UNIT 3 REGULATORY FRAMEWORK Regulatory

Framework

Objectives

The main objectives of this unit are to:

• provide a general framework of the Regulations governing the financial

services industry;
• explain different types of Regulation; and
• explain regulations that are in force for the banking, insurance and other
financial services.

Structure

3.1 Introduction
3.2 Types of Regulations
3.3 Regulations on Banking and Financing Services
3.4 Regulations on Insurance Services
3.5 Regulations on Investment Services
3.6 Regulations on Merchant Banking and other Intermediaries
3.7 Summary
3.8 Key Words
3.9 Self Assessment Questions
3.10 Further Readings

3.1 INTRODUCTION
At the centre of any economy, it is the process of financial intermediation and
disintermediation that helps the economy to grow and function smoothly. For
instance, the credit creation function of banking institutions allows the
economy to expand more than what it could do without banking institutions.
Financial services industry not only channels savings into productive
investments, it also helps the economic activities to take place without much
difficulties. For example, the cheque facility and clearing service and /or
digital banking service provided by the banks help several million people to
perform economic activities. Similarly, stock brokers help investors to sell
and buy shares which is critical for development of financial services and
financial markets. Insurance companies give protection against the risk of
many unknown events like fire, flood etc., that affect the business and allow
the firms to perform their activities with confidence. The financial services
have thus become indispensable in running the economy. Such an important
system faces two problems –cheating and instability. During the stock market
scams, many investors were cheated. Recently, internet bubble attracted
several investors, who lost their wealth. While such losses are partially on
account of investors overvaluing the securities, it is also on account of many
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Indian Financial firms providing misleading information. Financial markets are also highly
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volatile and show instability in that process. In view of its importance in the
economy, the need for strict regulatory machinery need not be emphasized.
This sector is governed by well established regulators. Though regulations
per se may not remove cheating and reduce volatility, it would certainly help
to reduce its occurrence and minimise the length of volatile period.

A financial service cannot generally be tested at the time of purchase since

there is a time-lag between the purchase of service and its actual effect. For
example, when you buy a share through a member of stock exchange, the
service completes only at the time of delivery of shares. Similarly, when you
buy units of mutual fund and avail its expert service of investment, the results
of this service is known only in the future. In case of dealings in cheques/on
line payments, the service concludes only when the amount is credited or
debited in your account but the time-lag is short. The need for regulation
stems from the problems of failure of the firms which provide financial
services and thus causing hardship to the purchaser. Since financial system is
closely integrated and inter-linked, failure of one firm often affects other
firms and thus the entire financial system is affected. Further, in a
competitive market for borrowing and lending where the spread is thin,
financial services firms often take high risk to maximize the return and thus
are more susceptible to default. There are several other events that can
imperil the interest of investors and others who avail the services. The list
includes fraud, misfeasance and collapse of an institution due to
mismanagement etc. Regulations are thus in place to safeguard the interests
of the participants of the system and prevent economic instability. Regulatory
bodies are interconnected with various industries, and a financial service is
no exception. Independent agencies are designated to oversee different
financial institutions’ operations, uphold transparency, and ensure that clients
are treated fairly. The second aspect assumes more relevance after several
East-Asian economies had suffered due to the failure of the financial system.

3.2 TYPES OF REGULATIONS

The health of the financial sector is a matter of public policy concern in view
of its critical contribution to economic performance. Financial regulation and
supervision assumes importance in ensuring that the financial system
operates along sound lines. The primary justification for financial regulation
by authorities is to prevent systemic risk, avoid financial crises and protect
depositors’/investor’s interest and reduce asymmetry of information between
depositors/investors and concerned institution. Besides, financial regulation
attempts to enhance the efficiency of the financial system and to achieve a
broad range of social objectives.

