What is the Indian Financial Code

The revised draft of Indian Financial Code, released on 23 July 2015, has already made to the headlines, as it proposes to dilute the RBI Governor's power; he may no longer have the power to veto policy rates.

The major change as of now is that there will be four members appointed by the central government and three from RBI, earlier the ratio was other way around.

The IFC bill is expected to table in the Winter session of the parliament. The Parliament will finalise the code, which will eventually find its way to the Union Cabinet for approval.  

What is the Indian Financial Code? How does it work? 

The Financial Sector Legislative Reforms Commission (FSLRC) was set up on March 24, 2011, for re-writing the Code to regulate the financial sector and introduce principles for financial regulation and the constitution, objectives, powers and interaction of financial agencies. Its aim was also to bring about coherence and efficacy in the financial regulatory framework.

In 2013, the commission, headed by Justice BN Srikrishna, submitted its report in two volumes, which included 'Analysis and Recommedation' and 'Draft Law'. The revised draft in twenty parts will strive to regulate financial agencies.

Under this Act, the Financial Sector Appellate Tribunal was established to exercise the jurisdiction, powers and authority conferred upon it.

According to the Act, the general direction and management of the financial agencies will be vested in the respective boards -- the Financial Authority Board for the Financial Authority, the Reserve Bank Board for the Reserve Bank, the Redress Agency Board, with respect to the Redress Agency, the Corporation Board for the Corporation; the Council Board for the Council and the Debt Agency Board, with respect to the Debt Agency.

The Code deals with the establishment of financial agencies, establishment and structure of the tribunal, allocation and regulation of financial services.

A part of it discusses the functioning of financial agencies, such as boards of financial agencies, strength and composition of boards; decision making, advisory councils, accountability mechanisms and funding for financial agencies.

It also mentions the disposal of applications, information and inspections, investigations and offences as executive functions of financial agencies. These financial agencies also have quasi-judicial functions -- administrative law, show cause notices and orders, enforcement actions, procedure for enforcement actions and penalties. 

Moreover, the Code also clarifies financial consumer protection, prudential regulation, contracts, trading and market abuse, capital controls, resolution of financial service providers, financial stability and development council,  development (provisions for review), public debt management  agency, offences, functions, powers and duties of tribunal, miscellaneous, and schedules. 

Analysis

The finance ministry has put out a revised draft in public domain and invited comments from stakeholders.

The commission proposes a financial regulatory architecture featuring six agencies:
(a) Financial Authority;
(b) Reserve Bank of India;
(c) Financial Redress Agency;
(d) Resolution Corporation;
(e) Financial Stability and Development Council; and
(f) Public Debt Management Agency

The 10 big changes the revised draft of the Indian Financial Code proposes could change the functioning of the Indian financial sector

1. MONETARY POLICY

Now: The Reserve Bank of India (RBI), and within the central bank it is the governor who enjoys absolute power in deciding interest rate

Proposed: The committee approach to decide interest rate where government will appoint four members, while three will be from RBI

Impact: RBI loses its power to decide interest rate. If autonomy of RBI is compromised in the eye of investors, it could have serious implications

2. MANAGING GOVERNMENT'S DEBT

Now: The central bank - investment banker for the government - manages its debt

Proposed: An independent debt management agency to manage government's borrowing

Impact: Conflict of interest issues are overblown on either side. There will be some conflict whether RBI or government manages it. But an independent debt management agency, with external professionals from the beginning could turn out to be risky, as they will not have experience of managing government debt

3. STABILITY AND SYSTEMIC RISK

Now: The Financial Stability & Development Council (FSDC), was set up in December 2010 to strengthen and institutionalise the mechanism for maintaining financial stability, and enhancing inter-regulatory coordination and promoting financial sector development. The chairman of FSDC is the finance minister, with all the sectoral regulators as members. FSDC also focuses on financial literacy and financial inclusion

Proposed: FSDC to identify and monitor systemic risk. To take all required action to eliminate or mitigate systemic risk

