The touchstones of effective regulation

We know Maslow’s hammer: “If all you’ve got is a hammer, everything looks like a nail. This cognitive bias leads to over-reliance on a familiar tool. A person with only a hammer is likely to fix everything using the hammer, often without considering other options.

In the era of the “regulatory state”, there is regulation to solve any market problem – real, illusory or hypothetical. This has created a thriving regulatory industry. Deregulation commissions / task forces have emerged in mature jurisdictions to stop growth and reduce regulatory burden. It’s no surprise that regulations have both supporters and opponents, raising doubts as to whether regulation is as much a disease as it is a cure.

Although ubiquitous, regulation remains an art and a science of the elite. It is an attempt to understand the basics of regulation – what, why, when and how. Although the reforms have replaced control with regulations, they are not opposed to each other.

The first prescribes what is allowed and what is not, while the second allows almost all activities subject to compliance with certain predefined standards.

For example, while the Capital Issues (Control) Act, 1947 prohibited raising capital in the market except with government approval, the SEBI Act, 1992 permits the raising of capital for any business, subject to truthful disclosures and complete. Regulations are legal prescriptions that encourage market players to carry out transactions (eg make a public issue) in accordance with the rules of the game and dissuade them from digressions.

Economists believe that there is only one reason to have regulations, which is to fix market failures; without regulation, the market is most likely to fail (to achieve optimal allocation of resources). The market only fails when it exhibits one of three infirmities: information asymmetry, externalities, and market power. The literature provides several other grounds for regulation such as safety, security, health and environmental concerns, consumer protection, prevention of market manipulation and anti-competitive behavior, and protection of market freedom.

Most of them are included in the three infirmities. For example, a polluting industry can keep the cost of production low by dumping pollutants into the nearby river. The producer and therefore the consumers do not bear the full cost of the product, which is an example of an externality. This attracts more resources to the industry, which is tantamount to market failure.

Regulations may require the producer to bear the full costs, through appropriate environmental interventions, to remedy the market failure. The ecological concern is therefore a subset of the infirmity externality. Regulations can have non-market motivations such as impartiality and fairness, such as reserving public issues for individual retail investors or integrating all sections of society such as minimal rural subscription by companies. insurance.

Regulation may be necessary in case of missing markets. For example, the derivatives market did not take off in India, even after the ban on options was lifted in 1995. It only found favor with investors when a regulatory framework was put in place. 2000. Regulation is necessary to develop the market and once the market develops, it must be regulated.

Derivatives market

This, however, is not valid when derivatives first appeared in the world. The derivatives market emerged when a few enterprising participants felt a need and designed a new product to meet that need. As people found the product useful, the market grew. With the development of the market, the participants understood the nuances of the market and developed light regulations to deal with the nuisances. As the market developed, a variety of derivative products emerged to meet the demand of each niche segment and cases of market abuse were also noted. This has led to a strong regulatory framework to deal with possible abuses.

Thus, development and regulation feed off each other in a virtuous circle for orderly market growth. This should guide the provision of a regulatory framework, subject to socio-ethical considerations, in the case of emerging areas such as artificial intelligence, internet content, social media, big tech, digital platforms and, more recently, cryptocurrency.

There has been an endless debate on whether regulations should be ex ante or ex post. This essentially involves regulations before or in response to an episode. There could be many episodes that were avoided by proactive regulations. We do not notice such regulations because the episode never happened. We only notice the regulations that follow an episode.

A responsive regulator, however, proactively designs and amends regulations with changing market needs. The recent provision of a pre-pack insolvency resolution is one example. This allows the law to continuously evolve in tandem with the market to fill emerging gaps, adapt to new structures, process innovative transactions and improve the efficiency of market operations.

While it is not possible to have standard regulations to remedy a market failure, it is essential to have a standard process for developing regulations to ensure that regulations are effective and adequate, but without be excessive. One example is the regulation adopted by the Insolvency and Bankruptcy Council of India which governs the way regulations are made.

These regulations mandate the regulator to involve the public in the development of regulations through a consultative process. To make consultation effective, the regulator must demonstrate that the benefits of the proposed regulation outweigh the costs, and of the available regulatory options, the one proposed is the most cost effective. Such consultation refines regulations and brings ownership, which facilitates implementation.

Thus, the regulator should ask a few sequential questions before introducing any regulation. Is there evidence or a high probability of a market failure? Can Regulation Address Market Failure? Is regulation better than non-regulatory options? Is the choice of regulation better than other regulatory options? Do the benefits of regulations outweigh the associated costs? Can regulations be enforced and not overturned? Do regulations have unintended consequences?

At all times, these tests should be applied to determine which regulation should be introduced, amended or repealed. This exercise, in common parlance, is known as “regulatory impact assessment”. The assessment can lead to ambiguous results as these depend largely on the subjective assessment of the test takers. Whenever possible, efforts should be made to make testing objective and be supported by credible research. Regulations should only be made after passing all tests to the satisfaction of an independent external body. This will usher in an era of better regulations.

Sahoo is a distinguished professor at the National Law University of Delhi. Guru is an Indian Economic Service officer. Views are personal

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