The financial system in India is regulated by independent regulatory bodies

in different fields namely banking, capital market, insurance, commodity
market, and pension funds. However, the Government of India plays an
70 important role in influencing the regulatory framework of these institutions.
The different levels of regulation on financial services is explained below in Regulatory
Framework
the Table 3.1

Table 3.1: Different Levels of Regulation on Financial Services

The regulatory framework relating to financial services can be broadly

classified into three main types. One set of regulations determine the types of
activities that different forms of institution are permitted to engage in. These
regulations can be called as structural regulations. For example, the
Securities and Exchange Board of India (SEBI) insists that merchant bankers
and stock broking institutions, separate all their fund-based activities.
Similarly, the Reserve Bank of India (RBI) has prescribed the activities that
commercial banks can provide to the investors. Structural regulation thus
involves demarcation lines between the activities of financial institutions but
many of them have in fact been eroding in recent years. Banks are now
providing various services like leasing, term loan, credit cards, etc., in
addition to their traditional service of working capital lending. The
rationale behind expanding the activities that can be provided by the
financial service companies is the desire of regulatory authorities to create
greater competition.

There are regulations that cover the internal management of financial

institutions and other financial service organisations in relation to
capital adequacy, liquidity and solvency. The SEBI for instance has
prescribed minimum net worth requirement for various financial service
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Indian Financial firms that come under its jurisdiction. The objective of these regulations is to
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restrict the firms without adequate resources from entering into this field.
Recently, the RBI has regulated the non-banking finance companies in
raising public deposits. These regulations are known as prudential
regulations as they aim to evolve certain prudential norms for the operation
of the industry.

There are number of investor protection regulations. All regulatory agencies

in the financial sector claim that the primary objective of the agency is to
protect the interest of investors. It is generally perceived that investors are the
weakest participants of the financial markets and hence need protection from
malpractice, fraud and collapse. The information asymmetry between the
investors and financial intermediary or institution affects the investors and
thus regulatory agencies step-in to protect the interest of the investors. Thus,
investor protection regulations are often in the nature of demanding larger
disclosure of information.

The regulations can also be classified on their scope. There are regulations
which deal with the macro aspects of the system. For example,
legislation enacted in the parliament like Banking Regulation Act,
Securities Contracts Regulation Act, etc., deal with the macro aspects of
respective institutions. The regulatory authorities under the legislation
evolve rules, guidelines and regulations that govern the micro aspects and
operational issues. In addition to the regulations stated above, there are self-
regulations from the industry association. For example, the foreign exchange
dealers have their own self-regulation in addition to several other laws and
guidelines that govern their activities. The RBI has recognized Micro Finance
Institutions Network (MFIN) as India’s first Self-Regulatory Organization
(SRO) for the NBFC-MFIs. Similarly; the Association of Merchant Bankers
of India (AMBI) has been granted recognition by SEBI to establish
standard practices in merchant banking and financial services. In the US
and other developed markets, there are associations for financial
analysts which admit the members after they pass examination and evolve
code of conducts when they desire to practice as financial analyst. Table 3.2
gives a list of self Regulatory organizations under different Regulators.

Table 3.2 : Self Regulatory organizations under different Regulators

Regulator Self regulatory organization under respective regulators

Reserve i) Micro Finance Institutions Network (MFIN)
Bank of ii) Sa-Dhan powers to monitor microfinance institutions
India
SEBI i) Association of Merchant Bankers of India (AMBI)
ii) Association of Mutual Funds of India (AMFI)
iii) Association of Custodial Agencies of India (ACAI)
iv) Registrars Association of India (RAIN)

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 Regulatory
IRDAI i) The General Insurance Council is a Self-Regulatory Framework
Organization for the non-life insurance industry’s market
conduct and practices.
ii) Insurance Broker’s Association of India.
iii) Institute of Actuaries of India(IAI)

The regulations in general aim to ensure the soundness and safety of financial
institutions, maintain the integrity of the transmission mechanism and
protection of the consumers of financial services. The regulations also ensure
freedom of operation to improve the efficiency and provide adequate scope
for innovation that benefit the investors and other participants. The success of
the regulation thus not only depends on its ability to ensure investors
protection but is also determined by the level of advancement and
sophistication the system has achieved. In other words, regulation should not
block the development of financial service industry. Financial services sector
firms are increasingly utilising technology to improve their services.
However, IT failures, or incidents within the financial services sector appear
to be becoming more common. It is in this background recently, the Reserve
Bank of India (RBI) released guidelines to regulate payment aggregators
(PAs) and payment gateways (PGs).

