R Gandhi: Regulating financial innovation - P2P lending platforms design
challenges
Valedictory address by Mr R Gandhi, Deputy Governor of the Reserve Bank of India, at the
Mint Marketplace Lending Summit, Mumbai, 17 May 2016.
* * *
1. I am very happy to be addressing this Conclave to debate the Discussion Paper that
the Reserve Bank has recently presented for public discourse on regulating the Peer to Peer
Lending Platforms. Let me first explain the rationale for financial regulation in general and
regulation on financial innovations in particular. Let me also discuss the different approaches
that the Reserve Bank had employed in the past in dealing with financial innovations and
finally the challenges that we have on hand in designing an appropriate regulatory approach
to the Peer to Peer Lending Platforms.
Financial Regulation
2. The traditional neo-classical economic theory argues that unrestricted or
laissezfaire competitive equilibrium is the most efficient economic arrangement. This is built on
Pareto equilibrium and on the assumptions of perfect competition, with no externalities and
no destructive competition.
3. Many academic liberals are doubtful of the benefits of regulation of financial
services. Their case, as effectively summarised by David Llewellyn in his paper "The
Economic Rationale for Financial Regulation", goes like this: there are no market failures or
imperfections; if they do exist they are not sufficiently serious to warrant regulation;
regulation may not in practice solve these failures; or if it does, it can do so only by imposing
costs that exceed the costs of the original problem; serious moral hazards may arise when
regulation is imposed; and regulation imposes a wide range of costs which are paid
ultimately by consumers.
4. Another set of argument against regulations is that financial regulations actually
serves the interests of the financial service providers and mostly detrimental to consumers,
particularly because regulation results in reduced competition. As G.J. Benston points out,
this happens because financial regulations typically include restrictions on entry, controls
over products, restrictions on allowable business, restraints on prices, portfolio restrictions,
restrictions on geographical diversifications, etc.
5. However, several other academics find that the validity of the neo-classical
assumptions, when applied to the financial sector, do not hold good as there are in reality
imperfections, information asymmetry, incompleteness, and failures in perfectly competitive
or laissez-faire financial markets.
6. They argue that financial systems, markets and participants need regulation.
Arguments range from the need for regulation per se to the need to avoid consequences of
absence of regulations.
7. Prof Charles Goodhart, in his book "Financial Regulation: Why, How and Where Now?"
argues that the private sector, left to itself, produces market failure, or at least sub-optimal
results. In his view, there are three main reasons for financial regulation. They are:
i. To protect the customer against monopolistic exploitation
ii. To provide smaller, retail (less informed) clients with protection, and
iii. To ensure systemic stability
8. According to David Llewellyn, financial regulations have three objectives viz., to
sustain systemic stability, to maintain the safety and soundness of financial institutions and to
protect the customers. He argues that the case for regulation depends on various market
imperfections and failures which, in the absence of regulation, produce sub-optimal results
and reduce consumer welfare. In other words, the purpose of regulation should be limited to
correcting identified market imperfections and failures.
9. One critical argument in favour of financial regulation relates to what happens in the
absence of regulation. As Prof Charles Goodhart, says "Whatever the social costs and
benefits of an externally imposed system of regulation may be, public revulsion at the effects
and outcome of failures of unregulated financial systems can force the establishment of ....
external regulation". Similarly, Randall Dodd argues "No matter how much responsibility is
granted to individuals or no matter how much self-reliance is promised by private enterprises,
when troubles become big and bad enough, they all turn to the government and demand that
prompt action be taken to rectify problem".
10. Prof Goodhart also cautions "Interposing regulation and supervision into an
otherwise free-market context weakens the incentives for the owners and managers to
monitor and control themselves, and for their clients to exercise due diligence".
Financial Innovation
11. The Journal of Financial Innovation defines financial innovation as "the action of
creating and popularizing new financial instruments as well as new financial technologies,
markets and institutions. This includes innovation in the level of product, process and / or the
institution". We also know that innovations occur in businesses, when ideas are applied to
meet the needs and expectations of the customers. It may be new needs, or hitherto
unarticulated needs, or existing needs met in unique ways. Innovations are also driven
sometimes by stringent rules & regulations.
12. There is a debate whether financial innovations should be regulated. Whether the
innovators and entrepreneurs should be largely left alone, or whether public policy authorities
should be actively involved in regulating those.
13. Innovations bring in positive changes in efficiency, productivity, quality,
competitiveness, and market share, among other factors. However, as innovations usually
result in paradigm shifts, they are typically disruptive. It takes effort and time to understand
them. The associated dangers include untested effects, lack of clarity on long term effects,
and can lead to misunderstanding and misusing the innovation. Innovations can sometimes
be bad per se; sometimes even good innovations can be misused.
14. The World Economic Forum opines that financial innovation has been more positive
than negative and hence it will be better not to regulate them away by imposing excessively
harsh standards or outright bans on new products. The Forum suggests that let innovation
occur; but react appropriately and quicker to any flaws that become apparent and therefore
the tendency should naturally be to err on the side of caution.
15. An OECD Report argues that we should preserve the benefits of innovative
activities, while ensuring that new products and services that prove harmful are appropriately
contained.
