Page 20 - DCOM304_INDIAN_FINANCIAL_SYSTEM

Unit 1: Indian Financial System

The conservatism that insulated Spanish banks from crisis also played its role in keeping Notes
the banking system healthy in Canada, which follows a principles-based system of
regulation. For example, mortgages with less than a 20 per cent down-payment have to be
insured, and most of the securitised mortgage market consists of Canada Mortgage Bonds,
which carry a government guarantee. The Canadian central bank also did not allow creation
of complex, synthetic securitised instruments involving Canadian mortgage assets.
In India, the Reserve Bank of India (RBI) has strict rules regarding housing finance,
specifying the risk weights to be attached to loans extended to borrowers. These risk
weights vary according to the LTV ratios. The RBI also specifies the maximum sanctioned
amount for LTV ratios as less than or equal to 75 per cent.

UK's System
In the UK, the Financial Services Authority (FSA) follows a principles-based regulation.
However, in its proposed reforms for mortgage lending, it has categorically banned
certain practices such as self-certified mortgages replacing it with those requiring
verification of the income of the borrowers. It also now requires mortgage advisers to be
personally accountable to the FSA.
Having realised that non-interventionist principles-based system need not always lead to
the desired regulatory outcome, there appears to be a distinct shift in the UK from a non-
interventionist stance to a more intrusive one.
The Federal Reserve has also notified a revision in its Regulation (which implements the
Truth in Lending Act and Home Ownership and Equity Protection Act), prohibiting
creditors from making higher-priced mortgage loans based on the "value of the consumer's
collateral without regard to the consumer's repayment ability".

Thus, in the case of the US and the UK, at least with respect to mortgage lending, the bias
is in favour of a rules-based system. But is this desirable?
One of the biggest criticisms levelled against the rules-based system is that it stifles
innovation by being too interfering. In contrast, a principles-based regulation is more
accommodative to innovation because it is pliant and flexible. But, as the recent meltdown
has shown, while gains from financial innovation benefit a few, the losses affect a greater
number through systemic instability. When it comes to a trade-off between profitability
and financial stability, the choice is very clear. Financial stability creates conducive
atmosphere for profitability and for carrying out banking. Therefore, a rules-based system
clearly scores over a principles-based system.
A developing country like India has its own compulsions which make a rules-based
system better suited when it comes to meeting our development objectives. For example,
with respect to financial inclusion, unless it is specifically laid down that banks must offer
no-frills accounts to their customers with zero or minimum balance and also relax criteria
for identification and account opening, the goal of financial inclusion may not be achieved.
Also, there is nothing in the rules-based system that disallows innovation. If that were the
case, Indian banks wouldn't have been allowed to offer several products that they now
offer. The pace of innovation would be slow but if it ensures financial stability for the
system, the trade-off would be well worth it.
Question
Discuss the importance of rules and regulation in financial system.

Source: http://www.thehindubusinessline.in

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