Tuesday, November 17, 2009

HK a very favourable location in which to establish a shareholder company (usually termed a special purpose vehicle or SPV) for investment in China.

By Matthew, November 10, 2009

A significant new notice was issued by the SAT last
week which will impact upon the application of withholding
tax in China. Circular 601 is the latest interpretation
by the SAT of China’s tax treaties.

This Circular looks at the concept of beneficial
ownership as it is used in the treaties – in the
withholding tax provisions (i.e. royalties, interest and dividends).

To understand how the changes operate
it is important to under the operations of Double Tax Agreements (DTA).

DTAs operate so as to allocate or apportion taxing
rights between two contries where both countries
domestic laws provide a right to tax on a particular
transaction or arrangement. The DTAs generally favour
the country of residence and give limited rights
of taxation source countries (effectively the
country where the income is sourced from) except
where the income is attributable to a permanent
establishment in that source country.

In the case of dividends the source country
(that is, the country where the company paying the
dividends is located) is usually entitled to tax
a shareholder receiving such dividends but only at
a specified rate (the same with royalties and interest).

This rate is usually 10% in China’s DTAs but it varies
from country to country. Importantly the rate between
China and Hong Kong is 5%. As a result, and amongst
other reasons, this has made HK a very favourable
location in which to establish a shareholder company
(usually termed a special purpose vehicle or SPV)

for investment in China.

However, Circular 601 will significantly alter the
benefits of using a HK SPV. The effect of the circular
is that a HK SPV will be disregarded for determining the
country of residence where it has limited functions and
risk (basically where it does nothing but act as shareholder).

Most SPV’s have very little functions and risk and this means
that it is likely that such arrangements will no longer be
entitled to obtain the benefits of the lower rate unde the
China-HK DTA. Instead one would need to examine the
DTA of the country where the ultimate owner is located.

If no such DTA exists, then a withholding tax rate of
10% will apply (withholding tax in China is 20% under
the Enterprise Income Tax Law but this was reduced to 10%
under the Implementing Regulations).

This Circular is the latest act by the SAT to aggresively
reduce off-shore tax avoidance practices. It should also
be noted how this Circular is linked to the transfer pricing
rules (which examine a company’s functions and risks in
determining if related party transactions are reasonable).

The SAT will continue to place considerable emphasis on
function and risk going forward. As I have said previously
we now have a very different tax environment in China
than 2 years ago. Interesting times.

Recent issues in FDI Policy

Anup P. Shah
Chartered Accountant

1. Introduction :

1.1 The Foreign Direct Investment (‘FDI’) Policy has always been a contentious issue. Recently in an attempt to simplify the FDI Policy, the Department of Industrial Policy & Promotion (DIPP), Ministry of Commerce & Industry, has issued 3 Press Notes — PN 2 of 2009, 3 of 2009 and 4 of 2009.

1.2 Press Note 2 of 2009 seeks to bring in clarity, uniformity, consistency and homogeneity into the methodology of calculation of the direct and indirect foreign investment in Indian companies across sectors/activities. Press Note 3 of 2009 gives guidelines for transfer of ownership and control of Indian companies from resident Indians to non-resident entities. Press Note 4 of 2009 lays down the policy for downstream investment by Indian companies.

1.3 Whether these Press Notes clear the confusion or add more fuel to the fire is anyone’s guess. This Article seeks to explain the issues which emerge as a result of this new Policy stance adopted by the Government.

2. Indirect Foreign Ownership (Press Note 2 of 2009) :

2.1 Any non-resident investment in an Indian company is FDI. However, if the domestic investment by resident Indian entities, which have invested in the Indian company, comprise non-resident investment, then the Indian company would have indirect foreign investment as well. Till recently the FIPB reckoned such indirect foreign investment on a proportionate basis in several sectors such as telecom. For example, an Indian telecom company had 36% FDI and 64% domestic investment and if the domestic investor had 50% FDI in it, then the indirect foreign equity in the telecom company was 32% and the total foreign investment, direct and indirect was 68%.

2.2 New method of calculating foreign investment in an Indian company :

2.2.1 All investments made directly by a Non-resident Entity into an Indian company would be treated as Foreign Direct Investment.

2.2.2 For reckoning the indirect foreign investment, the important factors would be the ownership and control of the Indian investing companies. Any foreign investment by an investing Indian company which is ‘owned and controlled’ by resident Indian citizens and/or by Indian companies which are in turn owned and controlled by Resident Indian citizens, would not be considered for calculation of ‘indirect foreign investment’. Such investment would be treated as pure domestic investment. The previous provisions (PN 7 of 2008) for investing companies in infrastructure and service sector and the proportionate method computation have now been deleted.

Let us understand the meaning of the terms ‘owned’ and ‘controlled’ :

Owned :

An Indian company would be considered as ‘owned’ by resident Indian citizens and Indian companies if more than 50% of the equity interest in the Indian company is beneficially owned


by resident Indian citizens, or

by Indian companies which are owned and controlled ultimately by resident Indian citizens.

Controlled :

An Indian company would be considered as ‘controlled’ by resident Indian citizens and Indian companies (which are owned and controlled ultimately by resident Indian citizens) if the resident Indian citizens and Indian companies (which are owned and controlled ultimately by resident Indian citizens) have the power to appoint a majority of its directors.

For example, in Bharti Airtel, SingTel of Singapore owns a 31% stake, of which only 15.8% is direct and the balance is through its investment in Bharti Telecom which owns 45% of Bharti Airtel. As per the new norms, only 15.8% would be treated as SingTel’s foreign ownership in Bharti Airtel, since Bharti Telecom is a company owned and controlled by Indians and hence, its entire investment in Bharti Airtel is treated as a domestic investment.

2.2.4 If the investing Indian company’s ownership and control is not directly/indirectly by a Resident Indian Citizen, the entire investment by such company would be considered as indirect foreign investment. For example, A Ltd. which is owned and controlled by an NRI, has invested 40% in B Ltd. The indirect foreign investment in B Ltd. is 40%.

An exception has been provided for in the case of downstream investments in a wholly-owned subsidiary of operating-cum-investing/investing companies. In such a case, the indirect foreign investment will be limited to the foreign investment in the operating-cum-investing/investing company. Thus, A Ltd., which is an operating-cum-investing company has 74% FDI and if it sets up a 100% subsidiary, B Ltd., then B Ltd., will be treated as having 74% indirect foreign investment.

