Government of India Volume I: Analysis and Recommendations

MICRO-PRUDENTIAL REGULATION
of offshore trading venues deny users of markets the lowest cost products and services.
Conversely, a regulatory race to the bottom where economic stability is sacrificed to increase
competitiveness is equally problematic.
PRINCIPLE 7. 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.
Numerous examples illustrate how micro-prudential regulation can be used in a
manner that reduces failure over a short period of time, though with much worse consequences
over a longer period of time. For example, regulations that allow conversion of
a pool of illiquid, poorly rated assets into liquid tranches of differentially rated securities
(some of them highly rated), may reduce the total capital obligations for the institutions
originating these assets, while also seeming to maintain safety and soundness. Such
regulation, if not conducted properly with sound alignment of incentives, requirement
of buffers at different levels, and other checks and balances, may encourage creation of
risks that may have consequences years later, perhaps going beyond the regulatory cycle
in which the regulation was notified.
PRINCIPLE 8. The need to minimise the pro-cyclical effects of regulatory actions.
Micro-prudential regulation can often be pro-cyclical, that is, it can amplify business
cycle fluctuations, and possibly cause or exacerbate financial instability. In a contraction,
regulatory constraints may bite well before the bankruptcy law does, as financial institutions
regard violating minimum capital requirements as extremely costly. Depending on
how the instruments of micro-prudential regulation are used, the extent of pro-cyclicality
may vary.
In the framework proposed by the Commission, the primary function of micro-prudential
regulation is to think about one financial firm at a time. The task of thinking about
overall systemic risk has been placed separately from micro-prudential regulation, precisely
because micro-prudential regulation requires a different perspective. This principle
requires micro-prudential regulators to be aware of the extent to which their rules are
pro-cyclical and to seek alternative mechanisms which minimise this phenomenon.
PRINCIPLE 9. 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.
Though the main objective of micro-prudential regulation is to maintain safety and
soundness for regulated persons, the regulator is not the one ultimately responsible for
the safety and soundness of the regulated persons. That responsibility should stay with
the board and management of the regulated person. Once a financial service provider is
identified for micro-prudential regulation, consumers, investors and other stake-holders
should not perceive themselves to be absolved from responsibility for the safety and
soundness of that institution. Regulation is only an additional set of measures that do not
replace the efforts of the board and management of the regulated person. The regulator
should lay out frameworks, which the board and management would be responsible for
implementing.
In addition to these principles enshrined in the draft Code, the Commission also recommends
that micro-prudential regulation be conducted in such a manner that there is
balance between a structured and a responsive regulatory approach. A very structured,
rules-based approach may bring clarity and certainty for regulated institutions, but may
limit the ability of the regulator to see risks arising from areas they may not have thought
about sufficiently in time. Also, if an institution is able to find a way to game the rules, the
regulator may not be able to see the problems at all. Regulators could miss the big picture
while being overly dependent on minutiae of the framework they have put in place. On
66 FINANCIAL SECTOR LEGISLATIVE REFORMS COMMISSION