RBI official shows enforcing rules is tough business

Written by Anil Sasi | New Delhi | Updated: Jul 7 2014, 14:04pm hrs
RBIReserve Bank of India offers an insight into how tough it is to enforce financial regulations in the country.
In the continuing debate on whether over regulation has the potential to throttle the corporate sector or if businesses will always manage to beat the regulator at ways to skirt the rule book, a perspective from inside the Reserve Bank of India offers an insight into how tough it is to enforce financial regulations in the country.

Speaking at a recent conference on corporate governance in Mumbai, G Padmanabhan, executive director, RBI recounted how companies responded to attempts by the central bank in 2007-08 to tweak the regulatory framework to discourage foreign currency borrowings by companies as a means to contain the rupee volatility.

In the preference hierarchy of capital inflows, equity inflows dominate debt inflows and as such India has a stricter regulatory regime for debt in comparison with equity.

According to Padmanabhan, companies responded by using at least three different ways to try and skirt the regulation.

Some companies issued convertible debentures, which, till 2007, were a permitted instrument for equity investment. But such debentures were structured in such a way that they were predominantly debt rather than equity. As an example, in a convertible debenture of Rs 100, only Rs 10 were convertible to equity on maturity.

Others adopted a slightly more sophisticated approach and issued equities, with a put option at a specified strike price in favour of the investor, thus camouflaging the debt nature of the instrument.

As an example, suppose an equity instrument valued at Rs 10 were to be issued with a put option after five years with a strike price of Rs 20. At the appropriate time, the investor exercises the option and sells back these shares at Rs 20 to the issuer, thereby getting a fixed return of close to 15 per cent. The economic essence of the whole transaction is that the company has borrowed the funds at a cost of 15 per cent.

Then there were others who adopted an innovative approach, whereby a company issued a share valued at Rs 10at a premium of Rs 25,000 and entered into a shareholders agreement promising a guaranteed dividend of 8 per cent on the face value of the share as well as the share premium.

Regulations thus are supposed to modify behaviour of those covered by the regulation and ensure that they behave in a socially desirable way. But whether the regulations will have to be in the nature of a nudge or a shove depends upon how the regulated entities respond to. When the regulations are simple and the regulated entities comply with the regulations in letter and spirit so that the objective of the regulator is achieved, it is not necessary for regulations to be complex and detailed, which makes both administration and compliance difficult, Padmanabhan said in his address.

At a time when the high exposure to debt by leading corporates has begun to seriously threaten balance sheets of a large number of companies and also the viability of the financial sector as a whole, its still a divided house on whether the RBI should be blamed for not being strict enough or the private sector should get the stick foroverleveraging its books.