Jaimini Bhagwati: Addressing systemic crises

Regulatory jobs under the Companies Act should be moved from the DCA to SEBI

Indian securities markets for debt and exchange rates are less market-driven than those for the highly traded equities, e.g. those included in the NSE's 50-stock Nifty index.

This is mostly because the principal buyers of government securities in primary market auctions of Indian government debt are usually a few public sector participants (government securities amount to about 70 per cent of the debt market and around 95 per cent of secondary market trading).

On an ex-ante arbitrage free basis, exchange rates amongst countries that have capital account convertibility are linked to interest rates by the interest rate parity theorem.

Since the Indian capital account is not fully convertible, rupee exchange rates are not quite market-based. As such, Indian securities in the debt and exchange rate markets cannot be consistently priced on a "fair" value basis.

The recent announcements by SEBI limiting the amount of FII investments in corporate bonds is another indication of the differentiated policies followed by the regulators and the ministry of finance (MOF) between markets in debt and equity.

In the Indian context, it would be unrealistic to expect that this asymmetry in treatment could be resolved without improving the fiscal balance.

It is evident from the JPC and regulators' reports on the stock market "scams" that banks, equity market intermediaries, mutual funds, finance companies, domestic corporates, and overseas corporate bodies were involved.

It is in recognition of the linkages between the regulatory and development aspects across these different components of the financial sector that some countries have set up super-regulators. For instance, in the UK the statute-based Financial Services Authority (FSA) is up and running.

Japan has moved in the same direction and has set up its Financial Services Agency (which reported recently that one in 10 listed Japanese companies provides misleading financial statements).

Germany's financial watchdog the BaFin was established in May 2002 under a law on integrated financial supervision. In contrast, the US continues with multiple regulators for the financial sector.

In well-publicised cases (e.g. Enron, Fannie Mae, Marsh & McLellan) these separate regulators (federal justice department, state-level attorney generals, SEC, CFTC, etc.) appear to be able to coordinate their actions and impose significant penalties.

In India, regulatory responsibilities are spread across the RBI, SEBI, IRDA, department of company affairs (DCA), and Institute of Chartered Accountants of India (ICAI).

While there are many contacts amongst these regulators, the only specific mechanism under which capital market issues that cut across the financial sector are discussed are in meetings of the High Level Committee on Capital Markets (HLCCM).

The HLCCM was set up by the finance ministry after the 1992 stock-market scandal to ensure regulatory coordination. The governor of the RBI is the chairperson of this committee and the members are the secretary (economic affairs), the chairman of SEBI, and the chairman of IRDA.

The DCA's responsibilities include administering the Companies Act, and the accounting profession falls under the purview of the ICAI. As of now, the secretary (company affairs) is not a member and the ICAI does not attend the deliberations of the HLCCM.

It would improve coordination if secretary (company affairs) were to be included in the HLCCM and the ICAI given invitee status.

When the HLCCM was set up, there was an urgency to get going and the RBI was far ahead of the only other financial sector regulator namely, SEBI. Since then, the IRDA has been included in the HLCCM and now the Pension Regulatory Authority is in the process of being set up.

The RBI governor chairs the HLCCM and consequently the RBI's views take precedence. However, as far as capital markets and related issues are concerned, the RBI's regulatory responsibilities are not any more significant than those of the primary capital market regulator, i.e. SEBI or for that matter the IRDA.

While the HLCCM has been effective for broad policy coordination, it meets too infrequently, usually not more than once a quarter, for adequate capital market surveillance coordination. The HLCCM has set up standing sub-committees but these do not function effectively because of turf reasons.

It would be help resolve turf issues and improve coordination if this committee were to be headed by a "neutral" party, e.g. the secretary (economic affairs) in the ministry of finance.

In India, accounting is essentially self-regulated through the ICAI. In view of past shortcomings, this is not a satisfactory arrangement and the regulatory oversight of accounting standards needs to be tightened. The finance ministry could take the initiative to examine the feasibility of making one of the existing regulators fully responsible for regulating the accounting profession.

Currently, the RBI is represented on SEBI's board but the reverse is not true. The SEBI Act provides for one RBI representative to serve on the SEBI board.

It is a measure of SEBI's lack of stature that even with the need for better capital market coordination, particularly between these two regulators, the SEBI chairman is not one of the 10 nominated members on the RBI board.

Investor confidence in prices of traded or privately placed securities is affected by their perception of the competence and integrity of management/sponsors, as also the soundness of financial statements of the firms involved.

In this context of corporate governance, why do many Indian firms set up multiple finance/subsidiary companies that make internecine investments and conduct NBFC or capital market operations? One possible explanation is that there are tax or regulatory arbitrage reasons.

A related issue is the role of independent directors on the boards of companies. Usually outside directors are not appropriately advised or consulted.

It is also not clear that they are legally liable when they certify either financial reports or acquiesce to decisions proposed by sponsors or management.

As elsewhere, many Indian corporates engage in the dubious practice of smoothing out earnings over quarters and years. Another significant failing is inadequate or inappropriate recognition of expenses.

To put it mildly, many independent directors in India are not that independent or knowledgeable.

It was claimed in the BPL Communications case, which came up before the Supreme Court, that shares of the parent company were sought to be "acquired by a complex non-transparent process".

More recently, Reliance Industries' investments in Reliance Infocomm have been questioned. Investors are likely to assume that the charges about these leading companies are at least partially correct and would understandably be sceptical about management practices and board decisions in "lesser" firms.

Past JPC and associated "action-taken" reports indicate that the existing regulatory set-up does not have the ability or, more importantly, the will to track connections amongst underlying finance/subsidiary companies and their actions.

Irrespective of the merits of the allegations in the BPL and Reliance cases, the implication is that there are major regulatory shortcomings. This should be a source of concern for the finance ministry and the regulators.

One deficiency that needs to be urgently addressed is to prevent regulating companies from falling between the DCA and SEBI stools. In this context, all regulatory responsibilities under the Companies Act (e.g. deposit-taking activities of corporates) should be moved from the DCA, a government department, to SEBI, a statutory regulator.

To summarise, there is enough evidence that there are systemic shortcomings in the regulation of Indian capital markets.

This needs to be addressed by: (a) reviewing the composition of the HLCCM and its sub-committees; (b) bringing accounting under the purview of a statutory regulator; (c) reviewing the composition of the RBI Board to include the capital market regulator; (d) reviewing the appointment and role of "independent" directors in the 50 Nifty companies; and (e) bringing all regulatory responsibilities under the Companies Act within the purview of a statutory regulator.

(The author is with the World Bank. The views expressed are personal)