## Sunday, January 29, 2017

### Are States Really at the Centre? Myth and Reality

By M. Govinda Rao.

Ever since the Fourteenth Finance Commission (FFC) recommended the tax devolution of 42% of the divisible pool to the States, many have held it responsible to the fiscal woes of the Union government. It is not surprising when the Finance Minister complains about it for all his fiscal difficulties, as he has to find a scapegoat. However, when a respectable senior editor such as Mr. Ninan, in his widely read editorial ruminates about "...the overly generous recommendations of the Finance Commission" resulting in the "... Central transfers to State governments ballooning by an astonishing 60 per cent in 2014-15" resulting in the total revenues in that year growing by 32%, we need to look at the matter more seriously.

Is the FFC really the demon responsible for the Centre's fiscal woes, or is it a fall guy? Incidentally, the FFC's recommendations came into effect in 2015-16 and not in 2014-15, and there must be something missing in Ninan's story of transfers to States ballooning by 60% in 2014-15 that needs unravelling. But, before that, it is important to understand how generous the FFC's "bonanza" really was. Indeed, 42% tax devolution, as compared to the 32% recommended by the previous Commission, looks a quantum jump. But, as the Terms of Reference of the FFC required it to consider total revenue expenditure requirements of the states without making a distinction between plan and non-plan, the Commission had to subsume the grants for State plan schemes (Gadgil formula grants) in its recommendations. This was equivalent to 5.5% of the divisible pool.

In addition, as the Commission included the area under forest cover as one of the factors to determine the share of individual States in tax devolution, and also decided that it will not give any grants other than those to achieve the States' budgetary balance, local governments and disaster relief. The amount saved on those discretionary grants was equivalent to 1.5% of the divisible pool. Thus, the increase actually is from 39% to 42%! How did it translate in terms of actual numbers? The accompanying table and the graph give the real picture of the volume of Union transfers to States.

Central Transfers to States
% of GDP % of Central Tax Revenues (Gross)
Years Tax Devolution Grants Total Transfers Tax Devolution Grants Total Transfers
2011-12 2.89 3.43 6.32 28.70 34.09 62.80
2012-13 2.91 2.99 5.90 28.10 28.90 57.00
2013-14 2.78 2.46 5.24 27.95 24.67 52.62
2014-15 2.71 2.74 5.45 27.13 27.40 54.53
2015-16 RE 3.73 2.31 6.04 34.68 21.51 56.19
2016-17 BE 3.79 2.32 6.11 35.00 21.46 56.46

In terms of % of GDP, tax devolution increased by one point in 2015-16 due to FFC's recommendation, but grants declined by 0.4 of a percentage point. Similarly, the share of tax devolution in Union taxes increased by 7.5 percentage points in 2015-16 over the previous year, but the increase in total transfers was just 2 percentage points! In fact, if one looks at a slightly longer time series, despite the Finance Commission's "bonanza", the total transfers relative to GDP actually declined from 6.3% in 2011-12 to 6% in 2015-16. The decline in the grants was due to the inclusion of plan grants in FFC's recommendations and partly due to the restructuring of the Centrally Sponsored Schemes.

 Central Transfers to States (% of GDP)

As mentioned earlier, FFC's recommendations came to effect in 2015-16 and the sharp increase in the transfers noticed in 2014-15 was actually not an increase, but an accounting change. It may be recalled that until 2013-14, grants to various Central schemes were given directly to the implementing agencies, bypassing the States. This practice was reversed in 2014-15 and the increase was due to change in budgetary practice and nothing else. Why did FFC decide to give slightly higher tax devolution, albeit marginal of about 3% of the divisible pool? FFC's analysis showed that between 2002-05 and 2005-11, Union government's revenue expenditures on State subjects increased from 14% to 20%, and on Concurrent subjects the increase was from 13% to 17% (see para 6.17 of the report). Thus, the Union government never found the lack of fiscal space a constraint in foraying into spending on various activities in the State List, quite a few of them in the nature of transfer payments. The arguments by the States was that why should the Finance Commission leave so much fiscal space for the Union government to intrude into their area though various Centrally Sponsored Schemes? While some of the Central Schemes are meritorious and it is therefore important to ensure minimum standards of services in respect of them across the country, FFC decided to provide greater flexibility to the States to spend on the subjects under their jurisdiction. The fact of the matter is, in the prevailing situation, it is not the Finance Commission, but the Union government that determines the total volume of transfers to the States, and blaming it for Centre's fiscal woes is like looking for a fall guy. The Finance Commission can only determine the volume of untied transfers, and that is what FFC did. The Finance Commission cannot be held responsible if the Union government did not pass on the benefits of lower oil prices but decided to levy cesses and surcharges on petroleum products to use the funds to initiate more schemes and expand on the existing ones.

The author is an Emeritus Professor, NIPFP and Chief Economic Adviser, Brickwork Ratings. He was a Member of the Fourteenth Finance Commission. The views are personal.

## Friday, January 27, 2017

### Establishing the Financial Redress Agency

by Dhirendra Swarup.

The Ministry of Finance has recently invited comments on the report of the Task Force to establish the Financial Redress Agency (FRA). The FRA is planned as a one stop forum for speedy and convenient settlement to complaints of retail financial consumers. In this article, I tell some of the back story, highlight the shortcomings of the current regime, and present the design principles of the FRA.

### The issue

Consumer protection involves prevention and cure. Prevention requires laws that set financial regulators on the objective of obtaining fairplay by financial firms. Cure requires effective complaint handling mechanisms. The current financial regulatory regime is lacking on both counts.

Gaps in prevention have resulted in unfair sales practices (e.g. see problems in bank led distribution) and poor product design (see problems in insurance). Such gaps have contributed to numerous crises involving abuse of consumers in recent years.

For the cure, we have consumer courts and ad-hoc arrangements by regulators. The consumer courts are over-burdened. They lack human and other resources to deal with financial products. Their interface with financial firms and financial regulators is inadequate. The arrangements put in place by regulators consist of multiple forums. These are SEBI, RBI, the banking ombudsman, the insurance ombudsman, IRDAI, and PFRDA. Consumers need to figure out which is the right one, depending on the situation they are placed in. For some products, like chit funds, one needs to approach the relevant forum in the concerned State. This framework has many weaknesses:-

Consumers are given the runaround. There are many locations in India through which the existing redress forums operate: 16 locations for the banking ombudsman, 17 for the insurance ombudsman and one by PFRDA. SEBI and PFRDA primarily rely on online systems. The consumers are burdened with identifying the right channel and bearing the travel and other related costs.

Lack of uniformity. Consumers and financial service providers (FSPs) have to deal with variations in approach, processes, capacity, service levels and powers across these forums. SEBI runs a facilitation system and is not empowered to award compensation. Therefore, it cannot do much if FSPs deny wrongdoing. PFRDA's system is quite similar to SEBI's. However, last month it appointed a part time ombudsman who can award compensation. The banking and insurance ombudsmen do award compensation. However, the approaches vary significantly. The banking ombudsman awarded compensation in 18 cases in 2015-16, out of over one lakh complaints. In contrast, the insurance ombudsman awarded compensation in nearly 25 percent of the 30,000 cases.

In addition to variations in the redress systems, there is a lack of uniformity in legal frameworks and supervisory capacity of regulators. This leads to regulatory arbitrage. FSPs try to push expensive and opaque products where they spot regulatory gaps or sub-optimal redress mechanisms.

Lack of specialisation. Cross functional teams are required for effective redress in forums like ombudsmen, which aim to resolve matters mainly though mediation. These teams bring together skill and experience in mediation and adjudication, domain expertise, industry experience and appreciation of consumer protection issues across consumer markets. The current system does not offer such possibilities.

Gaps in sectoral redress. Financial markets are converging. As a result, most intermediaries sell a variety of products. For example, banks are also the leading mutual fund and insurance distributors. An unhappy consumer may struggle to identify the party at fault and the relevant redress forum. Problems of this nature have been highlighted in the past. An IRDAI committee on bancassurance had emphasised making banks accountable to the banking ombudsman for insurance policy servicing complaints.

Conflicts between regulators handling individual complaints. Conflicts may arise if a regulator has an ability to deny or delay admitting to systemic problems. A redress forum dependent on the regulator would suffer from this flaw. A weak formal feedback loop between redress and regulatory functions leaves the system vulnerable. For example, the mis-selling in ULIP products may have flourished for an extended period owing to this. Moreover, levying fines on FSPs and awarding compensation to consumers is populist, but can mask prolonged existence of deeper failures of regulation. For instance, FSPs may be under pressure to comply even when they believe they are not in the wrong. This can be due to the fear of regulatory retaliation in some manner, in a non rule of law environment.

When uninformed consumers are asked to navigate this landscape, they are often hesitant and likely to avoid the formal financial system. This will give a sustained bias in the portfolio allocations of households, which is bad for the economy.

The shortcomings in the current consumer protection regime should no longer be ignored. The push for financial inclusion has gained significant momentum. First time consumers account for 260 million bank accounts, 130 million insurance policies and 8 million pension accounts. The push towards cashless payments has similarly brought millions of new consumers to financial payment providers. These new consumers have limited resources, low literacy and even lower financial literacy. There is an urgent need to build the financial regulatory machinery that will protect consumers better.