The above-mentioned methodology for computation of foreign investment does not apply to sectors which are governed specifically by a separate statute, such as the insurance sector. The methodology specified therein would continue.

2.2.5 The Press Note also treats foreign investment as including all FDI, FII investment (as on 31st March), FCCB, NRI/ADR/GDR investment/Convertible Preference Shares/Convertible Debentures, etc.

2.2.6 In the case of all sectors which require FIPB approval, any shareholders’ agreement which has an effect on appointment of directors, veto rights, affirmative votes, etc., would have to be filed with the FIPB at the time of seeking approval. It will consider all such clauses and would decide whether the investor has ownership and control due to them.

2.2.7 Issues :

The recent Press Note has thrown up several issues :

(a) It is necessary to note that an Indian company must be both owned and controlled by Indian citizens. If either condition is violated, then its investment would be treated as indirect foreign investment.

(b) For determining the foreign ownership of an Indian company it should have more than 50% foreign ownership. What happens in a situation where the Indian and the foreign partner have an equal (50 : 50) stake ? In several Indian JVs, the foreign partner desires one golden share (over 50%) to enable consolidation with his foreign company. If such a JV makes a downstream investment in any company, then the entire investment would now be treated as indirect foreign investment.

(c) For determining the foreign control, it only needs to be seen whether the foreign entity has power to appoint majority of directors. It does not address the other ways in which control can be exercised, e.g., veto rights, affirmative votes, shareholders’ agreement. In sectors where the FDI is subject to Government approval, the Indian company will need to disclose to the FIPB the details of inter-se shareholder agreements which have an effect on the appointment of the Board of Directors, differential voting rights and such other matters. But a similar treatment has not been extended to the indirect foreign investment. A majority of the private equity deals have a host of special investor rights, but may not necessarily have a majority of the Board seats.

(d) What would happen if an Indian investing company with 49% FDI and which is owned and controlled by Indian citizens, invests 26% in an NBFC which already has 51% FDI ? Under the new norms, 26% investment would be treated as domestic investment and hence, the NBFC would not have to comply with the minimum capitalisation norms applicable to an NBFC which has more than 75% FDI.

(e) What if the Indian investing company, which has 49% FDI and which is owned and controlled by Indian citizens, invests in a sector for which FDI is prohibited, e.g., lottery business ? Sectors such as retail trading, real estate, information, defence, avaiation, etc., are expected to benefit from this Press Note. We may soon have a case where several foreign retail players may try to invest in multi-brand retailing via the indirect foreign ownership method. As per Press reports, the RBI has objected to this Press Note.

(f) FII investment has been treated as foreign investment. However, to consider the same, one has to ascertain the limits as on 31st March. If one looks at the FII activity after 31st March, 2008 there are only withdrawals. Hence, even though the current position is drastically different from what it was on 31st March, 2008, yet one is required to consider the FII investment level as on 31st March, 2008. This provision would create a lot of problems. Further, clubbing ADR/GDR holding with foreign shareholding is also a vexed issue. The voting on ADR/GDR is by the custodian of the shares. How the custodian would vote is generally not specified. There are a few cases where it is specified in the prospectus. But generally, it is left open. Interestingly, Cl. 40A of the Listing Agreement, while computing the public shareholding in a listed company, excludes the shares which are held by custodians and against which depository receipts are issued overseas. The logic being that the custodian would vote in unison with the promoter. If that be the case under the Listing Agreement, then the stand taken by the FIPB is diagonally opposite, i.e., the custodian would vote in unison with the foreign receipt owners.

(g) Special investor rights are the norm in the case of private equity deals and hence, if PE deals are to be done in sectors requiring FIPB approval, then the Shareholders’ Agreement would have to be filed with the FIPB. Thus, if any courier company (where FIPB approval is required) wants to get PE funding, it would also have to get the Shareholders’ Agreement approved by the FIPB. Thus, the regulator would now exercise quasi-judicial functions. This amendment is truly amazing.

3. Transfer of Ownership & Control of Indian Companies from Resident Indian Citizens to Non-Resident Entities (Press Note 3 of 2009) :

3.1 The DIPP has issued new guidelines in respect of transfers of shares in all sectors where the FIPB approval is required or sectors which have caps of FDI. These include sectors, such as defence, air transport, ground handling, asset reconstruction, private sector banking, broadcasting, commodity exchanges, credit information companies, insurance, print media, telecom and satellites.

3.2 In all such sectors, Government/FIPB approval would be required in the following cases :

(a) If an Indian company is being established with foreign investment and is owned or controlled by a non-resident entity, or

(b) The ownership or control of an existing Indian company, owned or controlled directly or indirectly by resident Indian citizens, is being transferred to a non-resident entity as a consequence of transfer of shares to NREs through amalgamation, merger, acquisition, etc.

3.3 The guidelines will not apply to sectors where there are no foreign investment caps, i.e., 100% foreign investment is permitted under the automatic route.

3.4 Issues :

(a) Press Note 4 of 2006 had earlier put all transfers of shares from residents to non-residents on the automatic route, including in financial services sectors, or cases where the Takeover Regulations were attracted. It is intriguing that after a period of 3 years, the Government has decided to take a step backwards and put transfers in certain sectors on the approval route. When on the one hand, the RBI is taking measures for liberalisation of the FEMA, the FIPB on the other hand has taken us back to the approval raj.

(b) The FIPB’s approval would be required even in cases of Court-approved mergers, demergers, etc. This has increased the number of authorities whose permission would be required for a merger. Thus, if a listed company in the telecom field decides to merge with another listed company which has more than 50% foreign investment, then consider the number of approvals it would require — the High Court, BSE/NSE (under Cl. 24 of the Listing Agreement) and now the FIPB. The FIPB’s approval would be required even for cases of acquisition of shares. This would even delay the process for takeover of listed companies. A takeover, in a sector requiring FIPB approval for FDI, which attracts the SEBI Takeover Regulations, requires the clearance of SEBI, prior approval of the RBI and now also the approval of FIPB. Thus, this step is going to increase the time it takes for corporate restructuring.