Activity 3.1

a) State the broad objectives of regulations relating to financial services.

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b) Give a few examples of prudential regulations relating to stock broking

service.

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...................................................................................................................

c) Why do we need regulators when there are comprehensive legislation

covering different financial services?

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Indian Financial
System
3.3 REGULATIONS ON BANKING AND
FINANCING SERVICES
Financial intermediaries mobilise savings and allocate (lend) capital to
different users. Savings and capital allocation are two important activities of
the economy and they together determine the growth of the economy. Often,
these two are used to change the direction of the economy to achieve desired
results. The Governments all over the world frame the polices relating to
savings and capital allocation but entrust the responsibility of monitoring
them to the central bank. In India, the Reserve Bank of India, as the central
bank of the country, is the nerve centre of the Indian financial system. It
regulates all institutions that are connected with savings and capital
allocation.

By regulation, it does not mean that RBI determines the rate of interest on
deposits and /or rate of interest to be charged on advances. While in a closed
economy, these are determined by the government whereas in a free-market
economy to which India is slowly moving, these are by and large determined
by the market forces. The role of RBI is to frame regulations that help the
orderly functioning of the institutions that raise and lend the capital.
Commercial banks and Non-Banking Financial Institutions are two major set
of institutions that come under the regulation of RBI.

a) Banking Institutions
The regulation and supervision of the financial system in India is carried out
by different regulatory authorities. The Reserve Bank regulates and
supervises the major part of the financial system. The supervisory role of
the Reserve Bank covers commercial banks, Urban Cooperative Banks
(UCBs), some FIs and NBFCs.

Co-operative banks provide banking facilities to people of small means.

However, absence of regulatory oversight by RBI on par with commercial
banks has contributed to the poor performance of co-operative banks. The
Banking Regulation (Amendment) Bill, 2020 was introduced in the Loksabha
on 14th September 2020. The Parliament received the assent of the President
on the 29th September, 2020 It is now an Act. The said Act seeks to extend
RBI regulation of co-operative banks with respect to management, capital,
audit and winding up. Currently, RBI regulates and supervises 86 Scheduled
Commercial Banks, 45 Regional Rural Banks and 10 Small Finance Banks.
The Act extends RBI’s regulation and supervision to 1,544 UCBs, 363
district (central) Cooperative Banks and 33 State Co-operative Banks.

State Cooperative Banks and District Central Cooperative Banks are

registered under the provisions of State Cooperative Societies Act of the
State concerned and are regulated by the Reserve Bank. Powers have been
delegated to National Bank for Agricultural and Rural Development
(NABARD) under Sec 35 (6) of the Banking Regulation Act (As Applicable
to Cooperative Societies) to conduct inspection of State and Central Co-
operative Banks.
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In order to develop a sound banking system in the country, the RBI Regulatory
Framework
regulates the commercial and co operative banking institutions in the
following ways:

1) It is the licensing authority to sanction the establishment of new bank or

new branch;

2) It prescribes the minimum capital, reserves and use of profits and

reserves, distribution of dividends, maintenance of minimum cash
reserves and other liquid assets;

3) It has the authority to inspect or conduct investigation on the working of

the banks;

4) It has the power to control the appointment of Chairman and Chief

Executive Officer of the private banks and nominate members in the
Board of Directors.

5) It regulates factoring, bill discounting and credit card services offered by

the commercial banks and other institutions.