### The journey to consumer protection in Indian finance

In 2009, the Raghuram Rajan committee on financial sector reforms highlighted the regulatory gaps, overlaps, inconsistencies and regulatory arbitrage in the financial sector due to the many laws and agencies. It recommended that regulators work through a collective process to protect consumers and raise financial literacy levels.

In the same year, the Committee on investor awareness and protection, led by me, documented the widespread mis-selling that retail consumers face. It built a case for common minimum regulatory standards for retail financial advisers.

In 2011, the Financial Sector Legislative Reforms Commission (FSLRC), chaired by Justice B. N. Srikrishna, began its work to review the laws governing financial sector. It cemented the understanding that consumer protection was the essence of why we do financial regulation. In 2013, it conceptualised a framework for consumer protection and the FRA. The accompanying draft Indian Financial Code, a model financial sector draft law, placed consumer protection at the centre of financial law.

In 2015, the finance minister, in his budget speech, announced the setting up of a Task Force to establish a sector-neutral financial redress agency. Later that year, the Sumit Bose committee to recommend measures for curbing mis-selling further strengthened the case for a unified FRA. It identified regulatory arbitrage; mis-aligned distribution incentives; poor product design; and disclosure norms as key reasons for mis-selling. In 2016, the Task Force submitted its report to the finance minister. This report has now been released for public comment by the Ministry of Finance.

### Foundations of consumer protection

The Task Force, chaired by me, has recommended that a financial consumer protection and redress law be enacted. This should provide for the following basic protections to be uniformly implemented across the entire Indian financial system:

1. FSPs must act with professional diligence;
2. Protection against unfair terms;
3. Protection against unfair conduct;
4. Protection of personal information;
5. Requirement of fair disclosure; and
6. Redress of complaints by FSPs.

Enacting this law would reduce the extent to which consumers seek redress. On the FRA, the blueprint focuses on four attributes:-

Easy access. Consumers of all financial products would go the unified FRA. They would not need to know which regulator is involved. Consumers would be able to access FRA in a user friendly manner in multiple languages through letters; telephone; missed call service; email; mobile apps; text messages; and video. In addition, local facilitation centres would be available to handhold consumers. Consumers would receive regular status updates on their complaint.

Timely redress. FRA's processes, quality and capacity of teams, use of technology, quality of regulations and regulatory supervision: all these would be optimised to deliver timely redress. There would be a fast-track mechanism for simple complaints.

In each case, FRA would first ask the financial firm to offer a solution. Then, the FRA would form a preliminary view and discuss this with the consumer. The complaint would be resolved if a consumer is satisfied at this stage, or through mediation on conference calls. If mediation does not work, FRA would make a decision through adjudication based on facts. It would avoid court like processes.

Regulatory feedback loop. FRA would be independent of regulators, and have no incentive to cover up problems. It would create valuable databases about complaints, and give feedback to regulators to help improve regulations and supervision.

Accountability. FRA's accountability would be ensured through disclosure requirements and performance reviews. The FRA Board would be appointed by the regulators. It would have an Independent Assessment Office to consider complaints against its standard of service. In addition, orders by FRA would be appealable at the Securities Appellate Tribunal.

### Building State capacity in FRA

In Indian public policy, there are many good policy proposals, but the implementation capacity is often weak. It is difficult to construct State capacity in the various agencies of the government. The report has worked out the detailed project planning for the construction of FRA.

The Ministry of Finance has setup many new financial agencies in the past. These include SEBI, IRDAI, PFRDA, SAT, FIU, etc. In my knowledge, most of these projects had suffered from lack of adequate preparatory work with consequential delay in implementation. The project planning for FRA has avoided these pitfalls and provides a comprehensive blueprint for establishing this agency.

Consumer protection is the reason why we do financial regulation. The existing financial regulatory system requires major reforms in order to reorient it towards the objective of consumer protection. This will be a long journey. Implementing the FRA Task Force report would be an important step in that journey.

The author was formerly Secretary (Expenditure & Budget), Ministry of Finance; Chairman, PFRDA; Member-Convener, Financial Sector Legislative Reforms Commission and Chairman, Public Debt Management Agency.

## Wednesday, January 25, 2017

### How would demonetisation have shaped up under an improved RBI board?

Demonetisation has brought fresh attention to three aspects of RBI's board: autonomy, accountability and transparency. Patnaik and Roy (2017) demonstrate how the RBI Act lags behind sound international practices on these three counts.

The main financial reforms process in India has been the gradual enactment of the draft Indian Financial Code (IFC) drafted by Justice Srikrishna's Financial Sector Legislative Reforms Commission (FSLRC). In this article, we refer to version 1.1 of the IFC.

FSLRC strongly emphasised resolving deeper public administration problems that have bedeviled State capacity in India. One would assume that IFC solves many flaws in the functioning of the RBI's board which have been revealed in the demonetisation episode. However, both the FSLRC report and IFC have been previously criticised for undermining RBI's autonomy. After the demonetisation event, the IFC has been criticised for recommending a smaller RBI board.

In this article, using information available in public domain, we try to piece together what transpired at the RBI board when the decision to demonetise 86% of the currency in circulation was taken. We compare the RBI Act against the IFC. We play a war game' of thinking through the demonetisation drama under the IFC, and examine the extent to which IFC might have produced a stronger and more capable RBI. This war gaming sheds new light on how to create State capacity in India.

### What was the role of the RBI Central Board in the demonetisation decision?

The notification demonetising the currency notes of Rs. 500 and Rs. 1000 was issued pursuant to the recommendation of the RBI Central Board (hereafter, RBI Board). The RBI refused to disclose the minutes of the meeting where the RBI board decided to recommend the demonetisation decision to the Central Government. However, a response given by RBI to a RTI query reveals the following:

1. The recommendation was made in a meeting of the RBI Board held on 8th November, 2016.
2. When the meeting was held, some of the seats on the board were vacant and some of the members did not attend. Table 1 gives an overview of the RBI board composition and attendance at the meeting held on 8th November, 2016:

Table 1: Board composition and attendance at the meeting held on 8th November, 2016
Sanctioned Appointed Number of members who attended the meeting Number of votes allowed to be cast at the meeting
Governor 1 1 1 1 (plus a casting vote in case of equal votes)
Deputy Governors 4 3 2 0
Directors of local RBI Board 4 1 1 1

Independent Directors*

10 3 2 2
Nominees of the Central Government 2 2 2 0
Total 21 10 8 4 (plus Governor's casting vote)

*Independent directors are employees of neither the Central Government nor the RBI.

Under the RBI Act, only the Governor, the members of local RBI boards and independent directors are allowed to vote at meetings (Section 8(3), RBI Act). Table 1 indicates that out of the maximum sanctioned strength of 21, 11 seats were vacant on November 8, 2017. Out of the 10 appointed members, 8 members attended the meetings, and only 4 of them could vote. Amongst the voting members, 2 were independent members. There has been no public disclosure about voting by the members present on 8th November, 2016.

### Composition of the RBI Board: RBI Act vs. IFC

RBI has a (a) central board comprising of Governors and Deputy Governors and (b) four regional boards. One member, to be nominated by the Central Government, from each of the regional RBI boards is a member of the RBI Central Board. The discourse faults FSLRC for having abolished the regional RBI boards, and downsizing the RBI Central Board. Table 2 compares the provisions of the RBI Act and IFC on board composition.

Table 2: Comparing Board constitution
Feature Under the RBI Act Under IFC
What is the size of the RBI Board? Minimum 17, Maximum 21 (Section 8, RBI Act) Minimum 6, Maximum 12 (Section 10, IFC)
How many full-time members does the RBI Board have? Minimum 1, maximum 5, that is, Governor and a maximum of 4 Deputy Governors (Section 8, RBI Act) Not more than half the size of the current board (Section 10, IFC)
How many directors of local RBI boards are members of the RBI Board? 4 (Section 8, RBI Act) NA
How many nominees of the Central Government, does the RBI Board have? 2 (Section 8, RBI Act) Minimum 1, maximum 2 (Section 10, IFC)
How many independent members does the RBI Board have? 10 (Section 8, RBI Act) The balance remaining after filling the seats (Section 9, IFC)

Table 2 shows that under IFC, regulatory power and accountability are centralised in the RBI Board, as opposed to dividing it between a central board and local boards. Thus, there is one board that is empowered to carry out all the actions of RBI and accountable for the entire financial agency. Also, while the overall board strength has been reduced, IFC imposes a cap on the number of members who are not independent directors. Assuming the full strength of the board, today's RBI Board has more "independent members" as compared to the FSLRC recommendations. There are three takeaways from this:

1. Popular discourse has faulted the IFC for making the RBI Board vulnerable to Central Government's influence. Table 2 shows that on the contrary, the provisions governing board composition in IFC have tilted the board strength towards members of the board who are RBI employees.
2. Despite a large sanctioned strength and being overloaded with independent directors, the RBI board is now being accused of having not exercised sufficient independent discretion at the meeting held on 8th November, 2016. Thus, the sheer board size did not have the intended outcomes.
3. Modern thinking on the size of committees and boards suggests that a size range of 17 to 21 is excessive. It is likely to create a greater free rider problem and inferior discussions.

