Monday, September 14, 2015

How Independent Are Our Financial Regulators?

[The following guest post is contributed by Bhargavi Zaveri, who is at the National Institute of Public Finance and Policy (NIPFP), New Delhi. Views are personal.

An abbreviated version of this post appeared in the Business Standard]

A sequence of recent incidents has rekindled the public discourse on the independence of our financial sector regulators from the Government. Critics of the draft Indian Financial Code have accused it of clipping RBI’s wings. A recent appointment on SEBI's board was perceived as politicization of the regulator. These debates raise a larger question of how much independence our financial regulators enjoy under the current legislative and institutional frameworks governing them.

Why bother?

Why must an unelected regulator be independent of an elected government? Can an elected government not build technical expertise within itself to regulate specialized fields? In a democracy, the people elect the legislature to make laws that will bind them. Doesn’t the “agencification” of regulation-making diminish the link between the rule-maker and the electorate that is sought to be regulated? There are four reasons that underscore the need for regulatory independence.

First, the policy preferences of governments change from time to time. Often, policy preferences change even with the same government being in power. By creating an independent regulator, the government builds credibility by foregoing its decision making powers to a body that will not be influenced by its seasonal policy preferences (often referred to as the credible commitment theory). Second, the mandate of the regulator and the means to achieve it may conflict with the temporary incentives of the government in power. A classic example is the central bank’s mandate to control inflation that often conflicts with the government’s incentive to pursue economic growth, which may create an inflationary bias. Third, in an economy where the government runs businesses, the regulator’s independence from the government is imperative to ensure a level playing field between public sector undertakings and private sector players. Fourth, independence of the regulator becomes crucial when taking enforcement actions against the regulated. For instance, FSSAI’s actions against Maggi must be (or at least perceived to be) independent of any biases that the government may have against foreign retailers.

De facto and de jure independence

Independence of regulators can be classified into formal (or de jure) and informal (or de facto).

The regulatory independence that is assured under law is formal. A regulator’s formal independence is reflected in the structure and incentives given to its management. For example, factors such as the tenure of the regulator’s management (a longer tenure generally implies greater independence), whether the management is appointed by a single minister or a more encompassing expert body (the latter being indicative of higher independence), whether the government can dismiss the management body, whether the tenure of the management is renewable, etc. will indicate the extent of a regulator’s formal independence.  Similarly, questions such as the financial independence of the regulator, that is, whether its overheads are covered by government grants or fees, whether its decisions can be overturned by the government, etc. are indicative of the regulator’s formal independence.

Regulators do not function in isolation from society. Informal independence of a regulator refers to the pressures that a regulator is vulnerable to due to its interaction with other actors in the ecosystem. For example, an appointee’s alignment with a specific political ideology or the extent to which a regulator is influenced by the regulated will be factored in its informal independence score.

Independence score under current frameworks

Under current frameworks, India scores fairly low on de jure independence of her financial regulators. Laws establishing regulators empower the government to issue directions to regulators on loose grounds such as public interest and policy. The power to issue directions to regulators is supplemented with government nominees on the governing body of the regulator. The selection process for full-time members of regulatory boards is not institutionalized. The law merely says that the government will appoint members of the boards of RBI, SEBI and PFRDA. The rules which provide for a selection committee to make such appointments are made and can be changed any time, by the government. Within the government, these appointments go through several files before they are cleared by the Appointments Committee of the Cabinet. Sometimes, as was done recently for the appointment of a new SEBI chief, the government issues a public advertisement inviting applications for the post. Sometimes, the regulator’s management itself recommends names for selection.

The government enjoys varying levels of power to remove members of regulatory boards. For example, the government may remove members of the boards of RBI and SEBI with three months’ notice. These laws do not lay down specific grounds for removal. Members of the boards of IRDA and PFRDA can, however, be removed on specific grounds such as abuse of position, insolvency, etc.

It is difficult to assess the informal independence score of regulators, as there are no official indicators (such as laws or formal structures) of de facto independence. However, the experience so far indicates that India scores reasonably well on regulators’ de facto independence. For instance, although the law allows the government to substitute the boards of RBI, SEBI, etc. this power has not been used till date. Nor has the power to issue directions in public interest been exercised by the government.

Is there scope for improvement?

India’s formal mechanisms leave much to be desired to ensure that regulatory independence is not threatened. The fact that the executive has so far not impinged upon regulatory independence through the use of formal mechanisms is no solace in itself.

The draft Indian Financial Code is a big stride in this direction. It institutionalizes a formal search and selection committee process for the appointment of the management of regulators in the primary law itself. The committee has independent experts and the law sets out a detailed merit-based selection process. Similarly, the removal of the management is handled by an independent enquiry committee and the law sets out the specific grounds for removal. Regulatory agencies are mandated to fund their overheads from fees generated by them. Finally, the draft IFC does not confer any power on the government to issue directions to regulators in public interest or on policy.

The recent clamour ignores extant frameworks and continues to believe in their capacity to protect regulatory independence. An objective review of existing laws may, perhaps, add perspective on this subject.

- Bhargavi Zaveri

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