Government of India Volume I: Analysis and Recommendations

MICRO-PRUDENTIAL REGULATION
cannot be designed with extreme examples in mind. Regulations framed from the perspective
of malign institutions could lead to over-regulation just as the same framed with
only the most benign institutions in mind could lead to under-regulation.
Regulators will also need to take into account the possibility of developing robust
models, given data sufficiency constraints. Faulty modelling is a possible consequence
of poor data, drawn from illiquid or opaque markets. As such, the draft Code authorises
the regulator to consider alternative pathways and/or impose overall or risk-weighted
capital requirements.
The micro-prudential provisions in the draft Code will ask regulators to confront the
tradeoffs, and make wise decisions about the optimal regulation that is reasonably feasible
for regulated persons to implement, and for the Regulator to monitor and supervise.
Over the years, accumulation of datasets and academic research will give feedback about
how certain initiatives have worked. Over the years, the financial system itself will evolve.
The combination of these factors will give a healthy evolution of the appropriate tradeoffs.
PRINCIPLE 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.
In the financial system, there are many ways of achieving the same objective. Products
looking very different can be constructed that essentially fulfil the same function.
The only difference would be the way these products look, and the specific contracts they
comprise of. As an example, consider the number of ways of taking a levered position in
shares of companies in the index, all of which fulfil the same function:
1. Buy each stock individually on margin in the cash stock market.
2. Invest in an index fund and borrow from a bank to finance it.
3. Go long a future contracts on the index futures.
4. Go long an over-the-counter forward contract on the index.
5. Enter into a swap contract to receive the total return on the index and pay a fixed interest rate.
6. Go long exchange-traded calls and short puts on the index.
7. Go long Over The Counter (OTC) calls and short puts.
8. Purchase an equity-linked note that pays based on returns on the index, and finance it by a repo.
9. Purchase, from a bank, a certificate of deposit with its payments linked to returns on the index.
10. Borrow to buy a variable-rate annuity contract that has its return linked to the index.
Since these are functionally equivalent, each of these mechanisms would add the
same risk to the regulated person. Regulators need not treat this diverse array of possibilities
with a sense of alarm, neither should they be blind to these possibilities. The choice
of a certain mechanism for fulfilling a function may depend on various factors, such as
differences in financial systems, constraints imposed by institutional form, technological
constraints, various types of transaction costs, and so on. An institution should be
able to choose the best possible mechanism, given all the factors it chooses to consider.
However, with a healthy financial regulatory structure, differences in micro-prudential
regulation should not favour any one of these mechanisms over another.
If the regulators take a functional perspective towards risk, treating similar risks in
a similar manner, it would help reduce regulatory inconsistencies across products and
markets. This principle is likely to lead to efficient regulation, because it allows innovation
and encourage competitive neutrality. It is also necessary because as system evolves
and opportunities to earn supernormal returns become difficult to find, regulatory arbitrage
could be used to destabilise the system. Capital will flow towards sectors with less
expensive regulations and this can often involve inappropriate risk-taking.
64 FINANCIAL SECTOR LEGISLATIVE REFORMS COMMISSION