### Consequences of not filling up vacancies on the board: RBI Act vs. IFC

The obligation to fill up vacancies on regulatory boards is crucial. The board-size becomes moot if the seats of independent directors are vacant. At the time the decision was taken by the RBI Board, only 3 out of the 10 independent members were appointed. Table 3 compares the provisions of the RBI Act and IFC on the consequences of not filling up vacancies on regulatory boards.

Table 3: Vacancies on the RBI board
Feature Under the RBI Act Under IFC
Time-limit for filling vacancies on the RBI board None Vacancy must be filled within (a) 15 days from the date on which the vacancy arose, where the board-size falls below 6; and (b) 180 days from the date on which the vacancy arose, in all other cases. (Section 25, IFC)
Consequence of the Central Government not appointing independent directors on the board of RBI None Central Government to prepare a report within 90 days from the expiry of the timelimit, stating the reasons for the failure; and lay it before Parliament in an ongoing session or where the Parliament is not in session, in the immediately next session. (Section 25, IFC)

### Meetings of the RBI board: RBI Act vs. IFC

Decision-making by members of a board is inherently connected with the way meetings are convened and conducted. Table 4 gives a comparative overview of the provisions in the RBI Act and IFC governing the conduct of meetings of the RBI Board.

Table 4: Convening and conduct of meetings of RBI board
Feature Under the RBI Act Under IFC
Notice for convening board meetings 1 month (Regulation 8, RBI General Regulations, 1949) 7 days. (Schedule 2, IFC)
Can a meeting be convened at shorter notice? Yes, with sufficient notice to be given to every Director who is in India to enable him to attend (Regulation 8, RBI General Regulations, 1949) Meetings may be convened in special circumstances with shorter notice, provided the special circumstances are recorded in writing at the meeting. (Schedule 2, IFC)
Can members request the Governor for a meeting to be convened? Yes, 4 members may request a meeting to be convened (Section 13, RBI Act) Yes, 2 members may a request a meeting to be convened (Schedule 2, IFC)
What if the Governor does not convene a meeting at the request of the members? No implication (Section 13, RBI Act) Members may convene the meeting without the Governor. (Schedule 2, IFC)
Can quorum be constituted without independent members? Yes (Regulation 8, RBI General Regulations) Yes (Schedule 2, IFC)
Who is entitled to vote at meetings? Only the Governor, the directors of local boards and the independent members. (Section 8, RBI Act) All members are entitled to vote at meetings of the RBI board. (Section 26, IFC)
Can members attend meetings through technological means? Yes (Regulation 10A, RBI General Regulations) Subject to physical attendance at atleast one meeting a year, yes (Schedule 2, IFC)

There are four main takeaways from Table 4:

1. First, both IFC and the RBI Act are lacking in the details to be furnished to members of regulatory boards before the meeting is convened or at the time the meeting is held. Unlike commonly accepted secretarial standards which require an agenda and notes on each proposal tabled at a meeting of corporate boards, the laws governing regulators do not elaborate these requirements. Presumably, this has been left to the regulator's bye-laws which governs the internal affairs of regulators.
2. Second, again, contrary to popular perception, IFC vests more voting power in the full-time members of the RBI board, as compared to the RBI Act. It puts all board members at par with each other, in so far as their voting rights are concerned.
3. Third, while IFC requires a shorter notice to be given for meetings, as compared to the RBI Act, it has more robust processes for convening meetings at notice shorter than that required under law, including recording reasons for such shorter notice.
4. Under both the RBI Act and IFC, the quorum can be constituted without independent members. This is problematic and needs further deliberation.

### Relationship between the RBI and the Central Government: RBI Act vs. IFC

The way the relationship between the Central Government and the RBI is codified in the law, can hamper or increase the independence of regulators. Table 5 gives a comparative overview of this relationship, as codified in the RBI Act and IFC.

Table 5: Relationship between the Central Government and the RBI Board
Feature Under the RBI Act Under IFC
Can the Central Government give directions to the RBI board? Yes (Section 7, RBI Act) No.
Can the Central Government supersede the RBI Board? Yes (Section 30, RBI Act) No
Can the Central Government remove any member of the RBI Board? Yes (Section 11, RBI Act) Yes, on the limited grounds specified in the law (Section 22, RBI Act)
What is the process for removal of a member of the RBI Board? The law does not specify any process. The process involves a hearing before an inquiry committee comprising judges of the Supreme Court and a High Court and experts in the field of finance (Section 23, IFC)

Table 5 indicates that the IFC has provided for an arms' length relationship between the Central Government and the RBI. While the RBI Act gives considerable powers to the Central Government to supersede the board and issue directions to members of the RBI Board, such powers are absent from IFC. To be clear, it is nobody's case that the Central Government had used its direction-making powers under the RBI Act in connection with the demonetisation decision. However, being de jure indicators of independence, they are necessary though not sufficient conditions for ensuring independence.

### Internal and external accountability mechanisms: RBI Act vs. IFC

Accountability can be ex-ante or ex-post. Ex-ante mechanisms comprise of processes which must precede the performance of any function. IFC requires all quasi-legislative instruments to be issued through a robust regulation-making process comprising a cost-benefit analysis and a public consultation process. It requires the RBI Board to review regulations made after every three years. These measures are absent from in the RBI Act.

As regards executive and quasi-judicial functions, IFC provides for a time-bound licensing process, specific grounds for rejection of licenses, an administative law wing that is independent of the other departments of the RBI, for taking enforcement actions, and appeals against executive orders of RBI. These are ex-ante mechanisms to ensure that each function is discharged as per process and rule of law.

However, the power to "recommend" demonetisation is neither a quasi-legislative power nor an executive or quasi-judicial power. Hence, these ex-ante mechanisms built in IFC may arguably have not been applicable to the proposal.

Ex-post accountability mechanisms generally perfrom the function of auditing performance and conduct. Table 6 gives a comparative overview of other accountability mechanisms that would have been applicable in the exercise of a recommendatory power.

Table 6: Internal accountability mechanisms
Feature Under the RBI Act Under IFC
Is the RBI board bound to have its own performance audited? No. Yes, by an internal audit committee comprising of atleast two independent members.(Section 39, IFC)
What does the internal audit include? NA (a) Whether the RBI is functioning in accordance with applicable laws, (b) Whether the bye-laws governing internal processes of the RBI promote transparency and best governance practices, (c) Whether the RBI is complying with the decisions of the RBI Board, and (d) Whether the RBI is managing the risks to its functioning in a reasonable manner.
Is the RBI Board bound to set parameters for measuring its own performance at regular intervals? No. Yes (Section 42, IFC)
Are the results of the audit, paramaters for measuring performance and their results, published? NA Yes, alongwith the annual report of the RBI (Section 43, IFC)
External accountability mechanisms
Are the financial statements of RBI audited by an external auditor? Yes, by auditors appointed by the Central Government (Section 50, RBI Act) Yes (Section 44, IFC)
Is the performance and efficiency of the RBI reviewed by an external team? No Yes, the performance and efficiency of RBI is reviewed by a team of external experts every three years (Section 45, IFC)

Tables 6 shows that the RBI Act does not compel RBI to maintain any internal accountability or other mechanisms to review its own efficiency and performance. More importantly, the law does not mandate RBI to set goals or parameters against which its performance can be measured. IFC has, on the other hand, built in internal review and performance-setting obligations against which the regulator as well as external observers can measure its performance.

### Transparency of proceedings of the RBI board: RBI Act vs. IFC

Finally, ex-post accountability is greatly strengthened by transparency requirements. Table 7 gives a comparative overview of the transparency requirements imposed on the RBI, under the RBI Act and the IFC

Table 7: Transparency of meetings of the RBI board
Feature Under the RBI Act Under IFC
Is the agenda for a meeting of the RBI board to be published? No. Yes, within 3 weeks of the meeting (Schedule 2, IFC)
Are the minutes of meetings of the RBI Board required to be published? No. Regulation 8 of the RBI General Regulations, 1949 requires the proceedings of meetings of the RBI board to be circulated to the board members. Yes, within 3 weeks of the meeting (Schedule 2, IFC)
Are the votes casted by the members of the RBI Board at a meeting to be published? No Yes (Schedule 2, IFC)
Is there flexibility for redacting parts of the minutes of meetings before publishing them? NA Yes, on grounds listed in the law (such as where such publication can significantly frustrate the implementation of an action proposed by the RBI board)
Is there a process for deciding which portions of the minutes ought not to be published? NA Yes, reasons for not publishing must be recorded at the meeting, voted upon by a majority of the members of the Board and the vote of each member on the proposal to redact or not publish, must be published.
Do redacted portions of minutes ever get published? NA Yes, within six months, or as soon as the reasons for their delay cease to be applicable, whichever is later.

The main takeaways from Table 7 are that while one has to rely on the RTI Act to obtain a copy of the minutes of the board meetings of RBI. Application under RTI involves a monetary and non-monetary cost, and such attempts could fail. IFC mandates publication of the minutes, on an automatic basis, including in particular votes casted by members.