Indian Experience
16. How have we been regulating financial innovations in India? The Reserve Bank has
employed several approaches while examining whether a financial innovation should be
regulated. They include:
i. To ignore
ii. To watch out
iii. To regulate passively
iv. To regulate actively, and
v. To ban
17. What determines the approach? I can answer this in a simple, rule of thumb
manner as follows:
i. Can the innovation cause large scale damage; then ban it.
ii. Is the size or magnitude very small; then ignore it.
iii. Can informed decision be taken by the consumers; then caution them.
iv. Can it be beneficial to many consumers; passively regulate it with light touch
regulation.
v. Can it be beneficial to many consumers, but consumer protection issues loom over;
then actively regulate it.
18. For example, the Prize chits and Money Circulation schemes have been banned,
whereas with regard to the virtual currencies like Bitcoins, we cautioned the public about the
risks involved in dealing with them. We had a studied stance and we preferred to err on
caution based on the simplicity or complexity of the product or service. While we said "Yes"
to micro finance, we said "No" to complex derivatives. In some other cases, we looked for
risk mitigants and permitted them only after they are available. For example, we did not
permit banks to engage agents to collect or pay moneys, until technology enabled Banking
Correspondents were available. We permitted Mobile Banking initially only for very small
amounts and as security and confidence were built only then, higher amounts were
permitted.
19. As regards Micro Finance, let me explain a little more, as it offers a good case
study. When Micro Finance came on the scene in early 1990s, we recognized it as a new
paradigm, with immense implications and were very supportive. When the demands for
regulating the Micro Finance Institutions were made, Shri Jagdish Capoor, the then Deputy
Governor, stated in 2001 "As MFIs are significantly different from commercial banks both in
terms of institutional structure and product portfolio, application of the same set of regulatory
and prudential guidelines to MFIs, in our view, not only runs the risk of distorting the
emerging market but it may also reduce the efficiency of these institutions". When the
demands gained momentum by 2005, the then Governor, Dr YV Reddy stated in August
2005, "Microfinance movement across the country involving common people has benefited
immensely by its informality and flexibility. Hence, their organisation, structure and methods
of working should be simple and any regulation will be inconsistent with the core-spirit of the
movement". Thus we were extending every possible support for a financial innovation which
was assessed by us as very important for furthering financial inclusion in the country. We
were very convinced that light touch regulation was sufficient in those formative years.
However, as the sector grew, certain inadequacies and failures became apparent. As Shri
Anand Sinha, my predecessor mentioned in April 2012, "In their eagerness to grow business,
the institutions had given a go by to the conventional wisdom and good practices such as
due diligence in lending and ethical recovery practices. Over-indebtedness of the borrowers
led to difficulties in repayments and the forced recoveries by some MFIs led to public uproar
and the subsequent intervention by the state government". Consequently, we also had to
tighten our regulations on micro-finance, based on the Malegam Committee
recommendations.
Regulating P2P Lending Platforms
20. The first set of questions that we need to answer in dealing with the issue of
regulating the P2P Lending Platforms are:
i. To regulate them or not?
ii. If to regulate, should it be ex-ante or ex-post?
iii. Is it now the right time? and
iv. If it is now the right time, should it be light touch or intensive regulation?
21. In the Discussion Paper, we have noted that internationally there are every type of
approach to dealing with the P2P Platforms, ranging from outright ban to total indifference.
Our tentative assessment is that P2P Lending Platforms need to be regulated, it may be the
right time now and it can be light touch. Let me re-emphasize that these are tentative. We do
want the stakeholders to express their views - either affirming our assessment or reasoning
out alternate assessment.
22. Given the MFI episode and the prescient words of wisdom by Prof Goodhart and
Prof Dodd about public reaction to failures of unregulated entities, that I referred to earlier,
we feel P2P Lending Platforms need to be regulated, even though they have not yet really
taken serious magnitude.
23. Regulations are of two types - prudential regulation and conduct of business
regulation. While the prudential regulation focusses on solvency, safety and soundness of
financial entities and financial system, the conduct of business regulation focusses on how
the financial entities deal with their customers and includes information disclosure by the
entities, their competence, their continuity and fair business practices.
24. It is clear that prudential regulation may have to be light for these Platforms, as they
will not be handling the moneys of the lenders. Actually, we need to be prohibiting them from
dealing in such moneys. Obviously, the conduct of business regulation will be appropriate.
As the lenders "trust" the Platforms for getting to know the borrowers, and avail additional
services like KYC authentication, credit scoring, legal formalities, recovery assistance, etc.
code of conduct and fair practices norms will need to be applied.
25. Next set of questions relate to the Platform's structure - should it be a corporate
entity or other types as well, what should be its capital, how should its governance structure
be, etc. We have given certain proposals in the Discussion Paper regarding these questions.
These were primarily guided by the need for serious, fit and proper and long term players to
maintain the Platforms.
26. Finally, the risk management structure focussing on operational risk and business
continuity, and the technology and customer grievance redressal mechanisms will need
attention. As lending and borrowing is a maturity transformation matter, continuity and
availability will be the essence for the services rendered by the Platform. Accordingly, the
expectations in this regard have been spelt out.
Conclusion
27. In the end, let me reiterate that the Reserve Bank considers that the innovation of
P2P Lending through Platforms facilitates direct interaction between small lenders and small
borrowers, and hence further financial inclusion; as consumer protection issues can get
amplified, the role of the Platforms come into focus; with appropriate regulatory arrangement,
we hope that the Platforms will be worthy of the trust that the lenders and the borrowers
repose on them.