Government of India Volume I: Analysis and Recommendations

MICRO-PRUDENTIAL REGULATION
let that happen. For example, if consumers’ funds are kept in a bankruptcy remote vehicle,
it should be possible to let the regulated person fail, without significantly affecting
the interests of consumers. In the stock market, the success of clearing arrangements has
made possible a regulatory stance where many securities firms have failed with no adverse
consequences to consumers. The construction of the resolution corporation thus
greatly changes how regulators would view failure.
For systemically important financial institutions, safety and soundness should be
taken to mean reducing the probability of firm failure, and for all other micro-prudentially
regulated persons, it should mean reducing the probability of the event of regulated person
failing to meet the obligations made to consumers. The Commission recognises that
the acceptable probability of failure for regulated persons is not zero. However, if regulators
are conferred with the objective of trying to minimise the probability of failure of
regulated persons, they may adopt an excessively restrictive approach that could result
in an adverse effect on competition or innovation in financial markets. This is not good,
particularly given the resolution mechanism being enshrined in the draft Code. Therefore,
the Commission recommends that the regulators should work with the objective of
reducing the probability of failure of regulated persons and maintaining it at below an acceptable
level. This acceptable level should be determined based on due consideration
of the principles enunciated in the draft Code.
Micro-prudential regulation must be distinguished from ‘systemic risk regulation’,
also called macro-prudential regulation (see Chapter 9). Sound micro-prudential regulation
is, of course, an essential ingredient of reducing systemic risk. Yet micro-prudential
regulation focuses on one firm at a time, while systemic risk regulation involves the financial
system as a whole. Micro-prudential regulation sees the proverbial trees to the forest
surveyed by systemic risk regulation.
6.2. A non-sector-specific micro-prudential framework
Micro-prudential regulation has often been a sector-wise concern. Some countries have
sector-specific laws, focusing on issues and instruments in the respective sectors. For example,
micro-prudential regulation in India is conducted by various financial regulators,
operating in different sectors, through an array of relevant laws. In this context, the Commission
recommends non-sector-specific micro-prudential provisions in the draft Code,
for the following reasons:
1. There is underlying similarity in financial contracts- they are all built from a small number of contingent
claims or obligations. There are common principles that underpin the micro-prudential
regulation framework in different sectors, though specific risk-types to be addressed and the way
instruments are to be used may differ. For example, there is significant convergence between
the Basel II framework for banks and the European Union’s Solvency II framework for insurance
companies. Unification of the law will yield more consistent treatment across apparently diverse
activities, which are actually constructed from a small set of core ideas.
2. As the financial system develops further, it will become increasingly difficult to draw sectorspecific
lines on financial products and services being offered. A common set of principles guiding
the regulation of the entire financial system will help minimise the potential for regulatory
gaps.
3. Once problems of competition policy are addressed, and competition in the financial system
heats up, easy sources of profit will be competed away. This will give firms a strong incentive
to pursue regulatory arbitrage. The use of a single set of principles, consistently applied across
different kinds of activities, will reduce the extent to which regulatory arbitrage might arise.
4. Sector-specific regulators administering different sets of provisions create the possibility of a race
to the bottom, where a sector regulator favours lax regulation in the interest of increasing the
growth of the sector. The presence of non-sector-specific provisions will help curtail such destructive
regulatory competition.
FINANCIAL SECTOR LEGISLATIVE REFORMS COMMISSION 57