### War-gaming demonetisation under the IFC

The comparative overview given above should help visualise how the recommendation to demonetise currency might have unfolded under the FSLRC framework. We attempt to do this through a prism of questions and answers.

Table 8: Visualising the role of RBI in the demonetisation decision under the FSLRC framework
Question Under the RBI Act Under IFC
Is the recommendation of the RBI Board required for the Central Government to issue a notification demonetising currency? Yes Yes
Is the RBI bound to honor the promise on the currency that has been demonetised? RBI Act is silent Yes (Section 278, IFC)
Could the quorum for the meeting where the demonetisation proposal is taken up, be constituted without the presence of independent members? Yes Yes
How many seats were vacant when the decision to recommend demonetisation was taken by the RBI Board? 11 NA
Was there a time-limit for filling up the vacant positions of independent directors on the RBI Board? No Yes (See Feature 1 of Table 3)
Does the law obligate the Central Government to report reasons for not filling up casual vacancies? No Yes (See Feature 2 of Table 3)
Is the RBI bound to publish the manner in which the members who attended the meeting, voted? No Yes (See Table 7)
Is the RBI bound to publish the agenda and minutes of the meeting? No Yes (See Table 7)
Will there be an internal audit of whether the RBI breached any law in making the recommendation to the Central Government? No Yes (See Table 6)
Will there be an external audit of the performance and efficiency of RBI in replacing the currency notes? No Yes (See Table 6)
If the RBI board did not recommend the demonetisation, could the Central Government have compelled it to do so? Yes, by exercise of its powers to issue directions, supersede the board or removal of members. No, as it does not have the power to issue directions or supersede the board.(See Table 5)

### Conclusion

Post demonetisation, the discourse on RBI board governance has focused on either the independence of RBI or the conduct of former Governors or the present Governor. This is problematic, as it misses the woods for the trees. The demonetisation event has shown us that neither sheer board strength nor a brute majority of independent directors, can ensure regulatory independence.

Independence, accountability and transparency are intrinsically linked. The fact that the conduct of board members at meetings, together with details of who voted in what manner, will be published, incentivises people to vote responsibly. Hence, any argument for autonomy is rather incomplete unless it simultaneously asks for transparency and accountability.

A good fallout of the demonetisation event is that it has re-invigorated debates on regulatory governance and its importance on outcomes that we generally underplay India. We must not waste this opportunity and the lessons learnt to continue our reform agenda on regulatory governance.

### References

Ila Patnaik and Shubho Roy, The RBI board: Comparison against international benchmarks, Ajay Shah's blog, January 24, 2017.

Bhargavi Zaveri is a researcher at the Indira Gandhi Institute of Development Research, Mumbai.

## Tuesday, January 24, 2017

### The RBI board: Comparison against international benchmarks

by Ila Patnaik and Shubho Roy.

### Transparency and governance in central banks

There is renewed debate about the working of the RBI board, after the demonetisation decision. In a recent article in the Indian Express, we linked the observed outcomes to the faulty institution that is the RBI board. The Public Accounts Committee (PAC) of Parliament has questioned the Governor about the role of the board. At a conceptual level, Parliament, controls the functioning of the executive and other statutory bodies through two steps:

1. Making laws that govern the executive or statutory bodies (such as RBI, SEBI, etc.); and
2. Reviewing, through the committee system, whether such bodies are acting in accordance with the law.

An institution, as an inanimate object, does not have a human personality; it cannot reflect on its actions and change its behaviour. Rather, an institution's DNA is the law that governs it. When this institution functions in an unexpected way, one must look at the legal structures governing it.

For example, in 2013, a series of unexpected corporate scams starting with Satyam rocked India. These created fresh urgency for Parliament to amend the Companies Act (1956) to address the issue. We did not stop at discussing whether Mr. Raju was a good person or a bad person; we went deeper and changed the Companies Act in ways that make such a crisis less likely.

RBI's Central Board controls the functioning of the body corporate, i.e. RBI itself. Hence, the sound functioning of RBI requires sound functioning of its board. The RBI Act (1934) determines the working of RBI's Central Board. Hence, we need to examine the RBI Act, and ask whether it features sound provisions for the working of the board.

In this article, we document how, when compared with similar laws in other jurisdictions, the RBI Act has many gaps in terms of transparency and accountability. Regulations are made by the Board to govern itself, which violates basic requirements of hygiene. The flaws in the RBI Act help us understand how the demonetisation event happened, and show the direction for reform.

### Board transparency

RBI does not publish either the agenda or the minutes of any Central Board meeting. All that comes out is a press release. For a contrast, consider the Bank of England (BoE), which is grounded in the same legal tradition as India. It releases the minutes of every board meeting, 6 weeks after the meeting. This flows from the Financial Services Act of 2012 . These minutes go back historically, with minutes available for as far back as 1694. By this yardstick, RBI in 2017 lags the Bank of England of 1694.

Similarly in the U.S., the Federal Reserve Board (FRB) and numerous government entities are governed by a transparency law that is aptly called the Government in the Sunshine Act. This act lays down transparency and accountability measures that government regulatory bodies must comply with, covering both the way meetings of a regulator are conducted and how the regulator makes regulations. Board meetings are divided into two types of meetings, open meetings and closed meetings. For open meetings, subsection (a)(2) of the law mandates:

"every portion of every meeting of an agency shall be open to public observation."

Under this law, prior notice stating the meeting agenda must be given for every open meeting (Example). Accurate minutes or transcripts are published after each open and closed meeting (Example), and a live video is provided for open meetings. If board members knew that the nation was watching each word that they uttered, each would be more responsible.

To maintain confidentiality when required (such as in relation to commercially sensitive matters or pending investigations), some meetings are closed to the public. This provision can be easily abused to achieve opacity. Hence, the Government in the Sunshine Act explicitly specifies the following four procedural requirements before a meeting can be deemed secret:

1. Ten clear criteria are provided under which a meeting may be closed. An item has to fall within this exhaustive list to justify closing a meeting. Public choice theory teaches us that the Agent, i.e. the agency, is biased in favour of opacity. Hence, this list of permitted exclusions should be controlled by the Principal, i.e. Parliament. The contents of this list cannot be modified either by the executive or the agency. As an example, the grounds for exemption under India's Right to Information Act are written into the law and cannot be modified by the executive (e.g. Ministry of Finance) or an agency (e.g. RBI).
2. Public notice: Even when a meeting is closed, the agency must issue a public notice containg a suitably abridged agenda, and stating that it proposes to hold a secret meeting.
3. Transcripts and minutes: The agency must maintain transcripts and minutes of closed meetings. Any agenda item discussed that does not meet the criteria closing the meeting is made available to the public. The rest of the proceedings are kept in order to be released once the reasons for confidentiality cease to exist.
4. For parts of a meeting to be closed and minutes withheld, the majority of the entire membership of the agency (not just those present and voting) must vote in favour of each agenda item or portion of the meeting to be closed.

The working of RBI, which is coded in the RBI Act, 1934, is inconsistent with contemporary thinking in Indian public administration. As an example, six years ago, the Chief Information Commissioner ordered RBI to disclose minutes of the board meeting. Oddly, this instruction appears to have been ignored.

### Quality of minutes

The purpose of maintaining public records of meeting discussions is to demonstrate that the persons appointed to positions of responsibility and power are discharging their duties with care and diligence. The most recent press release only records attendance, and provides a two line summary which reads:

The Board reviewed the current economic situation, global and domestic challenges and other specific areas of operations of the Reserve Bank of India.

Let us compare this against the equivalent institution, the Court of Directors of the Bank of England. They publish detailed minutes of each meeting. These minutes record attendance and, excluding confidential elements, report in detail the views of each member on various issues such as risk profile; supervision functioning; monetary policy report; financial stability report, etc.

Similarly, while minutes of a single meeting of the New York Federal Reserve Board are around 6000 words, and those of the BoE Court of Directors are around 2100 words, RBI's press release is 142 words long. This either shows that the Central Board does not deliberate, or that the deliberations are not being released.

### Board Committees

Most Central Banks have created committees based on modern principles of governance. For example the Bank of England has the following committees written into the general regulations of the Bank of England:

1. Audit and Risk
2. Nominations Committee for promotions within the Bank
3. Remuneration Committee for fixing pay
4. Transaction Committee for large value transactions which are not in the ordinary course of business
5. Sealing Committee to governing the affixing of official seal on Bank documents

These are in addition to committees mandated by law, such as the Monetary Policy Committee and the Financial Stability Committee. Similarly, the Federal Reserve Board, has created sub-committees to conduct specific functions:

1. Committee on Board Affairs
2. Committee on Consumer and Community Affairs
3. Committee on Economic and Financial Monitoring and Research
4. Committee on Financial Stability
5. Committee on Federal Reserve Bank Affairs
6. Committee on Bank Supervision
7. Subcommittee on Smaller Regional and Community Banking
8. Committee on Payments, Clearing, and Settlement

Each of these committees has specific terms of reference specifying their authority and duties. In contrast, apart from statutory committees, RBI's general regulations create one Committee of the Central Board. There is no risk committee; audit committee; remuneration committee, etc. Regulation 15 of RBI's General Regulations gives wide and sweeping powers to the Committee of the Central Board:

The Committee of the Central Board shall have full powers to transact all the usual business of the Bank except in such matters as are specifically reserved by the Act to the Central Government or the Central Board.

