How are financial innovations regulated in India?

Very nice speech by R Gandhi of Indian Central Bank. It is a pity that such speeches are barely covered in media. All we care for is newsbytes and news that hardly matters other than create hype.

The speech is given in the context of recent developments in P2P lending space where India has decided to regulate the space. After looking at various ideas around financial regulation (which makes for a great read as well), the speaker talks about Indian approach:

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

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.

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.

The problem has been we are just not made aware of the discussions/logic that go behind these decisions. We could have more working papers etc telling us about the broad reasons on why certain approaches have been taken.

For instance, histories of certain banks reveal that appointment of agents instead of opening branches was an easy thing to do till RBI came in the picture. Even after RBI came in 1935, it was only post Banking Regulation Act 1949  that regulator gained teeth. Add did it bite! So it is puzzling to read “we did not permit banks to engage agents to collect or pay moneys, until technology enabled Banking Correspondents were available.” It hardly is that big an issue. Banks in the past managed it well and cut costs on opening branches. There could have been some cases here and there but overall things just ran fine. While regulating we tend to look at some losses and tend to limit its potential. The idea should be to look at some history and the bigger picture.Similarly mobile banking which moved in a big way in African countries continues to remain much smaller in India. Again this is because of overcaution.

Anyways, the regulator had a changing approach towards regulation of microfinance:

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.

Here comes a classic dilemma for the regulator. When should one tighten screws? When the sector is on a roll or when it is collapsing? In this case, some might argue that treatment came much later and it was so severe that MFIs suffered a near death. The sector went from high highs to high lows in very quick time. The excesses were building and people let risks being built aware that govt/regulator will eventually bail them out. There was no clarity whether these institutions are basically being governed by markets or regulators. Whenever there is some doubt over this and a slight sign of government support, excesses keep building.

On P2p regulations:

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?

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.

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.

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.

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.

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.

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.

Clearly bitten by MFI sector, the regulator is trying to act against this P2P business early on.

There are two ironies to all this.

First P2P lending basically emerged to take advantage of lack of regulation in this space. Banking is a frustratingly highly regulated space and players are constantly looking for ways to fight regulations. But as the players gains some space, they are back to regulation fold. As already argued most of these P2P ventures are hardly anything new and chit-funds, nidhis, cooperatives etc are all form of P2P lending minus today’s technology. What makes them different is technology which allows the same players to come together in virtual space and lend their equity to others. This space is regulated physically with chits, nidhis etc being regulated by different players. But not the virtual space where these players started blooming. So in many ways this regulation for P2P ventures just widens its scope from the physical world to virtual world as well.

Second, was to see how people reacted to this regulation including the players themselves. Very surprisingly, they seem to be buoyed by the regulations. You kidding me? Since when have players reacted positively to regulation? But then this is not new to India, it is a problem in UK too.  Talk about confidence in your own product!

I don’t know but when we compare finance to other sectors, we see stark differences. Most of the the other sectors have moved away from stiff regulation to much easier ways. Firms come and go much smoothly without much issues. Atleast there is no regulation in day to day affairs. But with finance nothing of this sort is there. It is one of the highest regulated sector but there are continuous troubles in the sector. We are still struggling with similar issues which posed problems many years ago. The finance firms failed earlier due to lack of regulation (as we are told) but continue to be an issue in spite there being tons of regulation. They might not be allowed to fail due to Too big (or small) to fail but problems eventually continue to become bugger as we are seeing in banks worldwide and India.Instead of many small failures earlier what we see is one big failure. This is because problems are allowed to accumulate over a period of time hoping crisis will be averted. But it barely does and explodes one day as we saw in case of Lehman etc.

We need to do a serious rethink on this regulation business of financial sector. It should be drawn from history and based on local context and not the usual international best practice approach. International best practices are actually a joke and they usually mean just practices in US..


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