The central bank also effectively regulates the credit flows through monetary
policy. It controls the amount available for credit by prescribing cash reserve
ratio and statutory liquidity ratio. It also takes away cash through treasury
operations by periodically issuing bonds and REPOS. It also intervenes in the
credit flows, by prescribing limits of credit availability to different sectors
and industries or increases the bank rate to make credit unattractive. The list
of techniques used to control the credit flows are :

a) Open Market Operations,

b) Bank Rate,
c) Discretionary control of Refinance and Rediscounting,
d) Cash Reserve Ratio,
e) Statutory Liquidity Ratio,
f) Direct Credit Allocation and Credit Rationing,
g) Selective Credit Controls and
h) Moral Suasion.

b) Non-banking Financial Companies

The contribution of NBFCs towards supporting real economic activity and

their role as a supplemental channel of credit intermediation alongside banks
is well recognized. Over the years, the sector has undergone considerable
evolution in terms of size, complexity, and interconnectedness within the
financial sector. Many entities have grown and become systemically
significant and hence there was a need to align the regulatory framework
for NBFCs keeping in view their changing risk profile. The Scale Based
Regulation (SBR) framework encompasses different facets of regulation 75
Indian Financial of NBFCs covering capital requirements, governance standards, prudential
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regulation, etc.

In India, four types of non-banking financial companies (NBFCs), viz.,

equipment leasing companies, hire-purchase companies, loan companies and
investment companies are under the regulatory purview of the Reserve Bank.
With the increasing services sector activity in India, the NBFCs have been
playing a critical role in providing credit. NBFCs have extensive networks.
The insertion of chapter III B in the Reserve Bank of India Act, 1934 enabled
the Reserve Bank to regulate the NBFCs statutorily since February 1964.
Since then, the Reserve Bank has initiated a series of measures to
appropriately regulate and supervise the NBFCs according to the need from
time to time. In 1966, new directives were issued to increase the regulatory
powers of the Reserve Bank with regard to NBFCs. Earlier National Housing
Bank (NHB) was empowered under the provisions of the NHB Act, 1987 to
regulate the housing finance companies. However, the provisions of National
Housing Bank Act, 1987 were amended w.e.f August 09, 2019, pursuant to
the Finance Act, 2019 thereby shifting the power to govern Housing Finance
Companies (HFCs) from National Housing Bank (NHB) to the Reserve Bank
of India (RBI). Consequently, RBI, on October 22, 2020 issued the
Regulatory Framework for HFCs.

In addition to the regulation prescribed by the RBI, there are several Acts and
regulations that govern different types of Non-Banking Financial Companies.
For example, leasing companies have to take into account the provisions of
The Indian Contract Act, Motor Vehicles Act, Indian Stamp Act, etc.
Similarly, hire-purchase transactions are governed by the Indian Contract
Act, Sale of Goods Act and Hire-Purchase Act. The SEBI also regulates all
these companies whenever they approach the market to raise capital.

In the wake of failure of some NBFCs and loss of depositors’ money, the
supervision of NBFCs assumed critical importance. In the backdrop of the
recommendations of the Khanna Committee (1999), a comprehensive
supervisory model has been devised for effective supervision of the NBFCs
depending upon the size, type of activity and acceptance or otherwise of
public deposits.

For this purpose, a four-pronged mechanism comprising onsite inspection on

the CAMELS (Capital adequacy, Asset quality, Management, Earning,
Liquidity and Sensitivity) pattern, off-site monitoring through periodic
control returns using state-of-the-art information technology; an effective
market intelligence network; and a system of submission of exception reports
by statutory auditors of NBFCs were instituted in order to support the
regulatory and supervisory framework for NBFCs. The system of on-site
examination is structured on the basis of CAMELS approach and the same is
akin to the supervisory model adopted for the banking system. The inspection
policy of the NBFCs has recently been revised to regulate them effectively.
In order to bring the functioning of the NBFCs in line with international best
76
practices, the Reserve Bank initiated a consultative process with the NBFCs Regulatory
Framework
with regard to their plan of action for voluntarily phasing out of their
acceptance of public deposits. Recently, the Reserve Bank has laid down a
road map for Residuary Non-Banking Companies (RNBCs) with a view to
ensure that the transition process of these institutions complies with the
Reserve Bank’s directions.

RBI has been maintaining its surveillance on NBFCs on an ongoing basis and
intervenes whenever action is warranted. For example In January 1998, the
Reserve Bank issued a new regulatory framework for NBFCs building upon
its newly acquired powers under the RBI Act. It categorized NBFCs into

i) public deposit accepting,

ii) non-public deposit accepting but engaged in loan, investment, hire-
purchase and equipment leasing, and
iii) non-public deposit accepting core investment companies that acquire
securities/ shares in their own group companies comprising not less than
90 per cent of their total assets but not trading in these securities/ shares.

