India needs fewer rules but better supervision, a paper floated by Finance Ministry has said.

“FinMinIndia is initiating a Discussion Paper series in order to encourage debates on issues that left out in day-to-day discourse. The first paper in the series is: ‘Risk vs Uncertainty: Supervision, Governance & Skin-in-the-Game’,” Principal Economic Advisor Sanjeev Sanyal, who is also author of the paper, said in a tweet.

The paper intends to define what risk is and what is uncertainty. The concept of risk is distinct from the concept of uncertainty, according to the paper. The former relates to that which can be predicted, measured or quantified whereas the latter relates to ‘unknown unknowns’ and ‘known unknowables’ where outcomes and probability distributions cannot be meaningfully defined. The paper makes the case that the well-engrained policy frameworks used to deal with risk are fundamentally different from the policy toolkits required to deal with uncertainty.

Explaining the concept, Chief Economic Advisor Krishnamurthy Subramanian said that in a risky world, some weightage can be given, but in an uncertain world it is not possible.

Sanyal has used the example of Basel based norms. These norms have three pillars — risk, market based supervision and overall supervision, however, there is more focus on risk. Basel norms prescribe how much capital banks should have and that too in a specific basket.

The paper says that the use of heavy regulations and Basel-type capital requirements to tackle Risk have not only led to better capitalised banks, but also to the growth of shadow banking that is outside the heavily regulated arena.

The use of prescriptive risk weights for bank assets, moreover, means that there is no genetic diversity in how the banking system manages risk. “When faced with the unpredictable shocks of an uncertain world, the lack of genetic diversity is a possible threat to the stability of the global financial system,” it said.

Similarly, the assessment of risk is being effectively outsourced to rating agencies despite their mixed record on providing advance warnings. The current approach focuses exclusively on fixing the internal incentive structures of the rating agencies. However, this presupposes the ability of rating agencies to deal with uncertainty when the best they can do is quantify risk.

Given the inherent unpredictability of uncertainty, this paper argues that the better response would be to invest in active supervision rather than more stringent regulation. Simple systems that are transparent and flexible, and those that embed ‘skin-in-the-game’ and institutionalise corporate governance, are far better for dealing with uncertainty.

Both Subramanian and Sanyal were in favour of simple regulations but heavy supervision drawing parallels with the game of cricket — where rules are formed by the cricket governing body while supervision is by on-field umpires.

According to the paper, the approach of creating rules that encompass every possible deviation leads to unnecessary opacity and complexity that burden the majority that comply. The exclusive focus on “round-tripping”, for instance, has meant that India has not been able to develop a globally competitive fund management and financial services sector.

A simple, transparent system that presumes compliance, backed up by better supervision and legal enforcement, would be far better.

The paper argues that in an uncertain world where contracts, regulations and laws are inherently incomplete, no amount of ex-ante protective walls can prevent things from going wrong. This is why ex-post recovery and resolution must be an important part of a policy toolkit to deal with uncertainty

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