This post is a continuation of our blog series on the FSLRC report.

The FSLRC report identifies three problems that occur when regulators pursue the objectives of financial inclusion and market development like subsidizing credit for agriculture or increasing the flow of credit into certain states, for example:

1. When a bank is forced by regulation to provide more loans to open a branch in a non-profitable location, this imposes a hidden cost or tax on other branches, depositors and shareholders.
2. There could be dilution of accountability of the regulator due to conflicting objectives. For example, the number of households that participate in a certain financial product maybe increased quickly by reducing the burden of consumer protection. Similarly, the function of redistribution to exporters, by requiring banks to give loans to exporters, is in direct conflict with the function of protecting consumers who deposit money with banks.
3. The report takes the view that imposing costs on certain consumers for providing gains to others is a form of taxation. Such a selective taxation of certain consumers is inherently inefficient.

Due to the problems cited above, there is a need to clearly define the scope of objectives, powers and accountability of regulators. The report’s recommendations throw much clarity on three aspects-what the objectives of the regulators should be, how these objectives should be implemented and what the principles guiding policy-making should be. These are discussed below.

The FSLRC identifies three regulatory objectives of financial inclusion and market development:

1. Modernisation of market infrastructure or market process, especially those that relate to adoption of new technology.
2. Deepening consumer participation by undertaking measures that provide for the differentiation of financial products/services to specified categories of consumers, or that enlarge consumer participation in financial markets generally.
3. Aligning market infrastructure or market process with international best practices.

The report recommends the following institutional architecture for implementing the objectives identified above:

1. The Central Government should direct specific regulators on matters of financial inclusion. For example, regulators may be asked to ensure effective and affordable access to any specific financial service for a class of consumers. The Central Government is expected to reimburse the cost incurred by financial service providers in granting such in the form of cash or cash benefits and tax benefits.
2. Regulators should pursue a developmental strategy that seeks to achieve the objectives outlined. However, the goal of market development should be subordinate to the goals of consumer protection and micro-prudential regulation and should be pursued only when there is evidence of market failures that hinder it. The report recommends that the rule making process should involve features like cost-benefit analysis and notice-and-comment periods. There should also be ex-post evaluation of these initiatives, assessing their costs and benefits.
3. In initiatives that involve multiple regulators, the FSDC (Financial Stability and Development Council) will play the dual role of a think-tank (measuring the progress of initiatives, analysing past initiatives, recommending new ideas etc.) and be the agency that coordinates between regulators.

The report recommends that the regulators and the central government keep the following balancing principles in mind while formulating policies:

1. Minimize any potential adverse impact on the ability of the financial system to achieve an efficient allocation of resources.
2. Minimize any potential adverse impact on the ability of a consumer to take responsibility for transactional decisions.
3. Minimize detriment to objectives of consumer protection, micro prudential regulation, and systemic risk regulation.
4. Ensure that any obligation imposed on a financial service provider is commensurate and consistent with the benefits expected to result from the imposition of obligations under such measures.

Overall, the framework proposed by FSLRC focuses on regulatory functions that address market failures obstructing the efficient functioning of the financial system. The Commission is of the view that financial inclusion and market development are functions that aren’t strictly regulatory in nature. Financial regulators performing these functions could lead to distortions in the market (hidden costs, inefficient taxation and dilution of accountability). Such functions should therefore be pursued in case of market failures that hamper equitable distribution of financial services and market development.

In a new working paper, my colleagues Deepti George and Anand Sahasranaman develop a framework to compare costs of rural credit delivery across five dominant channels: PSB lending through its rural branch, PSB lending through a Self-Help Group (SHG), PSB lending through a Micro Finance Institution, Private Bank lending through its branch and Private Bank lending through a Micro Finance Institution. Importantly, they look at costs comprehensively including a) cost of debt b) cost of equity c) transaction costs and d) loan loss provisions.

Above excerpt is cross-posted from Bindu Ananth’s latest column on the Forbes India Blog. Click here to read the full post.

Continuing on our series on Unemployment Support In India, this post provides an overview of the Mahatma Gandhi National Rural Employment Guarantee Act (2005).