4. Downstream Investments in Indian Companies (Press Note 4 of 2009) :

4.1 The last of the Press Notes aimed at simplifying the Rules is Press Note 4. This deals with downstream investments by Indian companies. Downstream investment, which refers to indirect foreign investment by one Indian company in another, was hitherto governed by Press Note 9 of 1999. This dealt with any downstream investment by a foreignowned Indian holding company. FDI in such cases required prior FIPB approval. Recently, FIPB had taken an interesting stance that downstream investment on an automatic route was only permitted for pure investment companies and not by operatingcum-investment companies, those which have their own operations in economic activities and desired to invest in another Indian company. FIPB’s view was that this tantamounted to a change in status from operating to operating-cum-investment company and hence, required prior FIPB approval. Several renowned corporates such as JSW Energy Ltd., Aditya Birla Nuvo Ltd., etc. were pulled up for getting FDI and making downstream investments without FIPB approval. FIPB allowed restrospective clearance subject to compounding of penalties with the RBI under FEMA. In some cases, the foreign investment was as low as 1% and yet FIPB treated it as a violation of Press Note 9 of 1999. Thus, this was one area where there was a lot of ambiguity.

4.2 Operating Companies :

The new norms state that foreign investments in operating companies would fall under the Automatic approval route wherein the investing companies would have to comply with the relevant sectoral conditions on entry route, conditionalities and caps with regard to the sectors in which such companies are operating.

4.3 Operating–cum-Investing Companies :

Foreign Investments in operating-cum-investing companies would fall under the Automatic Route as explained above. Further, the Operating-cum-investing company which is making the downstream investment into the Indian Company would have to comply with the relevant sectoral caps and conditionalities which are applicable to the investee company. Thus, if Hindustan Unilever Ltd., which is a foreign-owned company, desires to invest in a retail trading company, then it would become an operating-cum-investment company and its downstream investment would need to comply with the conditions applicable to FDI in retail trading.

4.4 Investing Companies :

Foreign investments in purely Investing Companies would require FIPB approval, regardless of the extent of foreign investment. Further, as and when such Investing Companies make downstream investments in Indian companies, they would have to comply with the relevant sectoral caps and conditionalities. However, such downstream investments cannot be made for the purposes of trading of the underlying securities. The FIPB approval would be required regardless of the amount of foreign investment in such an investing company.

4.5 Shell Company :

Foreign investments into companies which are currently neither carrying on any operations nor do have any investment activities, would require FIPB approval regardless of the extent of the foreign investment. Further if and when such shell companies commence any operating/investing activity the relevant conditionalities as explained above would have to be complied with.

4.6 Additional Conditions :

In case of Operating-cum-Investing Companies and Investing Companies, certain additional conditions have to be complied with, such as giving an intimation to FIPB regarding the downstream investment within 30 days of such investment, compliance with the Pricing Guidelines as prescribed by SEBI, etc. Further, in order to make the downstream investment, the funds must be brought in from abroad only and not borrowed domestically.

5. Conclusion :

5.1 All the Government has a noble intention of simplifying the FDI policy, it may have unwittingly opened up a few more pandora’s boxes. It has plugged a few leaks by creating new leaks. The days to come are likely to throw up new issues in respect of these Press Notes and in some of the cases, the remedy may be more serious than the ailment. One hopes that the FIPB addresses these issues and comes out with a clearer and unamigious policy.

One is reminded of the US author, Kerry Thornley’s words :

“What we imagine is Order is merely the prevailing form of Chaos !”

Nandan Nilekani to Help Bihar Improve E-governance

Nov 14th, 2009

Patna, Nov 14 – Bihar has sought the help of Infosys co-founder Nandan Nilekani, the chief of India’s Unique Identification Database Authority, to improve the state’s e-governance system.

Bihar Chief Minister Nitish Kumar disclosed at a function here Friday evening that Nilekani will visit Patna Nov 17 and hold talks with senior government officials to strengthen e-governance in the state.

All 37 district headquarters and 470 block headquarters in Bihar can be accessed online through the Bihar State Wide Area Network. ‘We have made progress in e-governance in the last few years – from Remington typewriters to online access,’ the chief minister said.

Bihar had formally adopted e-governance as a state policy in 2006 on the advice of former president A.P.J. Abdul Kalam.

The state has constituted a Special Purpose Vehicle (SPV) with the objective of bringing about an Information Technology (IT) transformation in the state. The SPV was constituted as a tripartite joint venture of state-owned Beltron, Tata Consultancy Services and Infrastructure Leasing & Financial Services (ILFS) at an estimated cost of Rs.380 million.

The SPV is preparing a comprehensive special package for e-governance. Besides, separate e-governance packages have been created for different departments by the joint venture partners, based on specific requirements.

The state government has already equipped legislators with sophisticated laptop computers under the national e-governance plan of the central government.

The previous state government, headed by Rabri Devi had brought several departments online and launched an official web site of the state.

Her husband, Rashtriya Janata Dal chief Lalu Prasad, also a former chief minister, has often rubbished IT as a ‘tool of the elite’.

Countering black money thru treaties

At the recent G-20 summit, it was agreed that a “tool box of measures” would be used to get countries to comply with an exchange of information to end bank secrecy, which has been a foundation of tax evasion.

K. R. Girish
Sampath Raghunathan

Speaking at the Economic Summit on November 10, the Finance Minister, Mr Pranab Mukherjee, said that he has asked the revenue department to reopen negotiations with all the countries with which India has entered into DTAAs (Double Taxation Avoidance Agreements) so that the Government can have real time exchange of information on tax evasion and tax avoidance.

The Finance Minister said that the country had agreed to accept the guidelines prescribed by the Organisation of Economic Cooperation and Development (OECD) model tax convention code, which talks about exchange of information.

This approach of the Finance Minister comes close to the recent measure of the Finance Ministry proposing to introduce a new Direct Taxes Code.

Growing tax evasion across the globe is the biggest concern before the developed and developing nations. The G-20 summit held in Brussels, in April 2009, agreed upon a “tool box of measures” that will be used to get countries to comply with an exchange of information to end bank secrecy which has been a foundation of tax evasion around the world.
The ‘tool box’

The “tool box” contains the following recommendations:

Increased disclosure requirements on the part of taxpayers and financial institutions to report transactions involving noncooperative jurisdictions;

Withholding of taxes in respect to a wide variety of payments;

Denial of deductions with respect to expense payments to payees resident in a non-cooperative jurisdiction;

Reviews of tax treaty policies;

Requiring international institutions in regional development banks to review aid if tax cooperation is not agreed;

Giving extra weight to the principle of tax transparency and information exchange while designing any bilateral aid programmes.