In 2006, considering the increasing significance of the sector, the Reserve

Bank introduced differential regulation and classified NBFCs with asset size
of Rs. 100 crore and above as ‘Systematically Important NBFC-ND (NBFC-
ND-SI)’. Prudential regulations such as capital adequacy requirements and
exposure norms were made applicable to them. In 2014 regulatory guidelines
were revised, minimum Net Owned Funds (NOF) of Rs. 2 crore for legacy
NBFCs, was introduced. Minimum Capital requirements for each type of
NBFC varying from Rs.2 crores to Rs 300 crores was introduced for 7 types
of NBFCs.

In 2019, the NHB Act was amended and certain powers for regulation of
Housing Finance Companies (HFCs) were conferred with the Reserve Bank
of India pursuant to such amendments.

A Revised Regulatory Framework for NBFCs from October 2021

With effect from 1-10-2021 RBI has adopted a revised regulatory

framework for NBFCs. The highlights of the new framework are that the
Regulatory structure for NBFCs shall comprise of four layers based on
their size, activity, and perceived riskiness. NBFCs will now be classified
as, Base Layer, Middle Layer, Upper Layer & Top Layer.

• The Base Layer shall comprise of

- non-deposit taking NBFCs below the asset size of Rs.1000 crore and

- NBFCs undertaking the activities such as NBFC-Peer to Peer Lending

Platform (NBFC-P2P), NBFC-Account Aggregator (NBFC-AA),
Non-Operative Financial Holding Company (NOFHC) and NBFCs
not availing public funds and not having any customer interface
77
Indian Financial • The Middle Layer shall consist of
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- all deposit taking NBFCs (NBFC-Ds), irrespective of asset size,

- non-deposit taking NBFCs with asset size of Rs1000 crore and above
and

- NBFCs undertaking the following activities (i) Standalone Primary

Dealers (SPDs), (ii) Infrastructure Debt Fund - Non-Banking
Financial Companies (IDF- NBFCs), (iii) Core Investment
Companies (CICs), (iv) Housing Finance Companies (HFCs) and (v)
Infrastructure Finance Companies (NBFC-IFCs).

• The Upper Layer shall comprise of those NBFCs which are specifically
identified by the Reserve Bank as warranting enhanced regulatory
requirement based on a set of parameters and scoring methodology. The
top ten eligible NBFCs in terms of their asset size shall always reside in
the upper layer, irrespective of any other factor.

• The Top Layer will ideally remain empty. This layer can get populated
if the Reserve Bank is of the opinion that there is a substantial increase in
the potential systemic risk from specific NBFCs in the Upper Layer.
Such NBFCs shall move to the Top Layer from the Upper Layer

RBI Regulatory framework has now specified certain changes under scale
based regulation ( SBR) for the layers. As of now the minimum net owned
fund requirement was varying between Rs 2 crores to Rs 5 crores, By march
31st 2027 all NBFCs are required to maintain minimum net owned funds to
the tune of Rs 10 crores. RBI has prescribed a glide path to achieve this. A
glide path is provided to NBFCs in Base Layer to adhere to the 90 days NPA
norm to achieve by 31-03-2026. Large Exposure Framework (LEF) for
NBFCs placed in the Upper Layer has been introduced. Full details of revised
regulatory guidelines are available in RBI circular dated 22-10-2021.

