REGULATION AND DE-REGULATION OF THE STOCK MARKET IN INDIA
With internationalization, and the entry of new entities, government controls become ineffective. The de-regulation movement of the eighties sought to make regulatory structures for capital markets similar across emerging market economies (EMEs) in order to encourage capital movements yet minimize regulatory arbitrage. But the East Asian currency and banking crises of 1997 pointed to inadequacies in regulation. De-regulation turns out to require re-regulation or a smarter regulation that would create incentives for self-regulation.
The Indian liberalization, reform of capital markets and setting up of a new regulator, Securities Exchange Board of India (SEBI), in the nineties, illustrates this process. India had the advantage of being able to use cutting-edge technology, which facilitated rapid reform in market microstructure and in regulatory norms. Thus technology and better governance worked together. Since re-regulation proceeded along with de-regulation, and some protective capital controls were retained, major inter-sectoral spillovers were avoided. Problems remain–financial services are still not at the required level, market participation is shallow, large institutions dominate, and there are complaints about the consistency of punitive actions. Even so, inadequacies that are blamed on norms of behaviour were actually a response to market structure and incentives, and are changing with these. Insiders lost power as the old-style committee-based governance of stock exchanges broke down, and anonymous electronic trading systems were established.
PRINCIPLES OF REGULATION
Regulation can be defined as government intervention in markets to influence those decisions of private agents that would otherwise not fully consider public interest. Intervention is justified by market failure due to monopoly or market power, asymmetric or imperfect information, and the existence of externalities or of public goods.
The above definitions derived from welfare economics are a subset of the public interest theory of regulation, which is broader than the concept normally used in economics. In judicial review the concern is to solve disputes according to certain ˜values™ such as (a) protecting citizens from unfair treatment ; (b) enforcing state™s police power; and (c) controlling government™s power . Early reliance was on private litigation to correct social wrongs. Regulation was a later development .
The theory of regulatory capture, where regulatory agencies come to represent special interests , contrasts with the public interest theory. It makes a case for de-regulation or for better-designed regulation. For example, firms may seek government regulation in order to restrain competition from technologically superior rivals. Moreover, the transaction costs of regulation may be high, or regulatory agencies may be mismanaged. Human capital or information on the public™s requirements may be poor. Posner found evidence that regulation had socially undesirable effects, which benefited groups who had influenced the enactment of regulatory legislation. Public interest is sometimes used to hide group interests.
IN CAPITAL MARKETS
The basic principles of regulation combined with the special features of capital markets, indicate the major issues for regulation in capital markets. In Asian EMEs regulation has the added task of compensating for other weaknesses. La Porta et. al. (1998) have argued that a common law tradition is necessary for healthy equity markets. But, for example, China can set up a good regulatory institution faster than it can acquire common law .
Financial regulation serves the public interest if it ensures that finance meets the needs of the real economy, through efficient intermediation of savings, price discovery, allocation of investment, and the pricing and hedging of risk.
SPECIAL FEATURES OF REGULATION IN THE INDIAN CONTEXT
Since the rate of financial innovation is high regulatory practices should retain flexibility, even at the cost of some regulatory uncertainty, as long as they satisfy general principles. Then they would be able to encourage market functions, while moderating market flaws. Regulatory practices also need to be attuned to country specific features. We turn next to see how far the Indian regulatory structure satisfies these conditions .
SEBI: HISTORY,OBJECTIVES AND POWERS
Latecomers have the advantage of adopting best practices, but this is easiest done when a new institution is created. Changing old established institutions is difficult.
The Capital Issues (Control) Act 1947, administered by the Controller of Capital Issues (CCI), governed capital issues in India. As part of liberalizing reforms CCI was abolished, and Sebi set up in1988, was made a statutory body in 1992. Its objectives, in line with public interest, are to protect the interests of investors, ensure the fairness,
integrity and transparency of the securities market, and reach best international regulatory practices. Sebi™s tasks and powers, expanded over time, are to regulate stock and other securities markets, register and regulate all intermediaries associated with securities markets. Under the Sebi (Amendment) Bill 2002 its powers were expanded to cover all transactions associated with the securities market. In 2003 it was empowered to impose enhanced monetary penalties.
Asymmetries and imperfections of information leave investors susceptible to cheating. They also cause participants to follow each other in swings that create excess volatility and externalities. So improving transparency of markets is a top regulatory priority. Moreover, better corporate governance can reduce asymmetries of information between management and shareholders, improve incentives for complying with rules, and reduce conflicts of interest.
Disclosure: Strict norms regarding disclosure of price sensitive information, and conflicts of interest, contribute to reducing asymmetries of information and aid the markets in
Volatility: Price bands, complex value at risk (VaR) margining systems, circuit filters, exposure limits and suspension are all used to curb volatility. These allow adjustment for risk to be individual specific and therefore less inefficient than a common margin, while achieving the desired result of putting concave boundaries on convex returns, thus reducing one-way price movements.
Corporate Governance: Corporate governance (CG) is being tightened, and gradually extended to all companies. In 2000 Sebi specified principles of CG and introduced a new clause in the listing agreement of the stock exchanges. Statutory requirements now call for one-third of directors to be independent. They have to periodically review legal compliance reports and steps taken for any correction, and to reveal any non fee-based pecuniary connection with the company, although the latter does not as yet automatically disqualify them as independent directors.