The OECD’s update, ‘Overview of the OECD’s work on Countering International Tax Evasion’ (November 2009), highlights the progress made in its efforts in bringing all OECD countries accepting “Exchange of Information” requirement in accordance with Article 26 of OECD Model Convention.

The overview further highlights that Hong Kong (China), Macao (China) and Singapore have agreed to bring in place necessary legislation in 2009 to comply with this. The progress reports of countries such as Austria, Belgium, Bermuda, BV Islands, Switzerland, Luxembourg, Netherlands Antilles, Cayman Islands and Bahrain are also positive in this regard.
Identifying tax havens

In 1998, OECD set out a number of factors in identifying tax havens: no or nominal tax on the incomes; lack of effective exchange of information; lack of transparency; and no substantial activities.

The progress report now released touch on the “exchange of information” and not much on the other three situations, which also equally contribute to “tax evasion”.

Transparency in international finance, cooperation among all the countries to oppose any secrecy, loopholes and distortions in tax and regulation and introduction by all the countries a tax mechanism to support a level-playing field would greatly minimise the abuses that flow from the system.

However, achieving a healthy tax compliance practice in respect of international taxation should be the consequential result of a tax Treaty and should not be the driving objective.

Perhaps, the advent of European Union (EU) since 2001 is a roll model, integrating various countries in Europe and employing practical measures among member-countries of cooperation in the field of direct and indirect taxation and assistance in the recovery of taxes, besides strengthening the internal legislation in each of the country.

At the time of integration of various countries under the EU, different taxation systems existed in different European countries. The European Parliament realised the necessity of continuing to have the coexistence of such different taxation system among the member-countries, but have built in measures around that.
EU measures

Some of the noted measures in this regard were:

Introduction of a Common Consolidated Corporate Tax Base for EU businesses (CCCTB);

Treatment of cross-border activities among the EU member-countries as similar domestic activities;

Simplification of the tax environment and creation of a level-playing field;

Application of the Home State Taxation approach;

Introduction of clear VAT rules concerning international services and financial services;

Providing of exemptions among member-countries on assertive and reciprocal basis;

Removal of cross-border tax barriers among the EU member-countries with: a system of cross-border loss relief; and

A system to manage transfer pricing; and abolition of a number of unequivocal indirect taxes, such as capital duty.

Even though to achieve these, there was a common directive in place, it was more the willingness of the member-nations for improving trade and investment in their respective countries, they have agreed to bind themselves to these common measures.

China, India’s arch rival in attracting global investments, has brought out the following measures to combat tax evasion in February 2009.

The Chinese State Administration of Taxation (SAT) has removed tax privileges afforded under various double taxation treaties to foreign investors who misuse the system of ‘special purpose vehicles’ as a means of reducing their tax liabilities or circumventing exchange controls.

Special purpose vehicle

Based on Tax Notice 81 of SAT in a number of cases, the non-resident status of such entities has been disregarded for tax purposes.

The Special Purpose Vehicle (SPV) generally allows foreign investors which set up business ventures with local partners in China, two main tax advantages: lower withholding tax (WHT) on dividends; and exemption from Chinese capital gains tax on sale of their holdings in the Chinese business companies.

China, at present, has lower tax rates with Singapore, Hong Kong, Mauritius, Barbados and Ireland. This circular of SAT enables the tax authorities to scrutinise not just the form but also the substance of the ownership structures of SPVs to satisfy themselves that the investors have bona fide residence in these countries to take advantage of the tax treaties signed by China.

This is to combat the tax evasion tactics of Chinese expatriates, who form the largest group of foreign investors, but still maintaining their nexus within China. The proposed SAT’s intervention is to remove SPV tax privileges in respect of those SPVs which are controlled by Chinese expatriates, but who are deemed to be de facto PRC resident.

India should take its lessons from the EU model. Renegotiation of the Treaties should not be with the sole objective of facilitating the exchange of information with a view to combating international tax evasion and avoidance. Such an approach would be a total disaster to promotion of investment in any country.

As pointed out by the Supreme Court in the Azadi Bacho Andolan case, the main function of a Treaty should be seen in the context of aiding commercial relations between the Treaty partners. This could be more important than perhaps the essential function of any Treaty as being the division of tax revenues between the two countries.

The apex court further pointed that while the fabric of substance of the Treaty need to maintained by both the countries, certain evils like Treaty shopping need to be tolerated in the interest of long-term development. To achieve this, there must be a mutual trust among the nations.

The following measures also must be parallelly be put in place.

Develop a standard “Treaty Model” like a typical US/UN/OECD model and define clearly the technical explanation of the same.

Any deviation in the Treaty terms with a particular country must also have a proper “technical explanation” or Protocol, explaining clearly the terms of such modified treaty.

Any terms proposed in the renegotiated treaty, which has the remotest possibility of overlapping or contradicting with the terms of the Act must be clearly brought out in the “technical explanation”.

Any amendment proposed in the Act, which has the remotest possibility of overlapping or contradicting with the terms of the treaty with any other country must be renegotiated with the respective country and a protocol of the revised terms must be in place; this would be the real nature of at par respect of an Act or Treaty. The principle of co-decision of the respective country rather than a simple notification or consultation procedure should be in place.

The legal and tax system of the respective countries must be respected. Any adverse finding on the tax of a resident of the other contracting state resulting in a higher tax in India must be capable of being properly adjusted (irrespective of the time lag in terms of the legal system of assessment of such person in the home country) to ensure that no double taxation exists.

Last, but not the least, the country’s legal system should be revamped to ensure that the:

Principle of proportionality and subsidiarity of the functionaries under the tax system are well defined — the binding nature of the decisions of the Supreme Court , High Court, Income Tax Appellate Tribunal or National Tax Tribunal on the judiciary and quasi judiciary authorities must be properly defined

Mutual respect and recognition of the decisions among various courts functioning in India and that of the international courts.

A proper quality of education of judicial persons selected in various Courts and tribunals.

(The authors are practising chartered accountant and advocate respectively.)

