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Wednesday, March 21, 2018

Financial regulation for the fintech world

by Ajay Shah.

In India, there is a confusing term `non-bank financial company' (NBFC). This is an unfortunate phrase as the term, when taken literally, includes insurance companies, etc. In India, it denotes a $10 \times 2 \times 2$ classification of business models which are regulated by the RBI.

There is a lot of confusion in the present regulatory treatment of these classes of firms. The existing levers of regulation are inappropriate, and it is not clear why RBI -- which should be about sound money and sound banking -- is doing all this work. These concerns are becoming particularly important in the context of the fintech revolution, where all kinds of new firms are being shoe-horned into NBFC regulation.

It's hence useful to take one step back and think about  financial regulation from first principles. Where and why is financial regulation required? Financial regulation is based on exactly four motivations:

  1. Consumer protection. Financial firms generally require a layer of restrictions, that impact upon their dealings with customers, that improve fair play. These problems are heightened when the financial firm directly deals with unsophisticated individuals.
  2. Micro-prudential regulation. When a financial firm makes a high intensity promise to a consumer, generally there is a need for restrictions upon the risk-taking by the firm, to curtail the probability of firm failure. Such micro-prudential regulation is  (in turn) motivated by consumer protection: we wish to improve how consumers are treated in their dealings with the financial firm. When a firm takes a deposit from a household, that requires micro-prudential regulation, but when the firm lends to a household, the household is quite comfortable with the prospect of firm default, and no micro-prudential regulation is required.
  3. Resolution. When a financial firm makes promises to consumers, or when a financial firm is systemically important, the conventional bankruptcy process (of IBC) is inadequate. A specialised bankruptcy process is required, which is run by the Resolution Corporation. 
  4. Systemic risk regulation. The behaviour of firms needs to be restricted from the viewpoint of systemic risk. This is mostly about system thinking, and not looking at individual firms ("the woods and not the trees"). But one ("trees") element of this tends to be a reduced target failure probability for a few firms which are termed `systemically important'.

FSLRC drafted the Indian Financial Code (version 1.1, 2015). The four components of financial regulation show up there as:

  1. Part VII which does consumer protection (S.105 to S.151)
  2. Part VIII does micro prudential regulation (S.152 to S.184)
  3. Part XII does resolution (S.286 to S.310). This has morphed into the FRDI Bill.
  4. Part XIII does systemic risk regulation (S.311 to S.341).

This treatment is non-sectoral. There is no special law which defines consumer protection for banks vs. consumer protection for mutual funds. All kinds of financial business is treated identically, within these four components. The advantage of  non-sectoral law is that the law does not have to be modified when new business models are invented, or when multiple kinds of activities are undertaken under one roof.

Now let's apply this thought process to what, in today's India, would be called an NBFC. To keep things simple, consider a company which finances itself using the bond market, has no unsophisticated consumers, and gives out loans to companies. How would we think about regulating this?

  1. Consumer protection: As this firm has no unsophisticated customers, this simplifies the problem of consumer protection. See Table 5.5 in FSLRC Volume 1. The protections that would have to be enforced are: professional diligence, unfair contract terms, unfair conduct, privacy, fair disclosure and redress.
  2. Micro prudential regulation: As this firm makes no promises to unsophisticated individuals, there is no need for micro-prudential regulation. The bond market is what will discipline the risk taking of this firm. This is similar to how the bond market shapes the leverage and access to debt capital of an ordinary non-financial firm.
  3. Resolution: Ordinary IBC processes will suffice to deal with failure. The bond market will reward more resolvable businesses with a lower cost of capital.
  4. Systemic risk regulation: Until the balance sheet becomes 1 per  cent of GDP, i.e. $20 billion, the firm is not systemically important.

By this logic, for most NBFCs, there is a need for a little bit of consumer protection and nothing else. Most of the existing edifice of NBFC regulation, which seems to be inspired by the regulation of banks, is not required.

Enacting the Indian Financial Code addresses this situation at two levels. First, as described above, it gives a clear conceptual framework on how to think about financial regulation, without encoding business models into the law. Second, the FSLRC regulation-making process encourages the institutionalised application of mind. When mistaken ideas start out in the regulation-making process, there will be greater push back. The staff of financial agencies will rise to higher quality thinking when placed into the FSLRC regulation-making process.

In a previous article, Renuka Sane and I wrote about the barriers faced for the Fintech Regulatory Sandbox. The question discussed here -- the problems associated with shoe-horning fintech into the NBFC framework -- connects integrally to that. Once a project is proven in the sandbox, it will come out into the regulation making process. If the concepts and principles of the regulation-making process have basic defects, this will hamper the working of the regulation-making process, and yield poor outcomes.

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