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A blog on financial markets and their regulation
Rogues thrive most in regulatory regimes designed to keep them out. This paradox arises because regulations that try to keep them out also unintentionally keep out the good entrants. The few rogues who do get in are able to thrive because they are shielded from competitors who might otherwise have driven them out of the market. Therefore, an open entry policy coupled with a ruthless exit policy might be the best way to keep the system clean.
In India there are two areas regulators are struggling to arrive at the right entry policy—stock exchanges and banks. It is a fact that it is very hard to get a licence for a new stock exchange or a new bank, but it is also very hard to cancel the licence of an existing stock exchange or an existing bank. We have many existing licensed stock exchanges and many existing banks that are so poorly run that they would be unlikely to get a licence today if they were applying for the first time. Yet, it is not easy to kick them out.
If anything, there is a case for a complete reversal of this policy regime. It should be very easy to start a new stock exchange or a new bank, but it should be much harder to retain the licence. The rationale for this approach is that it is very difficult for any regulator to figure out whether a particular set of promoters will be able to run a proposed stock exchange or bank well enough. This question is completely hypothetical and speculative at the entry stage, and the regulators are forced to extrapolate from the promoters’ experience in other sectors or environments to make an assessment if the given licensees are able to do well in the new venture. In contrast, it is much easier to assess whether an existing bank or stock exchange is well run or not. It is easier because we are now dealing with a question of fact and not speculating about hypothetical future possibilities.
It is easier for rogues to get past stringent entry barriers because they can spend enough money to acquire all the trappings of respectability. They can easily meet minimum capital requirements. They do often succeed in hiring distinguished personalities to serve on their boards (or in senior management positions) and lobby on their behalf. They can engage expensive consultants to prepare impressive business plans. Of course, once they have got the licence, they can discard these ostensible plans, sideline the “distinguished” personalities, and get on with their real business plans.
For these reasons, tough entry barriers do not really keep out the rogues. For example, of the 10 new banks licensed in India in the first phase in the 1990s, the majority were failures in the broadest sense. There were serious and honest promoters who failed because of environmental changes or genuine management mistakes, but that cannot be said of all the banks that failed. A tiny number of those who did not deserve banking licences did manage to obtain them despite very tough entry standards set by a regulatory process that was widely regarded as free of corruption. At the same time, a large number of serious professionals with valuable ideas would have been denied a licence because of the tight entry norms.
The principal objection to the idea of relying on a strong exit policy to keep the rogues in check is the problem of “too big to fail”. This objection has, I think, lost its force after the global financial crisis. It is now accepted that a financial intermediary that is too big to fail is simply too big to exist. Current regulatory thinking is that big institutions should prepare “living wills” or “funeral plans” that ensure that they can die gracefully.
The idea of “funeral plans” applies with equal force to stock exchanges and clearing corporations as well. There is a high probability that a large clearing corporation in a Group of Twenty (G-20) country (or for that matter even in a G-7 country) will fail over the next five years or so. Rather than pretend that central counterparties can never fail, we should be working hard to ensure that they could fail without dragging the whole system down with them. This means multiple central counterparties, which in turn means higher margins and collateral requirements. In a post crisis world, a lower level of leverage is probably not a bad thing.
It is often argued that stock exchanges are a natural monopoly because liquidity begets more liquidity and trading gravitates towards the most liquid trading venue. In reality, however, liquidity has many dimensions. A dark pool can be the best source of liquidity for some investors, while being a terrible trading venue for others. Moreover smart order routing can aggregate liquidity across multiple venues.
A financial system with numerous small banks, many exchanges and multiple central counter parties would be more robust. It would also have fewer rogues, or at least fewer big rogues who can do great damage.