A New Structure Of Financial Regulation

Context: The recent misconduct in the financial sector has necessitated an enhanced enforcement of regualtions.

Recent instances that necessitate a new structure of financial regulation

• Mis-selling of auto-loans: RBI recently found that (over complaints from a whistleblower) HDFC Bank had forced customers to purchase a vehicle-tracking device for four years till December 2019;
  • RBI has thus, imposed a penalty of Rs 10 crore on HDFC Bank for deficiencies in regulatory compliance last month.
  • The RBI had asked HDFC Bank to halt the launch of all-new digital programmes and onboarding new customers for its credit card business until further orders.
• Misconduct in the behaviour of credit rating agencies: YES Bank AT1 Bonds, DFHL, and IL&FS all sported AAA or AA+ ratings just months before they went bust.
  • Raters are paid by companies they rate, and so there is already a conflict of interest in their relationship.

Need for enhanced enforcement:

• Scams, misconduct, and misdeamonour happen with high regularity, not because these are inevitable, but because the price of getting caught is insignificant (kid-glove treatment).
• Although five financial regulators were specifically set up to stop this mischief, aggrieved investors let down by regulators run from the police to already clogged courts to seek redress.

Way Forward: If policymakers want to change any of these, they need to look at four aspects of enforcement.

1. Outcome: Regulation needs to be focused on the outcome — for a financial crime, the principal outcome recovery of money apart from an exemplary penalty to act as a strong deterrent.
   • Right now, it is arrest, interrogation, and jail without bail. It fetches us nothing remedial for those affected, and litigation drags on endlessly.
2. Pin individual responsibility: In each case of proven malfeasance, individual officers, including reporting bosses, should be personally penalised to ensure that the next time the senior management at banks orders something irregular, employees resist it. Sebi has tried to do this in many cases.
3. Whistleblower rewards: ICICI Bank’s bad loans to the Videocon and other groups, IL&FS’s issues (which the board ignored), the NSE algo scam, and the HDFC Bank case all became public due to whistleblowers. Even if a regulator is proactive, there is only so much it can discover on its own.
   • Having an effective whistleblower mechanism with rewards, like in the US, would be useful. The Indian revenue authorities have one too.
4. Standardise: The evidence so far is that if you let lawyers into the enforcement process, the crooks, armed with powerful legal representation, will undermine it. It is worthwhile examining whether to have the RBI model for the securities market.