The notion that public works programs can provide a strong social safety net through redistribution of wealth and generation of meaningful employment has been integral to the Indian policy-making agenda. The Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA) 2005 is currently a major part of this agenda. The Act was enacted at a point in time when more than a decade of sustained high growth in GDP experienced in the 1980s and the 1990s was perceived not to have made a sufficient dent in poverty in the rural India.

The Act was notified on 5 September 2005 and was implemented in rural districts in 3 phases. Each state is required to design an employment guarantee scheme based on a set of national guidelines. Public work programmes or employment generation programmes like the Maharashtra Employment Guarantee Scheme (MEGS), Food for Work Programme (FWP), Sampoorna Grameen Rozgar Yojana (SGRY) and National Food for Work Programme (NFFWP) have been used to address the issue of unemployment and generate employment through the creation of labour- intensive productive assets and have thus provided the foundation for the MGNREGA.

Rationale

A common feature of all the schemes mentioned above was that they were formulated and executed by implementing agencies and their termination was at the will of the executive. The theoretical rationale behind employing these programmes is fourfold: i) mitigation of unexpected and seasonal shocks ii) mitigation of idiosyncratic shocks iii) anti- poverty measures; and iv) provision of public goods and services.

Mandate

The Act mandates enhancing livelihood security in rural areas by providing at least 100 days of guaranteed wage employment in a financial year to every household whose adult members volunteer to do unskilled manual work.

Objective

The primary objective of the Act is augmenting wage employment for the poorest of the poor while the secondary objective is to strengthen natural resource management through works that address causes of chronic poverty, like drought, and thus encourage sustainable development. (MoRD 2012).

The Act is an attempt to provide a legal guarantee of employment to anyone in rural areas willing to do casual manual labour at a statutory minimum wage. What makes the MGNREGA distinct from any other public employment programme is that it is a universal and enforceable legal right concurrent with some of the provisions of Article 39¹ and Article 41² of the Directive Principles of State Policy in the Indian Constitution that enshrine the ideals of the Right to Work.

Planning, Implementation and Funding

The graphic below depicts the processes and agencies involved in planning, implementation and funding of works under the MGNREGA.

Design features

Key design features in the context of social security and unemployment support:

• Guaranteed Employment - Any adult member of a rural household applying for work under the Act is entitled to employment. Every rural household is entitled to not more than 100 days of employment.
• Guaranteed Wages - Wages are to be paid on a weekly basis and not beyond a fortnight. Wages are to be paid on the basis of:
  1. Centre- notified, state- specific MGNREGA wage list
  2. Time rates and Piece rates as per state- specific Schedule of Rates (SoRs)
  3. In any case, the wage cannot be at a rate less than Rs. 100 per day.
• Unemployment Allowance – If work is not provided within 15 days of applying, the state is expected to pay an unemployment allowance which is one- fourth of the wage rate.
• Provision of Work – Work is to be provided within a 5km radius of the applicant’s village, else compensation of 10 per cent extra wage is to be provided to meet expenses of travel.
• Gender Equity – Men and women are entitled to equal payment of wages. One- third of the beneficiaries are supposed to be women. Worksite facilities like creches are to be provided at all worksites.
• Financial Inclusion – Since 2008, all wage payments have had to be transferred to bank or post office accounts of beneficiaries.
• Social Security Measures – In 2008, a provision was created which made it possible to cover beneficiaries under either the Janashree Bima Yojana (JBY) or the Rashtriya Swasthya Bima Yojana (RSBY).
• Transparency and Accountability – All MGNREGA- related accounts and records documents have to be available for public scrutiny. Contractors and use of machinery is prohibited.
• Rights- based, demand- driven approach – Estimation and planning of work is conducted on the basis of the demand for work. Hence, beneficiaries of the scheme are enabled to decide the point in time at which they want to work.

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1 – Article 39- Certain principles of policy to be followed by the State: The State shall, in particular, direct its policy towards securing
a) that the citizens, men and women equally, have the right to an adequate means to livelihood;
d) that there is equal pay for equal work for both men and women
2 – Article 41- The State shall, within the limits of its economic capacity and development, make effective provision for securing the right to work, to education and to public assistance in cases of unemployment, old age, sickness and disablement, and in other cases of undeserved want.
References – Ministry of Rural Development (MoRD). “MGNREGA 2005: Report to the People”. New Delhi (2012).