There is no provision for board committees with identified duties. The composition of the Committee is quite unusual. Regulation 10(i) if the General Regulations states:

A committee which shall be called the Committee of the Central Board, consisting of the members of the Central Board who may at the time be present in the area in which the meeting is held,

The quorum for the Committee of the Central Board is quite unusual. Regulation 10(ii) states:

Two directors of whom one shall be a director nominated under section 8(1)(b) or 8(1)(c) or 12(4) of the Act shall form a quorum for the transaction of business.

RBI has a sanctioned strength of 21 directors. However, only 10 are currently appointed. But, since the Committee of the Central Board can take most of the decisions with just two directors, the debate about the size and vacancies on the Board becomes moot. This committee can carry out all tasks, except those specifically allocated to the Central Board.

### Financial Accountability

The RBI budget seems to suggest poor oversight. There is no evidence that the Central Board actually discusses the budget. While the RBI budget for 2014-15 was Rs.13,356 crore, evidence that the Central Board looked at expenditure items is lacking; a large budget was approved without any observation. In contrast, BoE releases detailed comments on its financial dealings. Discussing the draft annual report for 2013, the released minutes of the Court of Directors notes:

Mr Jones noted that the Accounts were likely to show an onerous lease provision of £24mn, reflecting the Bank's assumption of the unused space at Canary Wharf formerly occupied by the FSA, unless tenants could be found. Negotiations with several possible tenants were in train.

The Central Bank of Canada, among other disclosures, also provides a list of all contracts above CAD 100,000 every quarter. For example, in the 3rd quarter of 2016, Bank of Canada paid Diebold Company of Canada, a manufacturer of ATMs and security systems CAD 150,000.

### Conclusion

Under the rule of law, agencies and persons should be judged against set principles of law. However, in India, Parliament has set very low standards of transparency and accountability in the RBI Act (1934). Parliamentary committees with the power to hold government agencies accountable is a healthy feature of democracy. However, with the present silences in the RBI Act, the current approach where the Legislature questions RBI's functioning is yielding inadequate outcomes.

The correct approach for the legislature is to first formulate a law mandating transparency and accountability, from the Central Board and the organisation. The draft Indian Financial Code addresses most of the current concerns. After that, Parliament it must conduct regular oversight meetings (through the parliamentary committees) to hold the agency accountable against the mandated standards.

Ila Patnaik and Shubho Roy are researchers at the National Institute of Public Finance and Policy, New Delhi. The authors thank Nelson Chaudhuri, and Sanhita Sapatnekar of NIPFP for their inputs.

### Judicial Procedures will make or break the Insolvency and Bankruptcy Code

by Pratik Datta and Prasanth Regy.

The key test of any default resolution process is: how much value is recovered by the lender? The most important factor that determines this amount is the time taken to complete the resolution. India has set up many recovery mechanisms that have given us long delays and low recovery rates. Most of the delay in the resolution is due to poor judicial processes that enable parties to obtain repeated adjournments.

The Insolvency and Bankruptcy Code (IBC) offers us a new beginning to fix the problem of low recovery. It imposes several timelines on its Adjudicating Authorities (National Company Law Tribunal (NCLT) for corporate defaults and Debt Recovery Tribunals (DRT) for individuals). For instance, it requires these tribunals to complete insolvency resolution in 180 days. It also requires NCLT to ascertain the existence of corporate default within 14 days of an application. Commentators have pointed out that without digitised credit data from Information Utilities (IUs), it will be difficult to adhere to these timelines. In this article, we argue that even with the IUs in place, it will be difficult to meet the timelines unless NCLT's procedures are redesigned.

### 1  Triggering Insolvency Resolution

As an example of an IBC time-limit, consider the process laid out by the Code in the case of a corporate default. A creditor can apply to NCLT to initiate an Insolvency Resolution Process (IRP) against the debtor. Along with the application, the creditor needs to do two things: furnish evidence of default recorded in an IU (or other evidence of default); and propose the name of a resolution professional (RP).

On receipt of the application for IRP, NCLT has 14 days to accept or reject it. The application is accepted only if NCLT is satisfied that default has occurred, and that the proposed RP has no disciplinary proceedings pending against him. Now let's see how this process will actually work out under the current NCLT rules.

### 2  Current procedure

Matters filed in NCLT under IBC are governed by the Insolvency and Bankruptcy (Application to Adjudicating Authority) Rules, 2016. Under this, the procedure for making an application under IBC is the same as that for company matters before NCLT. These rules require applications to be:

type-written, lithographed or printed in double spacing on one side of standard petition paper with an inner margin of about four centimeter width on top and with a right margin of 2.5. cm, and left margin of 5 cm, duly paginated, indexed and stitched together in paper book form.

E-filing is promised eventually: the application ... shall be filed in electronic form, as and when such facility is made available. Online payment of fees is not allowed: fees can be paid only by means of a bank draft.

NCLT has to make a reference to IBBI to check if there are any disciplinary proceedings pending against the proposed RP. This reference will be sent by post, and the reply from IBBI will likewise come by post. It is not clear how IU records are to be submitted to NCLT: if the Tribunal requires that all IU records need to be certified by a senior officer of the IU (like in the case of bank records) it will lead to more delays.

All these have to be done while the NCLT is dealing with its workload under the Companies Act. On top of these, it is estimated that under the IBC, about 25000 cases will be transferred to NCLT from Company Law Board, the Board for Industrial and Financial Reconstruction (BIFR), the High Courts, and DRTs. This combination — a gargantuan workload, and slow processes to deal with it — makes it unlikely that the NCLT will be able to respect the IBC timelines.

### 3  Redesigning procedures

The Bankruptcy Law Reforms Committee recognised this problem and suggested the extensive use of technology by NCLT and DRTs to achieve efficiency. If we are serious about meeting the IBC timelines, NCLT's procedures will have to be designed anew.

Let us revisit the previous example in this light. Submission of the application for initiating IRP should be electronic: all documents, including IU records, should be submitted online. This will make it easy to verify the evidence of default. The tribunal must not require any certification from IU officials that the IU record is authentic — the digital signature on the IU record should suffice. Verifying the RP's antecedents with the IBBI should be automated: it should only involve a computer at the NCLT querying another computer at IBBI. With these processes, the tribunal stands a far better chance of meeting the 14-day timeline.

Of course, meeting this deadline in and of itself is no fix to the issue of delayed recoveries. However, this deadline is crucial for two reasons: firstly, because insolvency resolution cannot begin till the application is accepted, so any delay in this process delays the eventual resolution as well; and secondly, once a precedent of ignoring IBC timelines is established, there is no reason to respect the sanctity of any other timelines in the Code, including the 180-day limit on resolution. The Code will lose one of its most compelling features.

### 4  Conclusion

India has been here before. We have created a long list of mechanisms to facilitate the recovery of debts. This includes the BIFR set up in 1987, the Company Law Board set up in 1991, the Recovery of Debts Due to Banks and Financial Institutions Act passed in 1993, and the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act passed in 2002. The RBI also has tried several schemes, including Corporate Debt Restructuring (2001), Joint Lenders' Forum (2014), Strategic Debt Restructuring (2015), and the Scheme for Sustainable Structuring of Stressed Assets (2016). None of these have been successful in resolving defaults efficiently.

We have another list of laws (including the IBC) that seek to impose deadlines on the judiciary. In the absence of rigorous process design, such attempts to eliminate judicial delays through legislative fiat have not worked either. Instead, there is ample precedent of ignoring these deadlines.

Now the IBC affords us yet another opportunity to achieve the goal of prompt recovery of debts. High-quality intellectual work is required to design and implement good judicial procedures for NCLT and DRT. If we do not make this investment now, IBC will also be a failure.

### References

Bankruptcy Law Reforms Committee. The Report of the Bankruptcy Law Reforms Committee Volume I: Rationale and Design. Government of India, 2015.

Prasanth Regy, Shubho Roy and Renuka Sane. Understanding Judicial Delays in India: Evidence from Debt Recovery Tribunals. Ajay Shah's Blog, May 18, 2016.

Pratik Datta and Ajay Shah. How to make courts work? Ajay Shah's Blog, February 22, 2015.

The authors are researchers at the National Institute of Public Finance and Policy, New Delhi. We thank Anirudh Burman, Suyash Rai, and three anonymous referees for helpful comments.

## Monday, January 23, 2017

### TRAI's consultation towards a net neutrality framework in India

by Amba Kak, Mayank Mishra and Smriti Parsheera.

### The context

The Telecom Regulatory Authority of India (TRAI) has issued a Consultation Paper (CP) on Net Neutrality seeking inputs for the formulation of final views on the subject. This comes almost a year after TRAI's regulation prohibiting discriminatory tariffs for data services based on content, framed using its power to determine the rates at which telecommunication services are to be provided. The present exercise covers a broader canvas of trying to identify the acceptable limits of interference in the provision of Internet access services. This includes practices like blocking, degradation or prioritisation of specific traffic, which often form the focus of the net neutrality debate. In TRAI's words, it is an attempt to "rethink the first principles of traffic management by telecom service providers (TSPs)".

