A V Rajwade: Costs of regulation

WORLD MONEY

When I went to work in London more than 30 years ago, one of my first culture shocks was a statement by the then Chancellor of the Exchequer in Parliament.

Inadequate supervision was permitting travellers to evade payment of duties. The Chancellor was aware of this but thought it advisable to wink at it since the cost of policing could well be more than the revenue collected!

Even 30 years later, one does not find in our country much debate about the cost of laws and regulations and to what extent they are justified by the benefits.

The recent Securities and Exchange Board of India (Sebi) regulation about fingerprinting and identity cards for individual investors is only one instance of what seems to be a growing tendency to over-regulate. (Wiser counsels seem to have prevailed and Sebi has recently appointed a committee to re-examine the coverage of MAPIN.)

The other day I was talking with the chief executive of a large mutual fund. He complained that 80 per cent of his time goes in compliance, leaving only 20 per cent for actual management of the fund!

My own experience as director of an asset management company is not too different "" an equal proportion of time goes in considering compliance issues.

There seem to be, in general, three driving forces underlying ever more detailed and prescriptive regulatory practices, in India and the world over:

The series of corporate scandals and frauds from Enron onwards, and the malpractices of equity analysts at the time of the dot com boom;

American propensity for extremely detailed, rule-based regulations. Their simplified personal tax code still weighs in at a thousand pages! The recent SEC rule on complex structured finance instruments runs to more than 500!;

In our case, in the bureaucratic style of functioning of our civil service and public sector culture, any suggestion from down below for greater restrictions and reports often goes through without a thought about the cost benefit.

After all, the cost does not fall on the person who refuses to resist the new regulation. On the other hand, should anything go wrong, he will be blamed "" and saving costs or providing hassle-free services to citizens hardly benefits his career.

The Centre for the Study of Financial Innovation conducts an annual poll of risks facing banks. The latest poll found a huge majority agreeing that "excessive regulation" is the biggest threat to the financial sector.

One imagines that the proximate causes underlying this perception are the introduction of International Financial Reporting Standards (IFRS) and Basle II, the new capital adequacy norms for credit and operational risks.

In the US, the cost of complying with the provisions of the so-called Sarbanes-Oxley Act on corporate governance is attracting increasing criticism.

Companies are complaining about high compliance costs and arguing that the complexities have just created a huge fee earning opportunity for lawyers and accountants "" with little tangible contribution to effective governance.

Some foreign companies listed on US stock exchanges are thinking of withdrawing from the listing because of the costs of compliance and complain of "regulatory imperialism".

The enactment was passed in the wake of the Enron and other major corporate scandals in the US. The desire to be "seen to be doing something" to curb corporate scandals probably led to the legislation, without much thought to the practicality, efficacy and costs of compliance.

The introduction of the IFRS also threatens to lead to a lot of regulation-driven decision making?

The latest scare is about the status of securitisation. The criteria for moving assets off balance sheet are so stringent that many existing securitisation deals could become unravelled "" conceivably, this could mean securitised assets having to be brought back on the books of the originator, thus affecting the originator's capital ratios and, perhaps, even credit ratings.

Desk Hurdsen, chief executive of the Institute of Chartered Accountants of Scotland, has criticised that "the whole process is imperilling a judgement-based approach". Compliance with the letter of the rule, howsoever nonsensical or perverse the outcome, is overtaking common sense and principle.

The chief executive of the Financial Reporting Council of the UK apprehends that in the rules-driven control system principles and fundamentals threaten to get lost.

The chief executive of Axa, the giant European insurance company, has come out with strong criticism of the IFRS: it does not improve transparency and risks creating artificial volatility in reported profits. Even for us in India, these are not merely theoretical issues "" the IFRS and Basle II are just round the corner.

In the new-style regulatory regime, how one misses the principles based supervision which was the forte of the Bank of England that would "advise banks to be cautious about ......" "" and that was sufficient and more effective than a 50-page rule.

The dangers of detailed, micro-level regulation are of regulators, auditors, boards and others missing the woods for the trees, of substance getting overlooked in the jungle of paper, of outdated regulations remaining in place even when circumstances have changed.

Email: avrco@vsnl.com