Friday, November 6, 2009

RBI Deputy Governor Shyamala Gopinath at FSA Turner Review Conference, London, November 2, 2009

Philosophy and practice of financial sector regulation – Space for unorthodoxy
(Speech delivered by Smt Shyamala Gopinath, Deputy Governor, Reserve Bank of India at the FSA Turner Review Conference, London, November 2, 2009)

It is a privilege to be invited to share my thoughts at this conference. The contribution of FSA in setting the terms of the debate in the aftermath of the crisis has been very significant and crucial. The clarity, conviction and clinical sharpness of arguments one encounters while reading the Turner review ask of us a very fundamental question – how could the world not have expected this crisis? How could the policy regimes world over, barring a few exceptions, failed to even recognize what now seems to be obvious? Perhaps it had to do with the force and might of the reigning doctrinaire regarding financial markets.
2. Post crisis, there was a natural effort to understand and assess the nature of various inexactitudes which had earlier been missed and incorporate these into the policy frameworks. Phrases such as systemic risk oversight and macro-prudential regulation have become the new touchstones for a repaired regulatory framework. There is a renewed effort to redefine the regulatory philosophy and principles around a different mould. The danger is in this organic mould continuing to derive its legitimacy from the pre-crisis framework. Hopefully, a crisis of such magnitude would not fail to provide the necessary impetus and support for departure of a more fundamental nature. I realize the huge challenge for this, given the sheer weight of the academic work of nearly four decades in the field of finance and the entrenched orthodoxy around it. To bring out any paradigm shift would require an equally weighty intellectual case for an alternative model. Yes, this crisis could provide a trigger for that process but as history shows us, paradigm shifts of such magnitude do not follow a set path.
3. It would however be imprudent to ignore the basic lesson of the crisis, which is that the existing framework has severe pitfalls. As with any stable ecosystem, what is needed is a space for heterogeneity – the space for unorthodoxy. As identified by the UN President’s Commission*, “strengthening the diversity of ideas” would be a key principle in addressing the issues underlying the crisis.
4. India has had the fortune of having a relatively stable financial system through the past few major crises affecting the world – the Asian crisis, the dotcom bubble and the recent financial crisis. I intend to divide my remarks today in two parts - I would like to start off with a discussion on the evolution of the financial sector regulation in India, particularly focusing on the elements of the policy framework which have contributed to the broader stability in the financial sector. In the second part, I would like to share my perspectives on some of the key issues in the current debate on future of financial sector regulation mainly dealt in detail in the Turner Review.
Indian Financial System: the Basic Structure
5. Historically, the Indian financial system has been a bank dominated one and the gradual process of disintermediation through ‘public markets’ has been of relatively recent origin. Banking institutions account for nearly 70 percent of the total assets of all financial institutions. The banking sector, as a whole, however has not grown disproportionately as a percentage of GDP and the challenge for us is to increase penetration of the banking system and ensure access of financial services to the large numbers excluded from the system.
6. The non-banking finance space comprises of heterogeneous entities separated across functional regulatory frameworks. Broadly speaking, the RBI regulates companies taking public deposits and non-deposit taking entities undertaking financial services involving asset financing, loan and investment companies. Other non-banking entities such as housing finance companies, mutual funds, insurance companies, stock broking companies, merchant banking companies, venture capital funds etc. are regulated by the respective sectoral regulators. There is also a separate framework for financial markets with equity markets completely under the securities regulator but the forex,  interest rate and credit markets and the related derivatives being regulated by the central bank, i.e. RBI, which is also the banking regulator.
Evolution of Regulatory Framework
7. The philosophy and practice of financial sector regulation in India has largely evolved in response to the sui generis nature of contexts and imperatives over the years, which is also reflected in the division of regulatory responsibilities over different markets. The bank-based financial system, as a concept had come in for sharp criticism in the wake of the Asian crisis,  and an “arm’s-length, market-based, Anglo-Saxon system”† was propounded as a better model from a stability, accountability and governance perspective. The recent crisis has again brought the centrality of banks in a financial system into focus and underlined their role as ultimate risk repositories and ultimate liquidity providers, whatever be the form of the financial market model.
8. The gradual process to introducing structural reforms in the banking sector was a unique experiment undertaken with the key objective of strengthening the banking sector balance sheets and governance frameworks in a non-disruptive manner while managing the given political-economy considerations. The reforms were carefully sequenced in terms of instruments and objectives. Thus, prudential norms and supervisory strengthening were introduced early in the reform cycle, followed by interest rate deregulation and gradually lowering of statutory preemptions. The more complex aspects of legal and accounting measures were ushered in subsequently when the basic tenets of the reforms were already in place. More recently, the regulatory framework has also focused on ensuring good governance through "fit and proper" owners, directors and senior managers of the banks. Broadly speaking, the evolution of regulatory framework for financial sector entities has been intrinsically derived from the objective of financial stability which has always been an objective for the RBI.
9. A unique feature of the reform of public sector banks, which dominated the Indian banking sector, was the process of financial restructuring. Banks were recapitalized by the government to meet prudential norms through recapitalization bonds (no cash payment was made). The mechanism of hiving off bad loans to a separate government asset management company was not considered appropriate in view of the moral hazard. The overhang of non-performing loans had to be managed by the banks themselves.  The subsequent divestment of equity and offer to private shareholders was undertaken through a public offer and not by sale to strategic investors. Consequently, all the public sector banks, which issued shares to private shareholders, have been listed on the exchanges and are subject to the same disclosure and market discipline standards as other listed entities.  The cost of recapitalization to GDP has been low relative to experience in other countries. On a cumulative basis it worked out to about one percent of the GDP and the value of the equity held by Government is much above the amount recapitalized. All these recapitalization bonds have since been converted to marketable securities.
10. The financial system has since expanded significantly across various segments and a number of cross-sector organisational forms combining banks, insurance companies and investment firms have emerged. In respect of certain identified conglomerates based on well defined criteria, there is an inter-regulatory mechanism for focused monitoring and supervision. However, in most cases, the non-banking functions are carried out in the form of bank-subsidiaries. While from a market perspective, such a model may tend to constrain growth, this model offers an interesting perspective in the ‘too-big-to-fail’ debate. I will be touching on this aspect later but internally within India there is support from certain quarters for a  ‘holding company’ structure.
11. The other aspect of the ‘too-big-to-fail’ debate, as succinctly dealt in the second FSA discussion paper on Turner Review relates to the core-banking versus trading activities of banks. We have a kind of hybrid model with banks being allowed to undertake proprietary trading as also sell insurance products. Insurance, all forms of asset management, merchant banking and broking have to be undertaken through separate subsidiaries. Issues with banks’ involvement with private pools of capital are being sought to be addressed through appropriate capital requirements for such exposures and the reputation risk.
