Government of India Volume I: Analysis and Recommendations

MICRO-PRUDENTIAL REGULATION
PRINCIPLE 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.
The incentives of regulators are usually asymmetric in favour of excessive caution;
regulators may not get much credit for maintaining the safety and soundness, but are
likely to be subjected to much criticism if the number of failures cross an acceptable level.
Consequently, regulators may tend to be too cautious and impose excessive costs on
regulated persons and the economy.
PRINCIPLE 5. The desirability of promoting competition, access and innovation, and minimising
the adverse effects of regulatory actions on competition, access and innovation.
Competition in financial markets is likely to have a significant positive impact on
growth. Competition and innovation often go hand in hand, since competition creates
the incentive for innovation. The strength of competition is likely to influence the efficiency
of financial intermediation and the quality of financial products.
Certain instruments of micro-prudential regulation, such as licensing, may have a
direct impact on competition, innovation and access in the system. As an example, it is
possible to use rules for entry in ways that close down entry altogether for years on end.
Going beyond entry barriers, instruments such as capital requirements, if not properly
used, could impede innovation and access.
The Commission believes that competition and high quality micro-prudential regulation
can go hand in hand. Indeed, the Commission’s reading of research of international
contexts suggest that high quality supervision in banking enhances stability and competition.
The Commission emphasises the pursuit of both goals: of high competition and
high quality micro-prudential regulation. A sound approach to regulation and supervision
is an integral part of a pro-competitive stance, through which there is no adverse
impact on competition.
The Commission also asserts that safety and soundness can be pursued in a manner
that minimises impact on access, innovation and competition. For example, hypothetical
situations could be imagined where simple leverage limits and risk-based systems of
capital adequacy achieve similar regulatory results though having a differential impact
on innovation and competition. The Commission recommends that concerns of stability
and impact on access, innovation and competition be considered in tandem.
PRINCIPLE 6. The need to ensure that regulatory actions are carried out in a manner that
is least detrimental to competitiveness of India’s financial system.
The Commission does not take a position on financial globalisation as such. The
financial system provides the pathways through which foreign capital gets infused in the
economy. The Commission simply notes that if policy makers continue to look to foreign
capital for assistance in meeting the development and financing needs of the economy,
micro-prudential regulation should be assessed in part by how such regulation affects
the ability of the country to attract such capital.
Regulations enhancing safety and soundness of institutions should help the country
attract financial capital, because investors are averse to losing capital due to instability
in the financial system. But if micro-prudential regulation over-reaches, then this can
negatively affect the return on capital. There is some evidence that global banks transfer
resources away from markets with highly restrictive financial regulation.
The Commission also notes that the viability of an onshore financial system is an
important measure of international competitiveness. Difficulties in regulation can lead
to financial intermediation involving India to move offshore. The Commission recommends
balancing two competing concerns. On the one hand, rules preventing the use
FINANCIAL SECTOR LEGISLATIVE REFORMS COMMISSION 65