Conflicts of Interest: In 2003 Sebi planned for new model byelaws for governance of stock exchanges. A separate entity would manage the surveillance and investigation functions of the stock exchanges or else the functions would be outsourced. The agency would be responsible for any misuse of the system. Stock exchanges would be empowered to impose penalties for failure to comply with any of the provisions of the listing agreement, subject to a limit of Rs 0.5 million for a specific violation and an overall limit of Rs 5 million in a financial year. These steps were expected to improve self-regulation of stock exchanges, define responsibility more clearly, remove conflicts of interest in policing members, and encourage clearer contracts, without deliberate or sloppy ambiguity.
Technology and Transactions costs: Automation made many of the above improvements possible. Insiders lost power not only due to more transparency but also as the old club-style governance structure of the stock exchange changed. India used new technology effectively to reach and sometimes exceeded international benchmarks in disclosure norms, trading volume, settlement cycle, and low transaction costs. In the order driven system, each investor can access the same market and order book, at the same price and cost, irrespective of location. Dematerialization of securities had been introduced to reduce bad paper risk. Settlement of trades in the depository is compulsory except for sales by small investors.
Flexibility: A principles-based stance gives flexibility to adjust to emerging trends. An example is Sebi tightening the norms for private placement in 2003, after many firms began to use these, since the stock markets were in the doldrums. But the resulting absence of disclosure increased risk. Apart from the stick Sebi also offered the carrot of reduction in the cost of open offers. In 2004 all listed companies were required to have a minimum 25 percent non-promoter holding, but since earlier companies had been allowed to list with less, they were given time to adjust. In 2005, following complaints that Sebi norms for public issues were too time consuming, steps were taken to simplify norms for follow on issues, and for companies with a good track record on disclosures.
Indian capital markets differ in that the retail investor has an independent role. In most countries the small investors come in only through mutual funds. In the late 1970s a large retail investor base was created when multinationals had to issue shares to Indian investors as part of the FERA dilution of share holdings. But small investors incurred losses due to fluctuations and scams in stock markets. Household investor surveys show that the retail investor base has been shrinking since 1997, due to fear of insiders. Thus even the 2003 boom in stock markets was largely driven by FIIs and many domestic investors used the opportunity to liquidate their holdings and exit the stock markets. Mutual funds have also not been able to attract small investors.
MONITORING AND SURVEILLANCE
De-regulation or moving away from government controls on allocation decisions and giving more economic incentives to market participants depends on strong non-invasive monitoring, surveillance and punitive actions to prevent deviations from the rules of the game. Technology has allowed great improvements in surveillance so that Laffont™s (2005) argument that monitoring is poor in developing countries does not hold for the stock market, but implementing of rules is still perceived to be imperfect and inconsistent . Primary responsibility for implementation lies with the exchanges, with oversight by SEBI. Retail investors are still concerned about management frauds and lack of transparency, price manipulation and volatility (NSE, 2003), although SEBI’s reforms
in 2001 have improved matters. Insider dominance and market manipulation becomes less feasible as the number of constituents and their geographical dispersion increases, and structural improvements reduce the power of remaining groups.
INNOVATIONS AND OTHER IMPROVEMENTS
Depth of markets, width of instruments and participation rates should improve as growth firms up and capital markets revive. But space has to be actively made for the small investor in order to help bring household savings back to the securities markets (see Table 1). There is disappointment that mutual funds have not delivered on this, and they are being pushed to innovate more. Allocation of market funds to small firms has to improve for more effective intermediation of savings; measures such as encouraging analyst research on small firms, venture capital for initial financing and enabling its exit through an over the counter exchanges (OTCEI) are required (Nageswaran and Krithivasan, 2004).
The paper has enumerated the pluses and minuses of regulation in the context of capital market development in India–the many achievements and further potential improvements. Principal based capital market regulation has been able to flexibly evolve with markets in India. De-regulation of government controls was accompanied by continuous re-regulation, which allowed more economic freedoms and incentives but enforced strict rules and more transparency. Scams occurred in the transition period, but since some controls were retained, the scams did not spillover into other sectors. For example, capital controls helped Indian markets escape contagion from the 1997 East Asian crises.
The paper brings out gaps between perception and reality. Because of a history of speculation in thin markets, there is a misperception that insider dominance is a feature of Indian capital markets. But it turns out to be a feature of open outcry and geographically concentrated capital markets. Technology and the geographical dispersion it brings about decreases their power. The latter has happened in India while it is still resisted in more developed countries. Once the government decided to back new technology these forces tipped trade in favour of modern systems. A rapid change became possible in Indian securities markets, without a change in the general level of legal and institutional development.
Imperfections in monitoring and surveillance were also due not so much to insider collusion as to imperfections in the structure of incentives and penalties. Design improvements are possible and are ongoing, as they are elsewhere in the world. The miasma of corruption from which markets are said to suffer is system specific and not inevitable. As growth revives and markets become more active, the tight norms established and the deep steady capital market reforms, to which Sebi has contributed, seem to be paying off.
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