12. As the financial system exists today, there are no major segments operating in an unregulated manner. The focus of regulation, though, is primarily on deposit taking institutions and systemically important non-deposit taking institutions. The model for regulation combines both direct entity regulation as well as overarching market regulation, where applicable. What such a framework enables is to provide a mechanism for containing market-based leverage, apart from a prudential oversight.  In our case, it proved to be an effective combination since banks’ exposure to such entities could be regulated through absolute exposure norms or even tweaking the risk weights applicable to such exposures. The problem, I realize, would be much more involved in predominantly market based financial systems where direct bank linkages are not very obvious but even in such regimes, as has been clearly demonstrated, the indirect linkages of banks with the unregulated entities can acquire systemic proportions. That is why it would be important to ensure that the markets too should not provide leverage capabilities to such entities beyond a limit.
13. Regulation of Non-Banking Finance Companies in India has gradually evolved from a focus on acceptance of deposits to acceptance of public funds in any form. With the growth of the financial system, it gradually came to be realized that even non-deposit taking entities, which were mostly in asset financing and loan business, could pose systemic risks on account of their interactions with the formal banking system and market based financing. Moreover, many such entities in this lightly regulated segment were essentially indulging in regulatory arbitrage – what was not permitted for banks was happening through this channel. It was therefore decided in 2006 to put in place an elaborate prudential framework for such identified entities having systemic implications. A gradually calibrated regulatory framework was created to address the issue of systemic risk, which included prudential capital requirements, exposure norms, liquidity management, asset liability management, creation of entity profile and reporting requirements, corporate governance and disclosure norms for non banking finance companies defined as systemically important. Banks exposure to these entities are subject to exposure norms and are separately monitored.
14. As regards the markets, there are two features that need to be noted: first, unlike many jurisdictions, there is a statutory responsibility on the central bank, the RBI, to explicitly regulate the forex, rate and credit markets and related derivatives; and second, since the dominant players in these markets are banks, there is also the added layer of entity regulation. The key aspects implicit in the regulation of organized financial trading in these markets relate to the product specifications, nature of participants, prudential safeguards, reporting requirements etc. OTC trades in such markets are legal only if one party to the counterparty is a RBI regulated entity. The operational aspects of trading and post-trade clearing and settlement in case of exchange traded instruments are regulated by the securities regulator i.e. the Securities and Exchange Board of India. The regulatory framework takes into account the macroeconomic situation as well as the huge costs of economic booms and busts brought on by financial instability -- a cautious approach that has till now served us well. That we could consider putting in place a more conservative framework for securitization markets – incorporating those very elements which are now being included as part of Basel II framework – was possible only on account of the cautious approach.
15. Lot of emphasis has been placed on the development of market infrastructure. As early as in 2001, the Clearing Corporation of India was set up to settle interbank spot forex transactions and all outright and repo transactions in government securities whether negotiated or order driven systems. CCIl has also introduced a collateralised money market instrument called CBLO which is also settled through the CCP. CCIL has also commenced non-guaranteed settlement of OTC trades in interest rate swaps in 2008. Once the risk management norms are determined they will be commencing  guaranteed settlement of these trades. In the near future it will also act as central counterparty for forward contracts which will mitigate risks releasing counterparty exposure limits. The margins are in the form of cash and government bonds ensuring the quality and liquidity of the settlement guarantee fund.
16. One of the early lessons from our past experience that we incorporated in the policy framework was to be very careful about the vulnerabilities originating in the external sector. Perhaps not entirely in conformity with the then established policy axioms, we have dovetailed the capital account management framework with the prudential framework. Now, of course, when financial stability has come to be recognized as an overarching objective, the merits of such a harmonized approach are being appreciated. As part of a differential approach, the policy in respect of financial intermediaries, including banks, is distinct from that for individuals or corporates.
Prudential Framework for Banks - Unorthodox Measures
17. In respect of the prudential framework for banks, while there was a commitment to move towards the international prudential standards for banks, in many areas a more contextual approach was adopted keeping in view the idiosyncratic and systemic concerns.
•             Counter cyclical measures were first taken on board in 2005 when risk weights and provisioning on certain segments were increased on account of rapid credit growth in these segments leading to concerns about potential impact of asset price bubbles and impact on credit quality.  However, the important difference was that Indian approach entailed sector-specific prescriptions. To illustrate, the housing loans and commercial real estate are the sectors which experienced high credit growth during the high credit phase of 2002-03 to 2006-07. Accordingly, the risk weights on real estate lending and mortgage backed securities over the years were increased. The objective was not so much to lean against the wind of rising asset prices but as a cautionary measure to contain the exposure of the banking sector to sensitive asset classes where rapid credit expansion was observed.
•             Banks are required to hold a minimum of 25 percent of their liabilities in the form of liquid domestic sovereign securities. This stipulation has worked both as a solvency as well as a liquidity buffer.
•             The credit conversion factors (CCF) used for calculating the potential future credit exposure for off-balance sheet interest rate as well as exchange rate contracts were doubled across all maturities in 2008. This was done since it was felt that the CCFs as per the Basel norms did not fully capture the volatility in the interest rate and forex markets in the Indian context.
•             Banks were encouraged to build floating provisions as a buffer for the possible stress on asset quality later. With the same objective, all banks have been advised recently to achieve a certain minimum provision cover. Very recently, provisions against commercial real estate standard loans have been increased from 0.4 percent to one percent.
•             In regard to wholesale funding markets, prudential limits were placed on aggregate inter-bank liabilities for banks as a proportion of their net worth. The overnight un-collateralised funding market was gradually restricted only to banks and primary dealers and there are ceilings for both lending as well as borrowing by entities in these markets in order to reduce the systemic risk arising from interconnectedness. Other entities can participate in the overnight market but only on a collateralized basis. Repo markets are subject to a regulatory framework.
•             To reduce systemic risk, investments by banks in subordinated debt of other banks is assigned 100% risk weight for capital adequacy purpose. Also, the bank's aggregate investment in Tier II bonds issued by other banks and financial institutions is limited to 10 percent of the investing bank's total capital.