Impact: In the US and UK, macro prudential regulation and supervision are a mandate of the central bank. Limiting the universe of systemic risk tools to three could be an area of concern, as more such risks could be evolving. The central bank, being the monetary policy authority and the only lender of last resort, is the natural choice for being the systemic regulator

4. REGULATION OF BANKS/NBFCS

Now: RBI is the regulator for the banking system, as well as non-banking finance companies and primary dealers

Proposed: RBI continues to be the banking regulator and for systematically important payment systems but non-bank credit institutions will be regulated by the Financial Authority. The Financial Authority will also regulate all financial products

Impact: Could lead to fragmentation of regulation and give rise to regulatory arbitrage. There is a view that RBI should oversee non-bank financial entities like insurance and mutual fund companies due to their interconnectedness with the banking system

5. REGULATION OF ENTITIES IN THE PAYMENT SYSTEM

Now: RBI is the regulator of prepaid payment instruments and has laid regulatory norms for payments banks

Proposed: Only systematically important payments systems will be regulated by RBI

Impact: Many new players are emerging with rapid product innovations. The full impact of all these on financial stability and monetary policy are not clear. RBI, which is the regulator of the payment and settlement systems of the country, could lose some power to oversee this function

6. CONSUMER PROTECTION

Now: While RBI has an ombudsman and insists on banks treating their customers fairly, banks routinely flout norms and mis-sell products. The penalties levied by RBI on banks for violating norms related to mis-selling of financial products to consumers are the bare minimum

Proposed: A separate consumer agency is proposed to protect and promote the interests of consumers and promote public awareness of matters relating to financial products and services

Impact: A welcome step to protect consumer interest, as the regulator is unable to both regulate and solve disputes in a time-bound manner

7. CAPITAL CONTROL

Now: The present law under FEMA vests the power of capital account regulation with RBI. In practice, the government and RBI consult before initiating a policy measure. While the government takes decisions on various issues, like foreign direct investment, the notification is issued by the central bank

Proposed: The government will "consult" RBI to make rules on capital controls (section 241). This consultation will cover the problem to be addressed, the goal sought to be achieved and the alternatives available to address problems and achieve goals. RBI will work as an administrator to implement rules. The draft code empowers the government to prescribe rules to seek its nod for capital account transactions which affect national security

Impact: The present practice of both the government and RBI being involved in deciding capital control has served the country well, particularly during the global financial crisis and the Asian crisis. The conduct of monetary policy will be weakened if capital control regulation is taken out from the central bank. Interestingly, the code is silent on the issue of financial stability

8. REGULATION OF MONEY MARKETS

Now: RBI regulates all these markets

Proposed: Separating regulation of such markets from RBI

Impact: In India, the exchange rate and interest rate are not fully market-determined. Due to the high fiscal deficit of the government, statutory liquidity ratio of banks are not going to come down in the near future. Since volatile capital flows impact such markets, the central bank should have a role in regulating these markets

9. ADDRESSING OPACITY IN DECISION MAKING

Now: Current regulatory decision-making process lacks transparency

Proposed: The annual reports of RBI and the central government must give a complete disclosure and analysis of the performance of functions by the central government and RBI. They must include the total number of approvals granted, the applications rejected and the time taken for disposal of each application. The FSDC must also publish in its annual report all significant trends identified in the financial system and an assessment of the stability and resilience of the financial system

Impact: These disclosures will bring about much-needed transparency and will reduce information asymmetry that currently plagues the system

10. ESTABLISHMENT OF A RESOLUTION CORPORATION

Now: There is no Resolution Corporation. The regulator has complete power over resolution of institutions

Proposed: The new code proposes to establish a Resolution Corporation to carry out resolution of certain types of financial institutions in distress. The corporation can take over the entity if it is classified in the category of critical risk. It can also inspect an entity independently, if it opines that the regulator's assessment of risk to viability of a covered service is incorrect

Impact: This is likely to speed up the process of resolution. Currently, this process is time-consuming, as was seen in the case of the Madhavpura Merchantile Cooperative Bank. This proposal is in line with similar institutions in other countries