Why India Badly Needs a New Financial Regulator

May 4 (Bloomberg) -- With two of its stock markets now among the world's five most active, India badly needs a modern financial regulator. The Securities and Exchange Board of India, which oversees the Indian capital markets, is bent on pushing itself into the abyss of irrelevance.
This became clear last week when in less than 24 hours, SEBI, as the regulator is known, first slapped a trading ban on one of the country's biggest retail brokerages. It then amended the order to say the restraint only applied to the broker's proprietary account and finally put the punishment in abeyance.
On the morning of April 28, the Mumbai Sensex fell 4.1 percent, the biggest single-day drop on the benchmark since Jan. 5, 2005. And then, as the regulator first relented and then wilted, the index erased all its losses to end a little higher than its previous day's close.
What makes SEBI's conduct unpardonable is that this episode of extreme volatility, which may have wiped out some of the same small investors whose interests the regulator presumably protects, was wholly avoidable.
SEBI said it was investigating what it claimed was a $16 million fraudulent capture of initial public offerings by a group of financiers. The regulator decided, based on what looks like wafer-thin evidence, that Indiabulls Securities Ltd. was one of the culprits.
Single Regulator
What's worse, Indiabulls was only given an opportunity to explain its behavior after being banned from buying or selling securities. The company asserted that it held 13,939 shares of Tata Consultancy Services Ltd., the country's biggest computer- software exporter, on clients' behalf to meet the margin requirements laid down by stock exchanges. It wasn't, as the regulator had claimed, a case of Indiabulls being a ``key operator'' that had somehow cornered IPO shares allotted to 559 retail investors.
The alleged IPO scam, which straddles both the banking system and the capital markets, clearly shows what needs to be done.
The Reserve Bank of India, the central bank, must let go of banking supervision and concentrate on monetary policy; SEBI needs to stop shooting everything that moves.
One strong independent regulator for banks, capital markets and insurance -- and funded liberally and directly out of the present securities and bank-debit taxes -- is urgently required in India.
``We find that integrated supervision is associated with a higher overall quality of supervision,'' researchers Martin Cihak and Richard Podpiera noted in a recent International Monetary Fund working paper.
SEBI's Failures
Quality of supervision is emerging as a big issue in Indian capital markets, which are growing in size and sophistication; by shooting itself in the foot with predictable regularity, SEBI has shown it isn't up to the task.
In May 2005, the regulator banned UBS AG from issuing offshore Indian equity derivatives for a year because the broker had apparently ``stultified'' a SEBI investigation by its ``contumaciousness.''
UBS challenged the decision and won. SEBI didn't have a ``clear and explicit understanding'' of its own rules, the appellate tribunal said.
In March 2004, SEBI had held that Samir Arora, a fund manager, was an insider in the companies in which he invested and banned him from Indian securities markets for five years for acting on confidential, price-sensitive information. Once again, the appellate authority set aside the order, which would have turned all private-equity investors in India into criminals.
IPO Scam
What's different about the current episode is that this time a real fraud has been perpetrated, motivated by a loophole in the Indian IPO allotment process.
To ensure that retail investors get a fair chance at initial share sales, a chunk of the stock on offer is reserved for them. This rationing system provides an incentive for financiers to bid for shares under thousands of bogus names to crowd out the genuine small investor.
An alleged scam like this couldn't have happened without the knowledge of bankers who had not only opened accounts for ``friends and relatives'' of financiers but even lent money to these fictitious clients to make their IPO applications.
Since regulating banks isn't SEBI's job, the market regulator has simply ignored them and turned its guns on the ``depository participants,'' whose job is to mediate between investors and the two central electronic storehouses of capital- market wealth. Physical share certificates are history in India.
`Rootless Wonders'
Instead of imposing a stiff fine on the depositories and getting them to discipline their agents, SEBI went for the dramatic effect.
It banned Karvy Stock Broking Ltd., the country's biggest depository participant, from carrying on business until further notice. Not only was Karvy, the regulator says, at the ``root of creating rootless wonders,'' it also pocketed gains from the alleged scam. This charge remains unproven in SEBI's 252-page report. Karvy, which has already obtained a court ruling staying a substantial part of SEBI's order, has denied the allegation.
The alleged IPO fraud was a good opportunity for SEBI to redeem its reputation. As a first step, it should have gotten rid of the quota system of IPO allotment, moving instead to the kind of Dutch auction system Google Inc. used for its 2004 IPO.
Now that SEBI has shown its preference for sensational action over enduring systemic change, it's time to take away its gun and give it to a new sheriff who knows how to use it.
To contact the writer of this column:
Andy Mukherjee in Singapore at amukherjee@bloomberg.net.