•             Securitisation guidelines issued in 2006 provided for a conservative treatment of securitisation exposures for capital adequacy purposes, especially in regard to the credit enhancement and liquidity facilities. A unique feature of these guidelines is that any profits on sale of assets to the SPV are not allowed to be recognised immediately on sale but over the life of the pass through certificates issued by the SPV. The policy enabled a liquidity facility by the originator or a third party, to help smoothen the timing differences faced by the SPV and was subject to certain conditions to ensure that the liquidity support was only temporary and got invoked to meet cash flow mismatches. Any commitment to provide such liquidity facility, is to be treated as an off- balance sheet item and attracts 100% credit conversion factor as well as 100% risk weight. The facility was specifically prohibited for the purposes of a) providing credit enhancement; b) covering losses of the SPV; c) serving as a permanent revolving funding; and d) covering any losses incurred in the underlying pool of exposures prior to a draw down
•             There are limits on the proportion of wholesale foreign currency liabilities intermediated through the banking system, other than for lending for exports. Retail foreign currency deposits from non-residents are subject to minimum maturity requirements and interest rate caps.
•             The incremental credit-deposit ratio of banks is monitored as part of the macr-prudential framewoork since this ratio indicates the extent to which banks are funding credit with borrowings from wholesale markets.
Some thoughts on the key issues in the current debate
18. India as a key constituent of the international fora designing the blueprint for the reshaped financial system such as G20, FSB, BCBS has been committedly engaged in the discussions. The exercises in multilateral conformism have, understandably, tended to round off some of the sharper reactions witnessed in the immediate aftermath of the crisis. It would, however, be myopic to ignore so early some of the fundamental issues raised by the crisis. While the repair of the banking system, through a strengthened prudential framework, has seen progress, the much needed reform of the financial markets must be the next focus area for global oversight bodies, particularly the G20 and the FSB.
19. The financial industry has an excellent way with assuming a self-regulatory role whenever a crisis happens and coming out with a corrective framework. The experience shows that such self-framed codes of conduct have not really worked. More than the intent part, I would like to believe that an inside view, in the realm of financial policy which necessarily has to deal with systemic issues, will always be an incomplete perspective.
20. The most fundamental issue pertains to the role of the financial sector relative to the real sector. Before the crisis a view was gaining ground that  while the need for ‘banking’ will increase, there will be a seamless transition to a bank-less, market based financial system. Issues of competitive neutrality gained importance and the view that banks are ‘special’ and therefore need to be effectively regulated perhaps assumed less attention. Now, with the kind of bank bailouts that the Governments have had to undertake, largely in view of the deep entrenchment of banks in the major markets, it is very clear that the amorphous existence of even the most deep and liquid financial markets also needed the sound institutional pillars of a banking system as the funding provider of the first and last resort. 
21. There is an unequivocal consensus on some kind of control on the operations of banks, particularly the large financial institutions having cross border presence. Any discussion on systemically important financial institutions needs to put the institutions in the perspective of the surrounding market dynamics. The FSA discussion paper has given a comprehensive overview of all the major aspects concerning the issue viz. interpretation of failure, definition of systemic importance and alternative policy approaches. There is really little one can add but I would briefly like to comment on each of these.
Interpretation of failure
22. The paper makes an explicit distinction between failures where only common equity holders face losses and others where even creditors, providers of debt capital, are forced to share part of the losses. It would thus seem that the moral hazard issue is more relevant for creditors, since equity holders in all cases will have to face the losses. This point regarding the influence of creditors i.e. debt providers/debt holders of different classes of debt securities issued by banks comes out more starkly in banking systems in pre-dominantly market based economies.
23. On this issue we need to take into account a few other dimensions arising from the ex-ante treatment of uninsured creditors. One is whether this will induce unintended distortions in market practices. The other is a more fundamental issue. One of the less appreciated fallouts of the market-based financial system, which is that over the years there has been an increasing tendency  in encumbrance of parts of banking assets either for issuance of various classes of debt/hybrid securities or to raise short term funds through money markets. Protection accorded to secured creditors as against unsecured creditors and depositors in case of banks, in a sense, goes against the basic model of banking which presupposes deposit mobilization by banks thereby requiring strict regulation. The classic dilemma, the likes of which the public policy needs to reflect upon is the case of covered bonds which has now gained centre place in few of its success in some countries. From the perspective of the bank and investors, this is an excellent instrument with sound collateral backing. It has been in operation for over a century and has facilitated fundraising by banks at lower rates and avoids pitfalls of securitization. However, by carving out a part of good assets of the bank backing the bonds, these create a risk to the deposit insurance system since these investors have priority over other creditors.
24. The above problem is further exacerbated by the exemption accorded to certain category of financial instruments from bankruptcy, an issue which has been widely commented upon in the post-Lehman phase. In all major well-developed securities markets, derivative securities and repurchase agreements (repos) enjoy special protections under insolvency resolution laws. Such transactions also enjoy netting and close-out benefits which are not always available to most other creditors. With these counterparties having first claim on available liquidity other creditors may have an incentive to push for bankruptcy impeding the use of other options for an orderly resolution. Though the primary argument for this was to contain systemic risk, in practice this dispensation has resulted in increasing systemic risk given the incentive structure for pushing the funding markets to more and shorter term. There is need to reflect on how to involve these creditors in burden sharing in the event of failure of an institution.
Defining systemic importance
25. Identification of systemically important banks is a very difficult and complex issue. As brought out in the FSA discussion paper the key variables to be taken into account are size and interconnectedness. Size, by itself, may not be very useful but it becomes important in respect of large conglomerates having presence across major segments as also for entities having dominance in the funding markets. Thus, size and interconnectedness need to be looked together as a matrix quadrant.
26. Both qualitative and quantitative criteria will be relevant; whether the bank is largely a domestic focused bank or multinational, complex or a constellation of subsidiaries and interconnectedness with the system. A large bank will also be dominant in financial markets and payment systems. On interconnectedness, an institution is clearly systemic if it is a dominant player in the inter-bank market or other funding and derivatives markets. The benchmark will no doubt be the guidelines that will emerge from the IMF/FSB paper. But emerging market countries would largely have to take into account the structure of their domestic financial system and its unique features. The definition of systemic importance has to be calibrated in a manner that it provides the right incentives for institutions which are large but not very interconnected or complex.
Policy responses
27. Broadly two kinds of policy responses are being debated: (i) reducing the probability and impact of failure of a systemically important institution and (ii) making the financial system better able to deal with such a failure. The single most important element in respect of both the above approaches would be containment of interconnectedness in the financial system.
