IL&FS effect: How relationship between regulator and regulated will change

Three key regulators - RBI, Sebi and MCA - are out to change their equation with those regulated

Take a look at two recent isolated incidents that could be a portent of how the relationship between the regulator and those regulated will change in the coming months, post the IL&FS incident.

On May 20, after a meeting of its central board in Chennai, the Reserve Bank of India announced setting up of a supervisory cadre to deal with growing complexities and inter-connectedness within the Indian financial sector. Currently, there are three supervisory departments in the RBI -- department of banking supervision, department of co-operative banking supervision and department of non-banking supervision. The regulator said these departments will be merged for better utilisation of supervisory resources. The plan is to supplement them with specialists from outside to spruce up the regulator’s supervisory bandwidth.

The second incident was the signing of a memorandum of understanding (MoU) between the Ministry of Corporate Affairs (MCA) and the Se­curities and Exchange Board of India (Sebi) for data exchange between the two organisations. The MoU comes in the wake of the increasing need for su­rveillance in the context of corporate frauds affecting important sectors of the economy, a Sebi release said. Of­ficials added that the MoU will ensure that both MCA and Sebi have a seamless linkage for regulatory purposes.

Experts say the reported observations by the Serious Fraud Inves­ti­gation Office in the IL&FS case indicting the RBI for inadequate supervisory bandwidth over non-banking financial companies (NBFCs) may have spurred action by various regulators to get their house in order. 

“The IL&FS issue partly manifests the issue of regulatory bandwidth. It also showcases that there are regulatory overlaps while supervising a company like IL&FS,” says J N Gupta, managing director, Stakeholders Empowerment Services (SES).

The key regulators — the RBI, Sebi and the MCA — now will have to learn to work with each other, say experts.

While experts welcome the presence of a specialist supervisory cadre, there is apprehension in certain quarters that in practice, more layers may bring in more inefficiency.

Experts say there is a need for the regulator to focus on the liquidity risk and capital adequacy more than the traditional provisioning.

“The regulator needs to move away from detailed supervision of generic institution to more of risk-based supervision involving data analytics which would highlight key inconsistencies in operations and highlight functioning of banks and NBFCs,” says Abizer Diwanji, head, financial services & restructuring & turnaround services, EY India.

Clearly, regulators need to work towards a better and relatively intrusive system of predicting both fraud and market-wide failure.

“The RBI’s move to set up a supervisory cadre is a good move as it needs to dig deeper into both banks and non-banks functioning to reduce the probability of market-wide impact of failure and minimise the chances of undetected fraud,” says Sandeep Parekh, managing partner, Finsec Law Advisors.

Experts note that the Banking Regulation Act is sparse in terms of accountability, transparency and due process requirements. “The power to inspect does not seem to distinguish between inspection and investigation. The objectives for which the powers are to be used are not precisely laid down in the law,” noted Suyash Rai, fellow at Carnegie India, in Regulation in India: Design, Capacity, Performance. The challenge of banking regulation in today’s India is not just to address structural problems, but also to respond to new business models that seek to disrupt traditional banking business, he noted.

Experts say the issue of weak state capacity is again reflected in the market regulator, Sebi.

As of March 2017, Sebi had 788 employees on its rolls, of which 692 were officers and 96 comprised secretaries and other staff members. In contrast, the US Securities and Exchange Commission (SEC houses around 4,600 employees. As per their respective annual reports, “the SEC has almost one employee for each listed company”, while “Sebi has one employee for six listed companies,” noted the Kotak Committee Report.

On the evolving regulator-regulated relationship, post the IL&FS incident, experts note that regulatory overlap is a reality of modern economies. “The hope is that regulators institute robust mechanisms to enhance the flow of information amongst themselves,” says Alina Arora, partner, L&L Partners. 

Diwanji is of the view that for any effective regulation, the regulated should always fear the regulator. “This is critical for discipline. On its own, the regulator should also be open to and be accountable for its actions,” he adds.