Government of India Volume I: Analysis and Recommendations

MICRO-PRUDENTIAL REGULATION
Table of Recommendations 6.9 Principles of micro-prudential regulation
The regulator must consider the following principles in discharging its functions and exercising its powers:
1. Any obligation imposed on regulated persons should be proportionate to-
◮ the nature, scale and complexity of the risks in the regulated activity being carried out; and
◮ the manner in which the regulated activity ranks on the factors stated in Table 6.2
2. Regulatory approach needs to take into account the feasibility of implementation by regulated persons and
supervision by the Regulator;
3. The need to minimise inconsistencies in the regulatory approach towards regulated activities that are similar
in nature or pose similar risks to the fulfilment of the Regulator’s objectives under this Act;
4. Any obligation imposed on regulated persons should be consistent with the benefits, considered in general
terms, which are expected to result from the imposition of that obligation;
5. The desirability of facilitating competition in the markets for financial products and financial services and
minimising the adverse effects of regulatory actions on competition in the financial sector;
6. The desirability of facilitating access to financial products and financial services;
7. The desirability of facilitating innovation in financial products and financial services;
8. The need to ensure that regulatory actions are carried out in a manner that is least detrimental to competitiveness
of India’s financial system;
9. The need to take into account the long-term implications of regulatory actions, which will include a period
of at least five years following a regulatory action;
10. The need to minimise the pro-cyclical effects of regulatory actions; and
11. The requirement that persons who control and manage the affairs of regulated persons must share the responsibility
of ensuring the safety and soundness of the regulated persons.
◮ the nature, scale and complexity of the risks in the regulated activity being carried
out; and
◮ the manner in which the regulated activity ranks on the factors stated in Table 6.2
This principle requires that regulatory instruments are used in a manner that is risk
sensitive; the intensity of regulation should be proportional to risk held by the regulated
person. For example, compare two banks with the same balance sheet size. One of them
is investing only in low risk assets, while the other is investing in high risk assets. A regulatory
approach that is sensitive to the risks will impose different micro-prudential requirements
on these two regulated persons, because they have different levels of risks to
their safety and soundness. Similarly, the factors listed in Table 6.2 translate the market
failures providing the rationale for micro-prudential regulation into tangible tests. These
tests can be used not just to determine where micro-prudential regulation will apply, but
also to decide the extent to which such regulation are to be applied. Regulation ought to
be proportional to the risks and market failures.
PRINCIPLE 2. Regulatory approach needs to take into account the feasibility of implementation
by regulated persons and supervision by the Regulator.
The Commission notes that the regulatory approach should be modulated in light of
questions of feasibility for regulated entities and the capacity of regulators to supervise.
For example, consider buffers to absorb losses. Risk-weighted capital based on internal
models is potentially the most sensitive to risk though also the most opaque from
the perspective of regulatory supervision. Simple leverage ratios are likely to be the least
risk sensitive though easiest for regulators to monitor and enforce. While laws should
not be constructed for regulatory convenience, the possibility of frustration of regulatory
objectives should be kept in mind.
Alternatively, consider institutional capability, including questions of regulated persons
manipulating regulatory frameworks to their advantage. A regulated person using
the right internal models, and having access to sufficient data, could achieve fairly risk
sensitive capital buffers. Conversely, a regulated person using poor models or insufficient
data could fail to do so. Opacity raises the possibility of manipulation though regulation
FINANCIAL SECTOR LEGISLATIVE REFORMS COMMISSION 63