This post is part of our series of posts on Long Term Debt Markets in the Indian context.

One of the standard instruments used to hedge against risk in a corporate debt market is the credit default swap or CDS instrument. A CDS is a credit derivative contract between two counterparties. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults or experiences a similar credit event. Development of a CDS market may lead to a gradual deepening of the corporate bond market as CDSs can enhance the bond market investors’ appetite for lower rated issuers, beyond their traditional favorites in the high-safety category. Before going into the details of the CDS market in India it maybe useful to understand the different elements of risks associated with CDS.

Default Risk: When entering into a CDS, both the buyer and seller of credit protection take on counterparty risk i.e. the buyer takes the risk that the seller may default (in which case the buyer loses its protection against default by the reference entity) while the seller takes the risk that the buyer may default on the contract, depriving the seller of the expected revenue stream. More important, a seller normally limits its risk by buying off-setting protection from another party — that is, it hedges its exposure. If the original buyer drops out, the seller squares its position by either unwinding the hedge transaction or by selling a new CDS to a third party. Depending on market conditions, which may be at a lower price than the original CDS and may therefore involve a loss to the seller.

Jump Risk: Another kind of risk for the seller of credit default swaps is jump risk or jump-to- default risk. A seller of a CDS could be collecting monthly premiums with little expectation that the reference entity may default. A default creates a sudden obligation on the protection sellers to pay millions, if not billions, of dollars to protection buyers. This risk is not present in other over-the-counter derivatives.

Systemic Risk: This risk arises from the interconnectedness of the different parties involved in a CDS transaction. One of the factors contributing to systemic risk in a CDS market is a ‘naked’ CDS contract–a CDS in which the buyer does not own the underlying debt. These “naked credit default swaps” allow traders to speculate on the creditworthiness of reference entities and were widely prevalent in the US financial markets before the Global Recession of 2008. If participants are permitted to purchase CDS without having the underlying risk exposure, there could be huge build-up of positions resulting in a scenario where the amount of protection purchased is higher than the total bonds outstanding. Such a position, if concentrated among a handful of participants and unregulated, can have systemic implications and lead to a dangerous build up of risks.

Counterparty default as mentioned earlier is also another factor that can contribute to systemic risk. The risk of counterparties defaulting has been amplified during the 2008 financial crisis, particularly because Lehman Brothers and AIG were counterparties in a very large number of CDS transactions. This is a classic example of systemic risk that threatens an entire market, and a number of commentators have argued that size and deregulation of the CDS market have increased this risk.

CDS market in India

India’s fledgling credit default swap (CDS) market kicked-off on Dec 6, 2011 with two deals covering 100 million rupees ($1.9 million) worth of bonds. The deals, both 1-year trades were between ICICI Bank and IDBI Bank (underwriter), at 90 basis points and covered 50 million rupees each of 10-year bonds issued by Rural Electrification Corp (REC) and India Railway Finance Corp, according to details on the Clearing Corp of India Ltd’s website. The RBI has since then allowed banks to begin hedging their banking and trading books using CDS, signaling that the infrastructure is finally in place for the launch of the instruments in Asia’s fourth biggest bond market.

According to paragraph 113 of the Second Quarter Review of Monetary Policy for year 2009-10, an Internal Group was constituted by the RBI to finalize the operational framework for the introduction of plain vanilla OTC single-name CDS for corporate bonds in India. Draft guidelines on CDS based on the recommendations of the Group were placed on the RBI website on February 23, 2011 and were open for comments from all concerned. Comments were received from a wide spectrum of banks, primary dealers and other market participants and accordingly the guidelines were suitably revised in the light of the feedback received. The guidelines became effective from October 24, 2011.