While issuing the discriminatory tariff regulation, TRAI had highlighted the importance of "keeping the Internet open and non-discriminatory". This idea also flows through the CP and the pre-consultation paper that preceded it in May, 2016. In fact, TRAI acknowledges in the CP that the term "net neutrality" is being used in its commonly understood sense of equal or nondiscriminatory treatment of content while providing access to the Internet. The word "equal", however, does not appear in the ultimate question posed by TRAI on what should be the "principles for ensuring nondiscriminatory access to content". The CP does not clearly spell out the reason for this. It could be due to the difficulties of monitoring equality in a best efforts delivery system; or perhaps because the term non-discriminatory already captures the concept of equality.

### Key issues raised by TRAI

The CP is reasonably comprehensive in its coverage of all major aspects that countries have considered while formulating their positions on net neutrality. Several of these, like reasonable traffic management, scope of prohibited activities and need for transparency were also discussed by TRAI at the pre-consultation stage. The difference, however, is that this CP takes a deeper dive into those issues, identifying the different approaches that could be considered and, in some cases, also weighing their pros and cons. On some issues, TRAI explores new areas, not covered in its earlier papers on the subject. The following are some key points discussed in the CP.

• First, TRAI notes that each country's approach on net neutrality is defined by its local context. Accordingly, it refers to some India-specific factors that may influence its approach. These include, the predominantly wireless character of access services -- 97 percent of Internet subscribers are on wireless networks. The CP later explains that traffic management on wireless networks may pose certain unique challenges due to spectrum constraints and variable usage patterns. It also refers to India's circle-wise licensing regime which often results in the usage of third party networks outside one's home service area. TRAI queries, who will be responsible for any neutrality violations in such situations?
• Second, the CP raises pertinent questions about the appropriate footprint of regulation, in terms of the services that are covered and the persons rendering them. In particular, it refers to the potential exclusion of "specialised services", which could be defined in several different ways. The manner in which India eventually chooses to answer this question will have far reaching effects on the adoption of future technologies in the country, particularly in the context of the Internet of Things revolution.
• Third, beyond trying to identify the reasonable limits of traffic management, this CP gets into more practical aspects of detection and monitoring of violations. It also suggests a collaborative approach for implementing the operational aspects of net neutrality, which, if adopted, would be a novel approach for the Indian telecom sector.
• Fourth, TRAI discusses the role of disclosures and transparency in guarding against discriminatory traffic management practices, an issue that was also raised in earlier consultation papers. However, in this case, it goes on to suggest two approaches on how this can be achieved -- a "direct approach" that would require a TSP to make specific disclosures only its own users; and an "indirect" one would also involve transparency towards third parties like content providers, consumers groups, research organisations and users of other TSPs.

### Scope of acceptable traffic management

The chapter on "Traffic Management" in the CP sets out the crux of the net neutrality policy debate. First, it explains why traffic management is an integral function of access providers -- to address congestion, security and the integrity of the network. Next, it notes that while such motivations for traffic management practices (TMPs) could be considered "reasonable", others might be "non-reasonable" due to their potentially discriminatory and anti-competitive effects. As such, it explains why regulating traffic management is being considered as a policy option and then mulls over the varied regulatory approaches that could be adopted.

Congestion management, which is explained in terms of the variability of demand or "peak-load", particularly on wireless networks, is explained to be one of the reasons for which access providers might legitimately engage in TMPs. TRAI recognises that the real solution to such issues lies in enhancing the overall network capacity but goes on to note that "even in a situation of enhanced capacity, some degree of scarcity might persist", hence creating a role for traffic management. The key takeaway from this discussion is that "differences in network architecture and technology" will play a role in assessing the reasonableness of any TMPs.

Next, the CP highlights that the same commercial considerations that prompt the use of traffic management tools to improve network performance could also become the cause of exclusionary or discriminatory practices. It notes that there have been global examples of TSP interference in networks for patently anti-competitive purposes, namely "service blocking, prioritising affiliated content provider services or throttling competing ones". While this explains the calls for regulation, traffic interference driven by commercial arrangements is not the whole scope of TRAI's enquiry. Instead, the CP provides two conceptual frames that might be used for such regulation -- the "broad approach" and the "narrow approach".

The "broad approach" appears to be a principles-based approach to identifying which practices would be considered reasonable. Drawing from the European Union's regulations, it refers to guiding principles like proportionality, non-discrimination, transparency and absence of commercial considerations that can be used to define the bounds of reasonableness. Practices like application-specific discrimination, throttling encrypted content, deep packet inspections, etc. can then be tested against these standards.

In contrast, the "narrow approach" will confine itself to formulating a "negative list" of practices that will not be permitted, without going into the contours of reasonableness. TRAI leaves the content of the negative list open for discussion, but gives the specific example of practices motivated by commercial/strategic partnerships with content companies as a potentially proscribed activity.

The distinction between the two approaches does not appear to be one of mere semantics. The paper acknowledges that a negative list is, by nature, likely to be restricted to situations that we are aware of today -- "This may motivate providers to develop other types of business practices that are not explicitly covered in the narrow restrictions although they may have similar harmful effects". It also notes that there could be difficulties in establishing a commercial motive. One way to address this could be to treat the lack of any objective/ technical reasoning for a traffic shaping practice as being indicative of "commercial motive", even where this may not be explicit.

By weighing these different approaches, TRAI seems to acknowledge that regulating TMPs is a tricky exercise, with high likelihood of false positives and negatives. Narrowly defined ex-ante rules may therefore be an uneasy fit with the complex and technical nature of traffic management. The controversy over AT&T restricting Apple's FaceTime application, its high-quality video-calling service, on its cellular network, presents an interesting example. In 2012, when Apple first launched FaceTime for use on mobile networks, AT&T declared that the service would be available only on select pricing plans. On the face of it, this constitutes an application-specific discrimination that violates net neutrality principles, as pointed out by many neutrality advocates. The case, however, also throws up several complex issues, which were discussed in the case study prepared by a Working Group of FCC's Open Internet Advisory Committee.

First, pre-loaded applications, like Facetime, are likely to enjoy more large-scale adoption, thus more likelihood of creating pressure on the network -- only about 10 percent iPhone users voluntarily downloaded Skype, while all had Facetime preloaded on their phones. Second, high-bandwidth video calling applications put a particular strain on mobile data networks, in both the upstream and downstream direction. FaceTime, in particular, was found to consume "on average 2-4 times more bandwidth than a similar Skype video call" at that point of time. Third, limited trial deployment of a new application, for instance, by limiting it to particular pricing plans, could be useful for gathering measurement data to assist in developing better TMPs. Fourth, application management can take place on the device, as was happening in this case, or on the network -- "whether it matters where an application-management decision is enforced, and which organization decides on it". TRAI has also touched upon some of these aspects in the CP by raising questions on "application-specific discrimination", "duty-bearers" in a net neutrality regime and impact of traffic management at the level of the device or operating system being used by a person.

### Conclusion

The public discourse that preceded the discriminatory tariff regulation took place in the shadow of Facebook's Free Basics offering. It led to heated debates and sharply polarised views, many of which were focused on the specifics of Free Basics. In contrast, this current consultation is taking place in a relatively less charged environment, with no poster child violation. This presents an opportunity for the regulator and stakeholders to proactively engage with one another for developing a suitable framework for India that can be tested against a range of potential practices. The real test will be to ensure that whatever principles India chooses to adopt at this stage convey a strong regulatory message on non-discrimination, but also have the flexibility to adapt to the dynamic environment of this industry.

The authors are researchers at the National Institute of Public Finance and Policy.

## Tuesday, January 17, 2017

What the demonetisation episode tells us about offshore currency markets by Sargam Jain and Anjali Sharma in Mint, January 17, 2017.

Reserved Bank of India by Ila Patnaik in Indian Express, January 14, 2017.

A vibrant market for debt would cut off a vital source of illicit political funding by T K Arun in Economic Times, January 11, 2017.

Note ban and the allure of authoritarian populism by Ashoka Mody & Michael Walton in Business Standard, January 10, 2017.

Strategy for 2017 by Ajay Shah in Business Standard, January 9, 2017.

The American dream is losing its charm among graduates of India’s elite IIT Bombay by Ananya Bhattacharya in Quartz India, January 4, 2017.

Near-term change, long-term effects by Somasekhar Sundaresan, January 5, 2017.

Sebi seeks review of algo trading guidelines by Jayshree P. Upadhyay in Mint, January 2, 2017.

People are standing in queue because they think there is something good in it - PM has taken that risk by S Gurumurthy in Times of India, December 30, 2016.

How Amazon innovates in ways that Google and Apple can't by Timothy B. Lee in Vox, December 28, 2016.

A beast, unleashed by Shubhankar Dam The Week, December 25, 2016.

UPA government also proposed it, we said no by K.C. Chakrabarty in The Hindu, December 2, 2016.

Set the Tone at the Top by Ashraf Khan in International Monetary Fund, December 2016.

## Monday, January 16, 2017

### What does the tax data tell us about the state of the economy?

by Suyash Rai.