28. The specific measures being discussed are: higher capital and liquidity requirements for systemically important firms;   preparation of ‘self wills’ by each of the systemically important firms and moving all OTC derivative markets onto a CCP model.
29. Although identifying an institution as systemic does present a moral hazard, in any event this element is present even today. Higher capital and liquidity requirement will be eminently sensible to make such larger firms internalize the costs of their externalities. The use of contingent capital can be explored once the details of this proposal are formulated. Apart from the quantitative parameters, the institution’s business model and its legal structure should also dictate the quantum of higher capital requirement. Less complex and less inter-connected firms may have to be provided a different leeway.
30. The 'winding down plan' seems useful since it will force the Board to understand group structures and raises the credibility of the threat. It is however premised on two basic assumptions: one, the entity has been transparent enough in terms of the information content in drawing up its own demise plan – the adverse selection issue and two, the regulatory authorities would actually be able to enforce these plans in times of crisis. In unexpected scenarios, as our experience has shown, the regulatory actions would largely be a function of contextual assessments and any readymade plans may be dysfunctional. It would however be interesting to see how this plan is actually operationalised.
31. OTC markets: There is committed effort globally to move all OTC derivative transactions onto exchanges/electronic trading platforms which is a welcome move.. This is a more broad-brush approach but going forward, I am sure we will need to devise a more nuanced approach in this regard as there will be continued need for OTC products i.e. customized to the needs of the real sector.   Furthermore, in regard to central counterparties, it is imperative to examine the incentive structures. To generate more income there is need for more volumes and that can come only from leverage. There is, therefore, need to closely regulate the risk management systems and mandate margin requirements in the form of high quality liquid assets. Given the nature of their functions and their systemic importance, it is worthwhile to consider central counterparties as ‘public utility’ not-for profit entities. It would also become imperative for such systemic entities to be brought under systemic oversight and be regulated by the systemic regulator.
32. More than the above immediate measures, what is required is a debate on some of the fundamental issues. Now that the centrality of banks in the economic system has been established, a much stricter view needs to be taken regarding the activities that banks can undertake with depositors’ money. Should large systemically critical banks be allowed to heavily leverage themselves with depositors’ money? Should the banks facilitate the high-risk high-return leverage game to benefit private investors at the cost of depositor funds? In that sense, I appreciate the arguments for separation of traditional lending business of banks from investment business. However, the extreme view is not very practical. The ‘hybrid approach’ indicated in the FSA paper seems to be the way out but I would suggest some form of  quantitative limit – banks must have a substantial part of their assets in the form of traditional banking assets in order that they perform the role of supporting the real economy.
33. The exponential growth in the money and funding markets outside the formal banking system, primarily at the shorter end, was one of the critical drivers underlying the crisis. The crisis has demonstrated the vulnerabilities of firms whose  business models depended heavily on uninterrupted access to secured financing markets. The entire market structure based on ample liquidity available against any kind of collateral –mainly illiquid and hard to value, with pro-cyclical haircut and margining regime hid severe underlying systemic risks The interplay of under-pricing and not recognizing both credit and liquidity risks through these collateralized markets, was an explosive amalgam exploited by many unregulated entities in the financial system, such as SIVs.
34. Going forward, there could be a multi-pronged, focused effort in the direction of: (i) removing the arbitrage incentives for creation of complex structures in the first place – tax, capital requirements, regulation etc. – to create simpler structures which are transparent and easy to regulate (ii) developing a prudential framework for funding markets, in terms of permissible leverage by any participating entity and nature of collaterals; (iii) explicit commitment to increase competitiveness in the financial sector to remove the perverse situation of few large institutions influencing the market and (iv) massively scaling up the supervisory monitoring framework for such entities. 
35. There have been suggestions to have common cross border resolution mechanism or global fiscal burden sharing. However, these do not appear to be feasible and the most practical approach would be to incentivise organization of a group as a ‘constellation of separately subsidiarised national banks’ in the case of systemic entities rather than as a globally integrated bank. There is inherent tension between the efficiency gains for individual institutions provided by centralized pooling of capital/liquidity and the objectives of host regulators/supervisors. Supervisors are accountable to the domestic depositors, creditors and policy holders and protecting the domestic financial system and therefore there may be justifiable reasons for requiring both capital and liquidity to be held locally, whether the presence is by way of a branch or subsidiary. In this regard, some of the short term efficiency gains may have to be compromised in the interest of broader financial system stability through containment of the contagion effects.
36. Much of the current debate on many issues centres on the epicenter of the crisis, the developed economies with relatively advanced financial systems. The emerging markets, though, can bring a different perspective from their own past experience. Many of the emerging countries, including India, are part of the global effort in search of a harmonized framework but certain key differences in perspectives in these two sets of economies need to be appreciated. The status of the financial sector of the emerging economies is different from that of the advanced economies with different set of imperatives having different implications for the trade off between financial stability on the one hand and financial development, financial inclusion and growth, on the other. For instance, with regard to identification and mitigations of sources of systemic risk, the emerging market concerns are heightened because of the fact that many sources of systemic risk lie outside their jurisdictions. There could also be the issue of negative externality of larger than warranted capital requirements without careful calibration which could adversely impact the flow of credit to productive sectors, particularly in bank funding based financial systems. Emerging economies are faced with the challenge of managing volatile capital flows which is not a source of systemic vulnerability for developed economies,
37. The financial system in India is admittedly not as advanced as in many other countries. Many of the issues I have touched upon in my remarks are based primarily on a secondary assessment and understanding of the experience of global markets. These are clearly not settled issues in our context and as we move forward to further liberalise our financial system, many other nuances may have to be addressed. However, what our experience till now has shown is that a more common-sensical approach, less driven by a doctrinaire mindset; clear prioritisation of objectives and studied caution while  replicating models successful elsewhere will be reliable guideposts. We can certainly have the advantage of learning the right lessons from the crisis before progressing further and we support the various initiatives underway in the FSB and BCBS.  However, we also realize that being responsible members of global policy making and policy influencing bodies, we are duty bound to bring required heterogeneity to the discussions. I hope that the reshaped financial system is different in a real sense.
* Commission of Experts of the President of the United Nations General Assembly on Reforms of the International Monetary and Financial System

†Rajan, Zingales, University of Chicago