A revamp of the legislative framework of the Indian financial sector is under consideration. The recently submitted report of the Financial Sector Legislative Reforms Commission (FSLRC) is an important landmark in this regard.

But the FSLRC’s report may not translate into restructuring of the financial system, if the opposition to it is any indication. Both, vested interests and old-style regulators schooled in the era of the 1960s and 1970s are against some of its key recommendations.

It is a well-known fact that “regulators” in the Indian financial sector so far have focused more on the “regulation” aspect of their respective charters. Development of the respective spheres of the financial sector which they “regulate” has not attracted the level of attention it deserves. Indeed, what will they “regulate” if there is no “development” at all of the respective segments of the finance industry?

RBI Under-performance

The preamble to the RBI Act, 1934, says that the RBI will keep reserves to secure monetary stability and generally operate the currency and credit system of the country to its (country’s) advantage. How do these lofty ideas propounded in 1934 correspond to the hard fact in 2013 that the level of exclusion from the credit markets in India is staggeringly large — it is documented that banks meet just about 15 per cent of the total credit requirements of the large and diverse medium, small and micro enterprises (MSME) sector in our country. (The MSME sector’s annual credit requirements are close to Rs 20,00,000 crore).

As for attempts to increase the flow of credit to the MSME sector from non-bank sources (primarily through NBFCs), the RBI’s philosophical stance is to pay lip service to the criticality of NBFCs in overall financial intermediation but framing regulations in such a way as to constrain their operations and growth.

It is no surprise then that the MSME sector even today meets three-fourths of its credit requirements only through unorganised and local money lenders/pawn brokers, among others.

Clearly, the RBI has seriously fallen short of attaining amorphous objectives such as “operating the credit system to the country’s advantage”.

As for monetary stability, the less said the better. The RBI’s serious under-performance in generating and preserving monetary stability — which is the same as preserving the purchasing power of the paper currency — is there for all to see. The inflation experience testifies to that.

The case for clearly defined and measurable economic objectives for a policy-maker and regulator such as the RBI is very strong. And that is precisely what the FSLRC has recommended.

Same story in insurance

The state of affairs in the insurance (particularly life) industry is somewhat similar. The Insurance Act is of 1938 vintage and the regulatory authority (IRDA), formed in 2000, does not have any quantified objectives. Indeed, given the high level of insurance exclusion in India, one would have thought that the IRDA charter would specifically mandate levels of insurance penetration and premium growth to be attained over specific time-periods.

Unfortunately, the focus of the regulator seems to have been too much on — well, regulation. Development has taken the backseat if the “developments” in the life insurance industry of the past decade are any indication. After a phase of rapid growth in the early years, the overall life insurance industry is now stuttering (even entered a de-growth phase) in the face of regulations. These have been quite at variance with the requirements of marketing a risk management product such as insurance, and are divorced from the overall macro-economic environment.

Indeed, for promoting any financial product, two kinds of facilitative tools are required. One is consideration of the underlying macro-economic environment in terms of levels of interest rates, yields, inflation expectations of the investing public, and earnings prospects of competing instruments such as equities, bonds, etc. This is the foundation.

The regulations governing the distribution infrastructure, network and the specific marketing and business developmental strategies of individual market players are the super-structure.

It is critical to get both these facilitative tools right.

regulations

It is distressing to note how all stakeholders in the financial system are now complaining of a serious drain and deceleration in household financial savings, which includes insurance. They recognise now, after all these years, that the key factor behind that serious deceleration is the “brazenly” negative rates of real return (that is, rates adjusted for inflation) on conventional financial savings, such as a bank deposit or a traditional insurance product.

Unfortunately, a long-range understanding of how repressed interest rates in the financial system can adversely impact the development of products such as insurance was not available (to the regulator) in 2000.

Real rates of return were negative even then, and this was the key driver behind the growth of equity-market linked insurance products, known as ULIPs. Now, unless this foundational macro-economic picture is understood and regulations are tailored for that situation, we are bound to have a high level of instability in the performance of insurance companies.

Under-performance will be compounded if the regulations also pose obstacles on the development of a micro-market distribution and marketing infrastructure.

The historical reality in India is of financial repression and consequently unrealistically low interest rates on conventional fixed income instruments such as bonds. Therefore, marketing a product such as insurance, which is not entirely a savings product but encompasses a significant risk component will be all the more difficult.

Regulations on products such as equity-market linked insurance and that on the distribution infrastructure such as insurance brokers have to take this reality into account.

(The author is a Chennai-based financial consultant.)

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