One of the most interesting questions in Indian macroeconomics today is: how are we faring since late 2016? In this article, I seek to analyse data on tax revenues and obtain some clues about the performance of the economy.

In a press release published on January 9, the central government reported the following increases in tax collections during April-December 2016, compared to the corresponding period of previous year:

1. Central excise duty: 43 percent.
2. Service tax: 23.9 percent.
3. Customs duty: 4.1 percent.
4. Corporation tax: 4.4 percent.
5. Income tax: 24.6 percent.

These are large values. Holding other things constant, they suggest buoyant economic activity. However, when looking at tax data, we have to look at the extent to which other things are indeed constant. When analysing tax data, in order to read the state of the macroeconomy, we need to adjust for the part of the tax revenues which are on account of 'Additional Revenue Mobilisation' (ARM). Two kinds of ARM are:

1. An increase in tax rate: additional revenues due to higher rate do not indicate robustness of the underlying activity.
2. An administrative measure: additional revenues from one-time administrative measures (eg. a tax amnesty scheme) may not reflect the underlying economic activity.

Let us walk through the major taxes, and see what we can tell, and what we do not know.

### Excise duty

The biggest increase in tax collection has come from excise duty. The collection during April-December 2016 was 43 percent higher than the corresponding period in 2015. Collection grew by 45 percent in April-October, 33.7 percent in November, and 34.8 percent in December, compared to the corresponding periods of previous year.

Excise duty rates during the reference period

Were the rates constant? Between April-December 2015 and April-December 2016, there have been certain changes in excise duties. Basic excise duties on these products were increased in five steps between November 6, 2015 and January 30, 2016. The detailed notifications can be found on the CBEC website. The cumulative impact of these increases is:

• Unbranded petrol: increased from Rs.5.46 to Rs.9.48 per litre
• Branded petrol: increased from Rs.6.64 to Rs.10.66 per litre
• High speed diesel: increased from Rs.4.26 to Rs.11.33 per litre
• Other diesel: increased from Rs.6.62 to Rs.13.69 per litre

Taxation of petroleum products is unfortunately the backbone of India's excise duty collection; we have failed to build a more broad-based indirect tax system. In 2015-16, the total excise duty (including cesses) collected was Rs.2,84,142 crore. From this, about Rs.1,94,061 crore, or 68.3 percent, was from crude oil and petroleum products (including cess on crude oil).

The increases in the specific rates for the four products would thus have an important impact upon the overall excise duty collections. Consider the excise duty on unbranded petrol. Since five rounds of rate increases happened between November 2015 and January 2016, when we compare collections in April-December 2015 versus April-December 2016, we are comparing periods with different applicable rates. During April-December 2015, the basic excise duty per litre on unbranded petrol was Rs.5.46 between April 1 and November 6, Rs.7.06 from November 7 to December 16, and Rs.7.36 from December 17 to December 31. However, throughout Apri-December 2016, the basic duty per litre of unbranded petrol was Rs.9.48. So, while comparing collections during these two periods, we need to deduct the additional revenue due to the higher rates.

Increase in collection during April-October

A press release on December 9, 2016 reported the indirect tax (excise duty, service tax, and customs) collection with and without ARM. During April-October 2016, the growth in indirect tax collection with ARM was 26.6 percent, while without ARM it was 8 percent. So, the total ARM was 18.6 percent of indirect tax collection during the same period of previous year. This is Rs.71,315 crore.

To the best of my knowledge, there has been no ARM in customs. ARM in service tax collections can be estimated by comparing applicable rates during the two periods being considered. During April-October 2015, the applicable rate for April and May was 12.36 percent, and it was 14 percent for June-October. So, the average rate during the period was 13.53 percent. During April-October 2016, the rate was 14.5 percent for April and May (Swachch Bharat Cess of 0.5 percent was introduced in November 2015), and 15 percent for June-October (Krishi Kalyan Cess of 0.5 percent from June 1, 2016). So, the average rate was 14.86 percent. The estimated increase in service tax collection due to ARM was (14.86-13.53)/13.53 percent = 9.8 percent of collection during corresponding period of previous year. This is Rs.11,059 crore. So, the remaining ARM, i.e. Rs.60,256 crore is estimated to have come from excise duty increases. Since the total increase in excise duty collection during April-October 2016 was Rs.66,485 crore, the increase without ARM was Rs.6229 crore, or 4.22 percent higher than excise duty collection in April-October 2015 (Rs.1,47,670 crore).

Increase in collection during November and December

During November 2016, the growth in indirect tax collection with ARM was 23.09 percent, while without ARM it was 8 percent. This suggests that, in November 2016, indirect tax collection from ARM was 15.09 percent of indirect tax collection in November 2015. This is Rs.8259 crore. Customs collections had no ARM. The effective service tax rate during November 2015 can be assumed at 14.25 percent, as half of the month had 14 percent rate (effective from June 1 to November 15, 2015) while the other half had 14.5 percent rate (0.5 percent Swachch Bharat Cess introduced on November 15, 2015). In November 2016, the rate was 15 percent (including Krishi Kalyan Cess of 0.5 percent). So, the ARM in this November's service tax collection is estimated to be (15-14.25)/14.25 percent = 5.26 percent of service tax collection in November 2015 (Rs.14,870 crore). This is about Rs.782 crore. Deducting this, we get Rs.7477 crore of ARM for excise duty in November. The total reported increase in excise duty collection in November 2016 was Rs.7477 crore. So, the increase in excise duty collection in November without ARM is estimated to have been zero. This suggests a deceleration from 4.22 percent growth in the preceding months..

Since these are nominal values, in real terms, collection may have declined in November. Excise duty becomes due at the time goods leave the factory. One did not expect any significant demonetisation impact on excise duty collection for November, as production and factory clearance schedules for the month were not likely to have been significantly affected by a decision taken in second week of the month. We saw this in the auto sector data, where November data showed a decline in sales but an increase in production, while the December data shows a decline in both sales and production. The latest IIP numbers, which show an increase in industrial production in November, also confirm this. So, the estimate of excise duty collection without ARM in November is surprising. Further, since retailers of petroleum products were allowed to accept old notes, the impact on these products should have been lower. So, to the extent increase in excise duty collection is an indicator of underlying economic activity, the news from November may be worse than expected.

It is difficult to make a reasonable estimate of excise duty collection without ARM in December, because, unlike the press release on December 9, the press release on January 9 does not include details about ARM, not even in the aggregate. When government releases December's data about excise duty collected without ARM, we can do this analysis for December.

Increase in excise duty collection (in percent)
April-Oct Nov Dec
With ARM
45 33.7 34.8
Without ARM (estimate)
4.22 0
NA

### Service tax

During April-December, 2016, service tax collections were up 23.9 percent compared to the corresponding period last year. During April-October, the increase was 27 percent, while it decelerated to 15.5 percent for November and 3.67 percent for December. This deceleration is significant, but we need to understand the increase without ARM.

Service tax rates during the reference period

Service tax rate has been increased thrice during the reference period

1. June 1, 2015: rate increased from 12.36 percent to 14 percent
2. November 15, 2015: Swachh Bharat Cess of 0.5 percent took the rate to 14.5 percent.
3. June 1, 2016: Krishi Kalyan Cess of 0.5 percent took the rate to 15 percent

Increase in collection during April-October

In the section on excise duty, I estimated that ARM for service tax during April-October was 9.8 percent of service tax collection during the corresponding period of previous year. The overall increase in service tax collection in April-October was 26.9 percent. So, the increase without ARM would have been about 17.1 percent.

Increase in collection during November and December

In November 2016, collection increased by 15.52 percent compared to November 2015 - from Rs.14,870 crore Rs.17,178 crore. In the previous section, I estimated that about Rs.782 crore of service tax collection in November 2016 may have been on account of ARM. After deducting this ARM from collection in November 2016, the increase without ARM was 10 percent.

The increase in service tax collection in December 2016 (Rs. 22,449 crore) was 3.67 percent higher than that in December 2015 (Rs.21,655 crore). Since, the service tax rate applicable in December 2015 was 14.5 percent, while that in December 2016 was 15 percent, ARM is estimated to have led to 0.5/14.5 percent = 3.45 percent increase in service tax collection in December. So, in this estimate, the increase in service tax collection without ARM was 0.22 percent. If this analysis is correct, it shows a significant deceleration in rate of increase in service tax collection without ARM: from 17.1 percent in April-October, to 10 percent in November, to 0.22 percent in December.

Increase in service tax collection (in percent)
April-Oct Nov Dec
With ARM
26.9 15.52 3.67
Without ARM (estimate)
17.1 10 0.22

### Customs duty

During April-December 2016, customs duty collection has increased by 4.1 percent, compared to the same period in 2015. During the corresponding period in previous year, the growth in collection was 17 percent. For November 2016, collection increased by about 16 percent. Partially, this may have been because this year Diwali was in October, while last year it was in November. Customs collections are mostly done on working days. November 2015 had fewer working days than November 2016. This effect might explain a part of the increase. Still, growth in customs collections in November was significant. This is along expected lines, as import orders usually do not get cancelled with a short notice. However, for the month of December, the customs collection was 7.6 percent lower than the same month in 2015. It is too early to say what this decline means. In the past also, there have been months when customs collections declined even when there was no obvious explanation.

