Appropriate Regulatory Structure for Development

A. D. Shroff Annual Public Lecture, by C. B. Bhave.

It is a great honour to be invited to deliver the A. D. Shroff
Annual Public Lecture. Mr. A. D. Shroff was an outstanding
financial thinker and a practioner who took great interest in
organisational and ideological issues. He was known to express his
views in a candid manner and without any fear of the consequences of
such expression. Regulators have a reputation of not speaking much
and if they do speak then not saying much. I will try to strike a
balance between Mr. Shroff’s forthrightness and regulatory

Costs and benefits of regulation

The world has gone through very troubled times in the last three
years. Unbridled growth and development in the financial markets is no
longer an accepted article of faith. Deregulation in developed markets
resulted in excessive leverage being built by large institutions, and
financial innovation being used more to hide risk than create real
value. This inevitably led to a crisis and the cost of repair is
being borne by the tax payer and the economies in general.

Those who are bearing the costs are, in a substantial measure, not
those who reaped the benefits of unchecked growth. In the event, there
is no support for development without regulation. For orderly
development, regulation is a sine qua non. Notwithstanding the
fact that regulation is a must for orderly development, we still need
to enquire and debate what constitutes an appropriate regulatory
structure. We need to debate issues around this especially in the
Indian context.

At the very basic level, regulation means restraint and restraint
is a hindrance. Thus any business subject to regulation does pay a
price whether the regulation is voluntary or imposed. The question is
not whether regulation will come in the way of development but whether
the price we pay by accepting regulation is worthwhile or not.

Three kinds of regulation

If we look at various sources of regulation one can roughly say
that there are three reasons why business entities agree to regulate
their behaviour even though it does make them pay a price for such
regulation or restraint:

  • The first source of regulation arises from the fact that the
    commercial entity interacts with the outside world, suppliers,
    customers, financers, shareholders and so on. There are certain
    norms by which the entity decides to bind itself irrespective of
    whether there are formal rules and regulations or deterrent
    punishment for deviation from norms exists or not. No trader can
    repeatedly violate his contract even if oral, with either his
    customer or with his supplier. It will simply render his business
    impossible. One can call this self regulation at its most basic
    level with the source of discipline being the market place. The
    market place simply does not deal with you if your behaviour is
    substantially out of line with basic norms and we don’t need the
    force of law here to enforce such norms.
  • As a second source of demand for regulation one can look at
    situations where entities engaged in a particular business activity
    may decide to come together and conclude that certain norms of
    behaviour are not adequately discouraged if the entire thing is left
    to the individual entities. Yet, the group feels that such norms
    need to be in place for the overall development of their
    business. Since such voluntary groupings of entities do not enjoy
    the force of law they may decide that any behaviour against the
    agreed rules of behaviour will be punished by making the concerned
    entity lose the membership of that group. Trade Guilds, clubs, the
    early form of stock exchanges are examples of this. This form of
    regulation is commonly known as self regulation. This self
    regulation is not regulation of activities by the entity by itself
    but is the regulation of the entity by a common interest group of
    which that entity has agreed to be a member. For such a grouping to
    succeed, individual members must be able to see the benefits of
    membership. The price of being expelled from membership should be
    high enough to ensure behaviour as per the commonly agreed norms by
    the group itself. Our experience in India has not been entirely
    satisfactory in this area. Nevertheless, we need to continue our
    efforts at establishing credible self-regulation.
  • That brings us to the third category of regulation which is
    regulation enforced by law. The argument in such cases appears to be
    that the activity of entities in a particular area of operation
    affects the lives of more than just the member entities. In other
    words the society has a stake in ensuring that the entities conduct
    their operation in a manner that is acceptable not just to those
    entities but to the society at large as well. The discontentment with
    financial meltdown is very aptly captured by the expression
    `privatisation of gains and nationalisation of losses’. This sentiment
    is also a reflection of the fact that there are stakeholders outside
    the universe of finance who suffer if finance is not regulated.

The interplay between self regulation and regulation by the
authority of law has been a subject of interesting discussion not only
in the area of capital markets but in other fields as well. Self
regulation is generally considered desirable since it is made by the
entities themselves and therefore,it is considered more business
friendly. Equally there are arguments that there are not sufficient
incentives in self regulation to put the interest of other
stakeholders before the interests of the participating entities. In
addition self regulation lacks the ability to enforce its rules beyond
depriving the member concerned the membership of the group. If a
significant group decides to violate norms the self regulatory
structure can become unsustainable and only the backing of law can
sustain such activity.

