June 23: Every time a scam breaks out, shrill cries for more regulation are heard. The fact that the scams continue to occur at fairly regular intervals, and regulators do not seem to have learnt anything from their past mistakes, do not worry the proponents of more regulation. After all, they have their logic. If two spoonfuls of the medicine don't work, give the patient four spoonfuls. Keep on increasing the dosage, and the disease will have to go--this seems to be the general reasoning.

Hence the Reserve Bank's decision to increase the statutory liquidity ratio for non-banking financial companies from 10 per cent to 15 per cent. Why stop at 15 per cent--why not, while we are about it, go the whole hog and legislate that 100 per cent of NBFC assets need to be kept in government securities? The Securities and Exchange Board of India does not want to be seen to be doing nothing, and it has barred 64 merchant bankers from undertaking any fresh business merely because they have not furnished particulars of their employees and their kin, particulars which amount to a gross violation of privacy.

But perhaps, if the medicine doesn't work, it is time to change the medicine. It is nobody's case that investors should be defrauded by unscrupulous operators--but the means for protecting investors must be effective. That calls for a change in medication, not merely increasing the dosage of ineffective regulation. The need for a new regulatory framework arises because of three factors--first, the current regulations don't work; secondly, because of the costs involved in micro-regulation; and thirdly, because of the fact that honest and above-board players in the markets are subjected to needless harassment merely because of the misdeeds of a few.

The costs of regulation are substantial. The taxpayer has to contend with a bloated bureaucracy whose sole function is to police the markets, and police it very ineffectively at that. Staff devoted solely to supervision, whether at SEBI or the Reserve Bank of India, constitute a cost which ultimately translates into a higher cost of capital for all players. Of course, we wouldn't mind paying these costs if they prevented frauds, but that clearly isn't happening.

What is the alternative? All through the CRB scam, the alternative has been there right under our noses, but our preoccupation with bureaucratic modes of regulation have blinded us to the facts. Consider how the CRB scrips have performed in the equity markets, and the notion of the market as a regulator does not seem as outlandish as it sounds.

The CRB Capital Market scrip started moving down from October 1996, soon after a downgrade in the company's debt rating. The CRB Corporation scrip started declining sharply from December 1996. During the period September 3, 1996 to April 17, 1997, before the whistle was blown on the group, the value of the CRB Capital Markets scrip declined from Rs 39.50 to Rs 10.40, while the value of the CRB Corporation scrip fell from Rs 24.50 to Rs 9.80 during the same period. Obviously, the market was not impressed by CRB Capital Market's declared Rs 5.5 annualised earnings per share based on the first half results of 1996-97.

It can be argued that, if only the investors in the company's fixed deposits had paid more attention to the share price of the company, and taken the trouble to enquire into the reasons for the decline, they could have pulled out earlier from the company. More accurately, if a vibrant debt market existed, and if CRB's bonds were traded, these would have provided reliable benchmarks to fixed deposit investors on the market perception about the company.

Contrast the market's lack of interest in the CRB group scrips with the behaviour of the BSE Sensex. During the period September 3, 1996 to April 17, 1994, while the value of the CRB scrips declined so precipitously, the BSE Sensex actually increased, from 3484 to 3696.

It is clear that the market knew more than the regulator. The information available to the supervising institution is limited to the knowledge and competence available to their supervisors. Often, the supervisor has no specialisation, and has no in-depth knowledge of any industry. And so far as the market intelligence gathering activities of supervisors are concerned, the less said the better. Further, bureaucratic supervision has no built-in incentives--a supervisor is not paid extra bonuses if he is able to uncover new information.

Contrast this state of affairs with the information available in the market. Any market player is constantly on the look-out for new information, as he can use it to his advantage. The market pricing mechanism resembles a complex, decentralised computer which receives information through purchases and sales made by investors and speculators, and synthesises all this information into the market price.

The advantage of the market is that the source of information is very widespread, consisting of thousands of market players. Even more importantly, market price also reflects privileged information, as company employees and directors seek to profit from their knowledge. This is especially true in markets such as India, where managements easily get away with insider trading.

Regulation therefore is best done by the markets, and the question which remains is how should markets be assisted to become better regulators? The answer is simple--since the market relies on information, more disclosure, greater transparency, and more frequent information about corporates should be supplied to the market. We could, for example, insist on quarterly unaudited accounts, with a corresponding cash flow statement. For financial companies, where asset quality is important, a quarterly revealing of its asset portfolio, perhaps certified by accountants, could be made mandatory.

All this would basically amount to a privatisation of regulation. Instead of remaining a secretive bureaucratic method, regulation would be participatory, with each market player contributing to the process.

Furthermore, the costs of regulation would be drastically reduced, and the hordes of supervisors engaged in policing the markets could be put to more productive work. Part of the onus of regulation is even today being carried by private parties such as the merchant bankers to an issue. Rating agencies too should be encouraged to take up further responsibilities. But for that to happen, some changes need to be made in the way ratings are given, and unsolicited ratings, which will increase competition between agencies, should be used allowed in order to keep rating agencies on their toes.

No regulatory system in the world can prevent rogue trading, as happened in the Barings and Sumitomo scandals. But the markets are more reliable early warning systems than bureaucracies. In cybernetics, there is a law called the Law of Requisite Variety, which states that the variety of a regulator must equal that of the disturbances whose effects it is to negate.

Translated into finance, this means that a regulator's learning systems must be as complex as the external environment which it seeks to regulate. In an increasingly complex financial world, the capacity of bureaucrats to regulate is under severe strain. In order to be effective, the energies of supervisors should be directed towards improving and developing the markets, in order to make them more efficient regulators.

Copyright © 1997 Indian Express Newspapers (Bombay) Ltd.