### Corporation tax

Corporation tax collection during April-December was 4.4 percent higher than the corresponding period last year. Last year, during the same period, the growth in corporation tax collection was 11.74 percent. Collection in December 2016 was 4.7 percent lower than that in December 2015. December is one of the months for deposit of advance taxes. This low collection may indicate that firms have revised their profit forecasts downwards. However, it is difficult to draw a conclusion, as there may be other explanations. For instance, disproportionate refunds may have been made in December. We do not have the data to draw a conclusion.

### Income Tax

During April-December, income tax collection was 24.6 percent higher than that in the corresponding period of 2015. However, a key factor here is the income declaration scheme that ended on September 30, 2016, and had mandated payment of tax, surcharge and penalty by November 30, 2016. The expected tax inflow from the scheme was about Rs.30,000 crore. This is a form of additional revenue mobilisation. Hence, unless we know the increase without this ARM, it is difficult to interpret the number. For instance, if Rs. 25,000 crore was collected under the scheme, the increase in income tax collection during April-December would be just over 8.3 percent.

### Conclusion

The analysis presented here suggests that the reading of tax collection numbers as signifiers of robust economic activity may be too optimistic. I have had to estimate some of the numerical values above because the data releases on tax collections have been parsimonious on details. This is especially true of the release on January 9. The consistent inclusion of details about additional revenue mobilisation for different taxes for each month would make it easier to conduct economic analysis using tax data.

Update: MR Madhavan pointed me to another source of additional collection under direct taxes this year. From this year, 75 percent advance taxes have to be paid by December 15, while till last year, this was 60 percent. This may have been a significant source of additional collection in December. So, the fact that corporation tax collections this year have been lower than they were in December 2015 is much more indicative of decline in economic activity.

The author is a researcher at National Institute of Public Finance and Policy. Views expressed here are personal.

## Friday, January 13, 2017

### South Africa vs. India: alternative paths to financial reforms

by Radhika Pandey and Smriti Parsheera.

As finance evolves, so must the legal systems designed to govern it. These changes often come about in firefighting mode. As an example, a discord between IRDA and SEBI on Unit Linked Insurance Plans led to a hasty amendment to the Reserve Bank of India ("RBI") Act to create a joint committee mechanism to resolve regulatory jurisdiction issues. The outburst of ponzi schemes and unregulated financial activities has led to attempts at legal reforms concerning unregulated deposit taking activities.

While there is a case for addressing felt needs, one at a time, there is also a need for mapping the big picture of financial law and the organisation diagram of financial agencies. This design work requires deep thinking based on long years of experience, research and debate. It is not a quick response to a crisis.

There are, thus, three ways through which the financial regulatory apparatus can evolve:
1. Addressing a felt need that arises at a point of time, without thinking on a system scale; or
2. A full redesign of the financial regulatory landscape through a comprehensive financial sector law; or
3. A full scale research and design effort, which establishes a strategy for reform, but this is implemented through numerous small steps.
By default, most countries pursue Method 1. It allows for prompt action to fix an immediate issue. This comes with the risk of missing the woods for the trees, with being stuck with financial regulatory structures that are decades out of date. However many countries have, from time to time, also followed the second or third paths.

In this article, we examine the recent South African and Indian approaches to large-scale financial reform. South Africa is pursuing Method 2 while India is pursuing Method 3. Our emphasis is on the policy process employed in both countries. We note, in passing, that there are remarkable similarities in the ideas shaping their financial reform, but this article is about policy process and not substantive content.

### South Africa's reform process

South Africa initiated a formal review of its financial sector in 2007, which culminated in the release of the report on A safer financial sector to serve South Africa better ("SA Report") by the National Treasury in February 2011. Prepared in the wake of the global financial crisis, this report strongly emphasised stability as a key policy objective, along with the goals of consumer protection, expanding financial inclusion and combating financial crime.

In July 2011, the South African Cabinet approved the SA Report's proposal to shift to a "twin peaks" system of financial regulation, which would separate prudential regulation from market conduct supervision. This was followed by a budget announcement to that effect in the subsequent year. In February, 2013, the Financial Regulatory Reform Steering Committee, comprised of representatives from South Africa's three key financial regulatory institutions - Reserve Bank, Financial Services Board and National Treasury, published a report on Implementing a twin peaks model of financial regulation in South Africa. This document, along with the SA Report, formed the basis for widespread consultations and preparation of a draft legislation to give effect to the proposed reforms.

Building on these documents, the Treasury put together the first draft of the Financial Sector Regulation Bill ("FSR Bill") in December 2013, followed by a second version in December 2014. Comments were invited at each stage, and public workshops were held to spread awareness about the proposals. A provision-wise summary of the comments received from stakeholders and the National Treasury's response to them was placed in the public domain.

The FSR Bill was then tabled in Parliament in October 2015, and referred to the Standing Committee on Finance ("SCOF"). SCOF held yet another round of public consultations between November 2015 and May 2016 and the Treasury declared its response to the comments received. In parallel, the government also released an Impact Study Report setting out the motivation behind the FSR Bill; the costs and benefits of its implementation for stakeholders and the government; measures for managing risks; and summary of the expected impact on national priorities.

Since then, the Treasury has published further revised drafts of the FSR Bill on 21st July 2016 and 21st October 2016, taking into account the matters raised by the Standing Committee as well as various stakeholders. South Africa's National Assembly voted on the Bill in December 2016 and it will now be placed before the National Council of Provinces.

### The FSLRC's reform agenda

India's work in financial reform was proceeding in similar years. In 2011, the Ministry of Finance setup the Financial Sector Legislative Reforms Commission ("FSLRC") with the mandate to review and recast the legal and institutional structures of the Indian financial system.

FSLRC released a report and a draft law in March 2013. This draft law is termed Indian Financial Code (IFC), v1.0. This was refined into IFC version 1.1 that was put out for public comments in July 2015.

IFC has not been tabled in Parliament. A large number of steps have, however, put this strategy in action:
1. IFC envisages many new elements of the financial regulatory architecture. The Ministry of Finance adopted a Task Forces' approach of setting up a group of wise people that would build the implementation strategy for setting up each new agency. Task Forces were set up for five financial agencies: the Public Debt Management Agency ("PDMA") under Dhirendra Swarup, Financial Sector Appellate Tribunal under N.K. Sodhi, Resolution Corporation ("RC") under M. Damodaran, Financial Data Management Centre (FDMC) under Subir Gokarn and then Financial Redress Agency (FRA) under Dhirendra Swarup. The FRA Task Force Report is open for public comments till 31st January 2017.
2. IFC envisaged an objective for RBI -- inflation targeting -- and a shift in rate setting power from the Governor to the Monetary Policy Committee. This was achieved in two steps: the Monetary Policy Framework Agreement and then the amendments to the RBI Act through the Finance Act, 2016.
3. The IFC chapters that established the RC were adapted into a standalone draft law and released for public comments.
4. An interim cell has been set up within the Ministry of Finance in the run up to building a statutory PDMA.
5. The appointments process for senior regulatory staff that is embedded in IFC has been implemented as the Financial Sector Regulatory Appointment Search Committee that will be used for all senior appointments in financial sector regulatory bodies.
6. IFC envisages a unification of financial markets regulation. The number of financial markets regulators went down from three -- RBI, Securities Exchange Board of India ("SEBI") and Forward Markets Commission ("FMC") -- to two (RBI, SEBI) with the merger of FMC into SEBI through the Finance Act, 2015.
7. IFC envisages that the power to issue capital control regulations should be with the Ministry of Finance. This was partially done, for non-debt flows, through an amendment to the Foreign Exchange Management Act, 1999 in May 2015.

### Comparing the two pathways to reform

There is a clear difference in the way the financial reform story has unfolded in these two countries. In South Africa, the Treasury drafted and owned the report from the very start. They were able to stay focused on the basic idea. This however comes with its own costs. A complete recast of the financial regulatory framework, having wide-ranging implications, implies that considerable time needs to be spent on building consensus among stakeholders. This is illustrated by the fact that South Africa initiated the idea for reforms in 2007 but almost a decade later, they are yet to adopt a final law. Due diligence of stakeholder consultations, impact assessments, and publishing responses to comments to each step of a comprehensive code adds to the complexity of the exercise.

In the Indian case, there is greater policy uncertainty as one piece is being done at a time. There is no assurance that the full vision will unfold successfully. As a self-contained draft, the different parts of IFC 1.1 speak closely to one another. Its full effect can therefore be achieved only if this consistency is maintained. Picking and choosing specific parts for implementation casts a greater responsibility to ensure that the proposals being adopted are consistent, not just with the myriad set of existing financial laws but also with the full concepts of FSLRC's report. If even one or two components stray away from the original vision, there is a danger of getting messy outcomes. It also leads to a duplication of drafting efforts to ensure that each part is consistent with the whole.

But there are some advantages. It gives the Ministry of Finance the ability to pick one battle at a time. In India, there are severe constraints on State capacity. If all parts of IFC had to be implemented at the same time, the project management would likely face more difficulties.

The authors are researchers at the National Institute of Public Finance and Policy. They were part of the FSLRC research secretariat.