The RBI guidelines which incorporate learning from the CDS markets worldwide ensure that CDS is neither used for speculative purposes nor to build up excessive leveraged exposures. Following stipulations are directed particularly at avoiding any serious systemic threat that maybe caused by such an innovative and complex financial product:

1. Only investors who own the underlying securities are allowed to purchase CDS insurance thereby ruling out the entire gamut of ‘naked’ CDS contracts and ensuring that the CDS market cannot get bigger than the underlying debt market. The investors are required to submit an auditor’s certificate or custodian’s certificate to the protection sellers, of having the underlying bond while entering into/unwinding the CDS contract. This is good for ensuring liquidity in the bond market without inviting systemic risk related troubles by curbing speculation but bad for the CDS market development per se.
2. Trading in the derivative contracts will remain confined to lenders based in India thereby limiting the number of participants and making it easier to regulate and monitor. At the moment only banks can sell protection whereas in markets like the US, the sellers would include hedge funds, insurance companies, and asset managers. In India, only Banks, primary dealers, financially strong non-bank finance companies and any institution approved by the RBI will be eligible as market makers and will be allowed to sell protection. Foreign participants and hedge funds, which typically have a big appetite for credit risk, are not allowed to sell protection. Foreign institutional investors are allowed as “users”, which means that they can buy credit protection to only hedge their credit risk. Although RBI’s guidelines allow insurance companies and mutual funds to be sellers, this is subject to their respective regulators (IRDA and SEBI) permitting them to do so. This is not likely to happen until the market has become a bit more developed.
3. Entities permitted to quote both buy and/or sell CDS spreads — market makers — need a minimum capital to risk (weighted) assets ratio (CRAR) of 11 percent and Net NPAs of less than 3 per cent.
4. Users or buyer of CDS contracts are not allowed to sell protection and are not permitted to hold net short positions in the CDS contracts.
5. Investors can exit their bought CDS positions by unwinding them with the original counterparty or by assigning them in favor of buyer of the underlying bond. The RBI has also included restructuring under credit events for CDS. Buyers will have a grace period of 10 business days from the sale of the underlying bond to unwind the CDS position.
6. CDS will be allowed only on listed corporate bonds as reference obligations. However, CDS can also be written on unlisted but rated bonds of infrastructure companies.
7. The CDS contract shall be denominated and settled in Indian Rupees.
8. The RBI does not permit dealing in any structured financial product with CDS as one of the components neither will it allow dealing in any derivative product where the CDS itself is an underlying.
9. Fixed Income Money Market and Derivatives Association of India (FIMMDA) shall devise a Master Agreement for Indian CDS. There would be two sets of documentation: one set covering transactions between user and market-maker and the other set covering transactions between two market-makers.
10. The CDS contracts shall be standardized. The standardisation of CDS contracts shall be achieved in terms of coupon, coupon payment dates, etc. as put in place by FIMMDA in consultation with the market participants. This guards against customized contracts wherein the market-makers and users are free to determine the terms.
11. Protection seller in the CDS market shall have in place internal limits on the gross amount of protection sold by them on a single entity as well as the aggregate of such individual gross positions. These limits shall be set in relation to their capital funds. Protection sellers shall also periodically assess the likely stress that these gross positions of protection sold, may pose on their liquidity position and their ability to raise funds, at short notice.
12. Market-makers shall report their CDS trades with both users/investors and other market-makers on the reporting platform of CDS trade repository within 30 minutes from the deal time. The users would be required to affirm or reject their trade already reported by the market- maker by the end of the day.
13. For CDS transactions, the margins would be maintained by the individual market participants. Participants may maintain margins in cash or Government securities.

The vast majority of the Indian corporate debt market consists of bonds from state banks and quasi government entities. The rest comprises mostly of debt from high investment-grade corporate borrowers where the motivation of the bondholder to buy CDS protection is low. The volume of medium to low investment-grade corporate bonds in India is insignificant but the availability of CDS protection may help it grow substantially.

Increased use of CDS, over the medium term, has the potential to impart additional liquidity to the bond markets, which have so far been predominantly illiquid. It will help lower rated borrowers diversify their funding sources by accessing the bond markets. CDS also holds promise of providing a thrust to the much-needed infrastructure financing. RBI has allowed dealing in CDS for infrastructure companies even on unlisted bonds, rather than only on the listed ones. A coordinated action by the other regulators can allow insurance companies, pension funds, and provident funds to also participate in this space through the CDS route.

