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Self-Serving Regulation

Self-regulation in the financial world is flawed & could end up as self-serving regulation…

Last week, some newspapers carried reports that the government intends to allow stock exchanges to form a self-regulatory organisation (SRO) which will handle the regulatory functions of the stock exchanges. This SRO will handle the regulatory functions of stock exchanges after they are listed. This will include surveillance as well as penalising violations. This SRO is said to be a way of isolating the regulatory and the commercial aspects of running a stock exchange.

Somehow, I’m unable to see how this is good news. The idea of self-regulation in the financial world is fundamentally flawed. In financial products, self-regulation eventually comes to mean no regulation, or rather, it comes to mean ‘self-serving regulations designed to enhance profits of the regulator’. Please read that phrase again—‘profits of the regulator’. It sounds fundamentally wrong, doesn’t it?

Doesn’t your idea of what a regulator is find the idea of a regulator making profits jarring. Yet, that’s exactly what is woven into the concept of a self-regulatory organisation. A group of for-profit corporate bodies will act as regulators and make the very rules that could affect their own profitability. At some point, they will be called upon to make rules which may enhance or erode their own profitability. They will also be called upon to make rules that govern the interactions between themselves and other businesses, in this case, brokers and investors. Now that we are apparently on our way to listed, profit-focussed entities as stock exchanges, isn’t it time to completely strip them off their regulatory role? There’s very little in the conduct of financial companies around the world that gives one the confidence that this is a good way of doing things.

As in so many other financial services companies, there’s this theory of the Chinese wall, which states that the regulatory and the commercial functions of the stock exchanges will stay isolated from each other. We’ve seen how badly Chinese wall works in the case of investment banks and credit rating agencies, among others. There’s little to suggest that this will work any better in the case of Indian stock exchanges.

In many professional fields (law, accountancy and medicine being the obvious ones), the idea of SROs is well-established. Financial services are different. The business of directly dealing with other people’s money possibly creates more powerful opportunity of acting unfairly.

Maybe SROs work well in some areas and not in some areas. However, the financial services are uniquely unsuitable to them. It’s surprising how people can forget what should be the main lesson of the financial crisis. Financial firms are uniquely prone to excesses that can have wide-ranging affects. The ideology that automatically regards all deregulation (and by extension self-regulation) to be good and regulation to be bad has been proven wrong. The basic idea behind self-regulation is that firms can be trusted to take actions that are in the larger interest of their industry or of society even if such actions reduce their profits. This idea is absurd in the extreme. I would say that the world has learned something different in the last few years. In fact, it would be prudent to assume that any industry which is promoting the idea of self-regulation is actually doing so in order to get an unfair advantage over its customers.

Regulation is the job of a real regulator and the healthiest basis on which a safe regulatory environment can be built is a universal mistrust. I know that sounds perverse, but in the long run, a neutral regulator who mistrusts everyone equally is a good basis on which to build a system that can be trusted.