In different jurisdictions, efforts have been made to make the
deterrent actions of self regulatory organisations stronger by
granting such organisations `recognition’. However, difficulties arise
if more than one organisation wants to be recognised as a self
regulatory organisation for entities in the same area or business. In
other words if the entities split and form multiple organisations, all
of which seek recognition as self-regulatory organisations, the
situation is not amenable to an easy resolution. Notwithstanding the
various forms of self regulatory organisations and the different
degrees of strength and their deterrent actions, it is commonly
accepted around the world that self regulation alone is not sufficient
and an apex regulatory body is necessary.

The functions of the regulator

Regulation with the backing of legislation is administered either
by the Government itself or their autonomous statutory regulatory
organisations. While the model of Government being a regulator itself
has been tried in the past,the modern consensus is to have independent
and autonomous statutory regulatory bodies. In the wake of the
reforms undertaken by the Government in 1991, SEBI legislation was
passed by the Parliament in April 1992. SEBI has been created as an
independent statutory body.

What are regulators expected to do? Regulators set rules for
conduct of market entities, the manner of conducting business, and
even the tariff to be charged in certain cases. Regulators may also
lay down norms for entry as well as continuity of business for
entities. It is thus apparent that regulators can enjoy powers in the
area of rule making for entry / exit regulation, conduct regulation,
tariff regulation, and risk containment regulation.

Regulators not only set rules but are also required to keep an eye
on the compliance of these rules. They therefore, end up setting up
an elaborate mechanism for ensuring compliance. If despite this, the
rules are breached then the regulators are charged with the duty of
carrying out necessary investigation and enforcing these rules by

The question of autonomy of the regulator

The list of responsibilities is fairly onerous and since the
regulators combine in themselves the roles of rule making (legislative
role), administration of rules and investigation if breach of rules
occur (administrative function) and adjudication (judicial function),
it is necessary to pay careful attention to the governance issues of
regulators. It is an accepted principle that regulators need to be
autonomous in discharging the duties laid down by law. A regulator,
subordinate to or dependent on the executive wing of the Government
will not be in a position to do proper justice to its duties.

Autonomy is not only a matter of creating appropriate structures
and legal provisions but also a matter of perception. Regulatory
structures in India are in different stages of evolution and therefore
the thinking on autonomy and the perception of autonomy has not yet
fully crystallised.

The Reserve Bank of India as a regulator has been in existence for
more than 75 years and therefore, the relationship between the
executive branch of the Government and the RBI is far more evolved
compared to the relationship of regulators which are of more recent
origin. SEBI is in its 19th year and stands somewhere in the middle of
regulatory evolution: it is more evolved compared to the regulators
that have been set up in this century but has lesser history when
compared to the Central Bank.

The first Chairman of statutory SEBI, Mr. G. V. Ramakrishna, once
famously remarked in the early days that brokers of BSE should know
that the route from Dalal Street (BSE) to Mittal Court (the location
of the SEBI head office, then) is not via the North Block (Finance
Ministry, Delhi). The brokers at that time had not got used to the
idea of a regulatory body having been formed which would independently
set regulations. Capital market regulation was part of the Ministry of
Finance functions till the formation of SEBI. They therefore had a
tendency to run to the Government for every little problem.

The tension between the executive branch of the Government and the
regulatory bodies is not a phenomenon only during the early stages of
regulation nor is it peculiar to India alone. Both the regulators and
the executive need to nurture this relationship in a manner that
reinforces regulatory autonomy. It is not easy for the executive to
deal with this especially when the very powers that were exercised by
the executive are transferred to the regulator. It is imperative in
this context to make sure that there are adequate supportive
provisions in law and the rules to support the autonomous character of
the institutions.

