Government of India Volume I: Analysis and Recommendations

MICRO-PRUDENTIAL REGULATION
Table of Recommendations 6.5 Regulation of risk-taking
The regulator will have the following powers in connection with reducing risks:
1. Regulating investments of own funds and consumers’ funds;
2. Regulating claims on consumers’ funds;
3. Regulating to foster business processes that reduce risks;
4. Regulating the valuation standards for assets and liabilities of regulated persons;
5. Regulating transactions with related persons; and
6. Regulating liquidity management.
Table of Recommendations 6.6 Regulation of loss absorption
The regulator will have the following powers in connection with absorbing losses:
1. Defining categories of capital resources, based loss absorbing capacities;
2. Prescribing the amount of different types of capital resources required to be held, and the solvency requirements;
3. Defining criteria for assessing compliance with capital resource requirements;
4. Defining how regulated persons should manage the capital resources, including the requirement to notify
the regulator while issuing certain capital instruments;
5. Regulating how the changes in values of assets and liabilities will be recognised; and
6. Mandating purchase of insurance from Resolution Corporation.
regulated persons. The draft Code also empowers the regulator to impose liquidity requirements
on the regulated persons.
6.4.3. Regulation of loss absorption
These powers allow the regulator to require the regulated persons to keep capital resources
and/or purchase insurance from resolution corporation for absorbing losses. Capital
resources act as buffers that are typically used for covering unexpected losses arising
from under-performing investments or under-valuation of liabilities.
In conventional thinking, equity capital is thought to play this role. Loss absorption
functions can be provided by a variety of instruments not limited to equity capital. Different
instruments have different loss absorption capacities, and these capacities may also
vary with time. Contingent capital has debt-like features, but can become equity-like loss
absorber depending on certain conditions. If there are instruments that require deep and
liquid markets, during times of crisis, this loss absorption capacity may be constrained.
The regulator will need to think about loss absorption capacities across different times,
and ensure that there are adequate buffers in place for normal times as well as for times
of crisis (see Table 6.6).
A mechanism of loss absorption being built in this framework recommended by the
Commission is the resolution mechanism, which presently does not exist in India. For
certain financial service providers, the regulator should mandate purchase of insurance
from resolution corporation, as a pre-condition for undertaking the activities they propose
to undertake. For example, for banking service providers, the regulator may impose
a condition of getting their deposits insured upto a limit determined by the resolution
corporation.
6.4.4. Regulation of governance, management and internal controls
These instruments empower the regulator to prescribe standards for good governance.
Since the regulator shares the responsibility for achieving micro-prudential objectives
with the board and management of the regulated person, it is important that these persons
are prudently governed and managed (see Table 6.7).
FINANCIAL SECTOR LEGISLATIVE REFORMS COMMISSION 61