This post is a continuation of our blog series on FSLRC report.

Keeping in mind the existing state of consumer protection measures in place for India, FSLRC has proposed a consumer protection framework for financial services, with the stated objectives being – to protect and further the interests of consumers of financial products and services; and to promote public awareness in financial matters. It is pertinent to mention here that the Commission has included, in its definition of retail consumer, not just individuals but also enterprises that avail a financial product or service whose value does not exceed a limit as prescribed by the regulator¹, or who has less than a specified level of net asset value or turnover, also as prescribed by the regulator . The previous post mentioned the rights and protections that the draft Code sets out. Among these rights are the right against unfair contract terms and the right to redress of complaints.

The right against unfair contract terms

The Draft Code deems an unfair term of a non-negotiated contract² to be void. A term is unfair if it causes a significant imbalance in the rights and obligations of the parties, to the detriment of the consumer, and is not reasonably necessary to protect the legitimate interests of the provider³. Further, the Draft Code enlists a set of factors that would be considered in determining whether a term is unfair or not – such as the nature of the service, the extent of transparency of the term, the extent to which the term allows comparison with other financial products or services, and the dependency of the term with the remaining contract and with other contracts under question. If a term was found to be unfair, the contract will continue to be enforced with the remaining terms as long as it can do so without the unfair term.

This is very much in line with the laws laid out in Australia, in as late as 2010, through the Competition and Consumer Act 2010. While Australia already had laws in place to protect consumers against unfairness in contractual dealings (ex: prohibition of unconscionable or misleading and deceptive conduct), this Act introduced a new ‘unfair contract terms’ regime to standard form consumer contracts⁴ under which courts can decide if a term in the contract is found to be unfair⁵, in which case the contract is void. However, the contract will continue to bind parties if it is capable of operating without the unfair term. Examples of unfair terms are set out in an indicative list in the law⁶.

The right to redress of complaints

The Commission addresses this right in two steps – the first, is by placing a requirement on providers to have in place an effective mechanism to redress complaints internally, to inform consumers about their right to redress, and the process to be followed for it; and the second, is by having a statutory body external to the provider, that will be a unified grievance redressal system to redress complaints. This body termed the Financial Redress Agency (FRA), will replace sector-specific Ombudsmans currently in existence such as those for banking and insurance. Whether or not the FRA will replace the Consumer Courts (instituted by the Consumer Protection Act, 1986), will be decided later based on how well the FRA succeeds in its task.

FSLRC has also created a niche for consumer advocates to contribute to the regulator’s functions, through the creation of an Advisory Council on Consumer Protection. This body, with adequate representation from experts in the fields of personal finance and consumer rights, is expected to advice, comment on, and review the effectiveness of regulator’s policies. The regulator in turn is held accountable to respond to such proposals made by the Council, thereby bringing in an element of transparency to the regulatory decision-making process.
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1. This is not uncommon. In Australia, for instance, retail consumer includes small businesses, which are defined by s761G of Corporations Act 2001, as a business employing fewer than 100 people (if the business manufactures goods or includes manufacture of goods), or 20 people (otherwise)
2. A non-negotiated contract is one in which the provider has a substantially greater bargaining power relative to the customer in determining the terms of the contract; and it is a standard form contract
3. This however does not include a term that is reasonably needed to protect the legitimate interests of the provider, is a basic term such as the price of a product, or is a term required under any law or regulations
4. All contracts will be presumed to be standard form contracts unless otherwise established. It is typically one that has been prepared by one party to the contract (the supplier) and is not subject to negotiation between the parties
5. A contract term is considered unfair if:
   • - It would cause a significant imbalance in the parties’ rights and obligations arising under the contract, and
   • - It is not reasonably necessary in order to protect the legitimate interests of the party who would be advantaged by the term, and
   • - It would cause detriment (whether financial or otherwise) to a party if it were to be applied or relied on.
6. s25, CCA 2010. Some are given below: A term permitting one party (but not another party)
   • - to avoid or limit contractual performance or to terminate the contract
   • - to renew or not to renew the terms of the contract
   • - to unilaterally determine whether to determine whether the contract has been breached
   • - a term limiting one party’s vicarious liability for its agents