Foreign Exchange Dealers' Association of India (FEDAI), Primary Dealers' Association
of India (PDAI), and stock exchanges among others.
National Law Perspective and International Law on Standards and Codes
The contribution of Professor Mario Giovanoli is pioneering and unique to the legal aspects of
international financial standard setting. As mentioned by him, the standards currently monitored by
Financial Stability Forum, by and large, belong to the category of rules which it has become customary
to designate as "soft law". In this context, the three criteria suggested for positioning the standards in
the gradation between "soft law" and "hard law" are very valid. These relate to degrees of obligation,
precision and delegation.
On a very judgmental basis, most of the current processes relating to international financial standards
(described in this paper in the Indian context) appear to be at the soft law end of the spectrum. The
recent suggestion floated by Ms Ann Kreuger, First Deputy Managing Director of IMF, on new
approach to Sovereign Debt restructuring, however, appears to be closest to the 'hard law' end of the
spectrum. After describing the four key features of the proposed formal sovereign debt restructuring
mechanism, the question of legal basis for such a mechanism is raised and answered in the following
words. "If we are to restrict the ability of creditors to enforce their claims in national courts, then the
mechanism must have the force of law in those countries where enforcement might be sought. It
would not be enough to pass laws in a few leading countries. In practice, the mechanism must have
the force of law universally. Otherwise, creditors will deliberately seek out the jurisdictions in which
they have the best chance of enforcing their claims". While it is not appropriate to comment on this
proposal which is still evolving, it is proposed to make some very general statements on the issue of
national law in the overall setting of international law, based on the current approach and experience
of India in regard to standards considered by Financial Stability Forum.
The approaches and processes in India clearly bring out the challenges being faced even in regard to
the domestic legislative processes in India at this stage of national development and global
integration. Further, there is clearly a significant 'soft law' element within the national legal framework
for financial architecture, and much of the legal framework, if not the whole of it, is enabling rather than
binding, thus circumscribing the scope for moving towards hard law in the foreseeable future.
Moreover, the regulatory bodies have significant role in the implementation of many standards, thus
imparting some discretion or considerable flexibility in regard to application of general principles. In
particular, the inevitable role of self-regulatory bodies in regard to many of the standards makes it
difficult to impact large elements of hardness to their soft law nature.
However, there are several ways in which greater harmonisation could be encouraged. For example,
model legislations like the one by Commonwealth Secretariat on money laundering will help both
expeditious processing and relative clarity of concepts as well as definitions. This approach is of
particular significance due to the predominant cross-border nature of money laundering operations.
Similarly, there can be a special chapter in bankruptcy law only in so far as cross-border insolvency
issues are involved. Such an approach could be considered, keeping in view the UNCITRAL model
law. For example, the Report of the Advisory Group on Bankruptcy Laws enunciates the scope of the
special Chapter on cross-border insolvency. The Chapter applies where assistance is sought in India
by a foreign court or a foreign representative in connection with foreign proceedings; or assistance is
sought in a foreign State in connection with proceedings under the laws of India relating to insolvency;
or foreign proceedings and proceedings under the laws of India relating to insolvency in respect of the
same debtor are taking place concurrently; or creditors or other interested persons in a foreign State
have an interest in requesting the commencement of, or participating in, proceedings under the laws of
India relating to insolvency.
Finally, the recent experience of Enron and Arthur Andersen gives a