To maintain the autonomous character of the institutions and its
independence from the executive one needs to start at the process of
the appointment and the terms of removal of the Members of the
regulatory apparatus. Interestingly, the framers of the Indian
Constitution saw the importance of this aspect in institutions such as
the Election Commission, the Higher Judiciary namely High Courts and
Supreme Courts and the Comptroller and Auditor General of India. The
Constitution makers were very careful in providing for the conditions
for removal of persons at the helm of these bodies even while
recognising that the appointments will be made by the executive. These
autonomous institutions have served India well. The prolonged tension
between the Election Commission and the other organs of the Government
is an example of how constitutional protection delivered a powerful
and autonomous Election Commission which admirably served the cause of

The regulators do not enjoy protection in terms of the
conditions under which their services can be dispensed with by the
executive. In fact the regulators are at the other end of the spectrum
in terms of provisions for their removal. In SEBI, the Members and
the Chairman are appointed for a tenure of certain number of years or
until further orders whichever is earlier.

A tradition has been established that regulators are not removed
from their jobs as easily as the functionaries in the executive
itself. There is no known example of the executive having resorted to
the clause `until further orders whichever is earlier’ to remove the
functionaries of the regulatory organisations. Whether it is
sufficient to rely on tradition or whether we need a better legal
mechanism with checks and balances needs to be debated, so that this
important aspect of governance is not ignored.

A vital component of autonomy is financial autonomy. In case of
SEBI and some other regulators such as IRDA this autonomy was built
into the legislation by way of providing that such authorities will
establish a separate fund into which the fees paid by the market
intermediaries will be credited. Such funds are to be used by the
authorities for discharging the functions entrusted to them by

Currently there is a line of thought – as you must have all read in
the media – that the regulatory authorities should not be allowed to
have funds of their own but these funds should be merged with the
Consolidated Fund of India. If the Government finally accepts this
line of thinking, substantial damage will be done to the autonomy of
regulatory institutions. If the regulators have to depend on the
executive for release of funds the question of independent behaviour
by the regulators would be jeopardised. It is necessary to carefully
consider the pros and cons of taking away financial autonomy from

The function of investigation in case of breach of rules is an area
that hinges in a vital manner on autonomy from the executive wing.
Regulators by the definition of their responsibility have
investigative wings. This function has come under increasing judicial
scrutiny and the movement of the last 15 to 20 years has been to free
the investigation function from the possibilities of influence by the

The CBI is a case in point. Under the direction of the Supreme
Court the supervision of this institution is with the Chief Vigilance
Commission which in itself is an independent statutory authority. I
would therefore, argue that regulatory autonomy vis a vis the
executive wing of the Government is not only necessary but is

The question of accountability

Any governance structure based on autonomy must also look into the
question of accountability. Since regulators have multiple roles, part
legislative, part administrative and part adjudicatory, the
accountability in the three areas is handled in different ways.
Regulators are creatures of law and the ultimate supervisory authority
of the Parliament to assess whether the regulators are discharging the
functions assigned to them is supreme.

The Comptroller and Auditor General of India is empowered under the
regulatory provisions to audit accounts of the regulators and submit
reports to the Parliament to help the legislative in its
assessment. In addition the regulators are required to prepare an
annual report on their activities and lay it on the table of both
Houses of Parliament.

The adjudicatory function of the regulators has been treated
differently and by its nature has to be a subject matter of
supervision by judicial bodies. A mechanism in the form of Securities
Appellate Tribunal headed by a retired High Court Judge and an appeal
provision to the Supreme Court of India forms an integral part of SEBI

The rule making powers of SEBI are supervised by the
Parliament in order to ensure that the rule making is confined to the
powers granted by the Parliament to the regulators. If a regulator
exercises power beyond the permissible limit of legislation, the rules
can also be challenged in the courts of law.

In the rule making function the regulators do interact with the
executive branch of the Government. The executive wing of the
Government will have legitimate imputs into the rule making process
and a fine balance is required between the need for autonomy and the
need for harmonisation. This is achieved through the presence of
Government representatives in the Board of SEBI.


In conclusion, it is quite clear that attempts at unregulated
development not only in a particular sector but even in small
sub-sections of sectors have failed. The failure is mainly because
such development ultimately leads to crisis. The cost of resolving
such crisis is high and the burden of the cost is borne not just by
those who benefited from the development but a large portion is borne
by those who were not part of the recipients of the benefits. Clearly
the collateral damage is very high.

The question is, therefore, not so much as to whether development
and regulation are in conflict as the quality of regulation that will
enable us to find a balance between the needs of development and the
need to keep the risk-reward relationship appropriate. It is
necessary to carefully think and design proper regulatory structures,
ensure regulatory autonomy and make sure that there are checks and
balances in the system to address the concerns of accountability as

Thank you.