3.4 REGULATIONS ON INSURANCE SERVICES

Before the nationalisation of life and general insurance and the setting up of
LIC in1956 and GIC in 1973 as monolithic institutions, insurers were
regulated under the provisions of the Insurance Act, 1938 which was
administered by the Controller of Insurance. The application of the Act was
greatly modified by the nationalisation of the insurance companies and most
of the regulatory functions were taken away from the Controller of Insurance
and vested with LIC and GIC. In order to improve the efficiency of insurance
services in India, the Government of India had appointed a committee headed
by R.N. Malhotra, the former Governor of Reserve Bank of India in April
1993. The Malhotra Committee submitted its report in January, 1994
suggesting a comprehensive framework covering the entire gamut of life and
general insurance. The Committee had recommended that private and foreign
companies be allowed to enter into insurance sector. It also recommended to
78 reduce the government holding in the LIC and GIC to 50% and mandated
investments from 75% to 50% for LIC and 70% to 35% for GIC and its Regulatory
Framework
subsidiaries. It also required the government to appoint a strong and effective
Insurance Regulatory Authority in the form of statutory autonomous board
on the lines of SEBI and the Tariff Advisory Committee be delinked from the
GIC and function as a separate authority under the regulator. With an
objective of reforming the insurance sector and allowing private entrants, the
Government of India had set up an interim Insurance Regulatory Authority
(IRA) in January, 1996 and introduced the Insurance Regulatory Authority
Bill, in December 1996 to give statutory status.

The IRDA Bill was passed in December 1999 and became an Act in April
2000. In July 2000, immediately after the first meeting of the Insurance
Advisory Committee, 11 essential regulations relevant for players entering
the Indian market were notified. At the time of opening of the insurance
sector, supervision and regulation of insurance was a relatively new
experience in India. It is the job of the Regulator to ensure that the insurers
have, at any point of time, sufficient resources to meet the liabilities and that
all customers are treated in a fair and equitable manner. The Regulations
framed by the Authority deal with both the issues in a comprehensive way.
The former is addressed by stipulating a high level of capital requirement for
entry of private insurers into the field and rigorous enforcement of the
solvency and investment requirements. The latter is covered by the regulatory
framework put in place for protection of policyholders' interests. The
Insurance Regulatory and Development Authority of India (IRDAI) is an
autonomous and statutory body which is responsible for managing and
regulating insurance and re-insurance industry in India.

The regulatory framework for Insurers includes

a) Registration / Renewal / Cancellation of registration

b) Opening and Closing of offices
c) Clearance of insurance products
d) Monitoring of Advertisements / publicity material of products
e) Solvency requirements
f) Investment norms
g) Accounting norms
h) Reinsurance requirements
i) AML - CFT Norms
j) Policyholder protection regulations
k) Corporate Governance guidelines
l) Penalties for non-compliance or violations

The IRDAI regulations govern all insurance agents and intermediaries, that is:

1) corporate agents;
79
Indian Financial 2) insurance brokers;
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3) insurance marketing firms (IMFs);
4) Third party administrators (TPAs)
5) surveyors and loss assessors; and
6) web aggregators.
7) Micro insurance agents

The IRDAI has issued regulations setting out the licensing or registration
requirements (including eligibility criteria, capital and net worth
requirements, qualification requirements of the principal officer, directors or
partners of the concerned entity) and procedures for all the above-mentioned
intermediaries. License or registration is typically granted for three years, and
may be renewed thereafter.

IRDAI has played a vital role in the growth and development of the insurance
sector in the country. It has through its policy initiatives protected
policyholders' interests; It has regulated insurance companies effectively.
Introduced licensing and established norms for insurance intermediaries. It
has overseen premium rates and terms of non-life insurance covers; specified
financial reporting norms. It has protected investment of policyholders' funds
by ensuring the maintenance of solvency margin by insurance companies; It
has taken effective steps in ensuring insurance coverage in rural areas and of
vulnerable sections of society. Supervisory role of IRDA includes, on-site
inspection, off site monitoring through returns and public disclosures, market
conduct based on complaints and market intelligence.

During the year 2020-21, IRDA has notified regulations which came into
force from 23rd May 2021which mandates insurers, and insurance
intermediaries to maintain minimum information in their books for the
purpose of investigation and inspection by the Authority, Through
(Insurance Advertisements and Disclosure) Regulations, 2021dated 9th April
2021 IRDA has asked the companies to ensure that the advertisements of
Insurance are relevant, fair and in simple language enabling informed
decision making by customers.

3.5 REGULATIONS ON INVESTMENT

SERVICES
Investment services are primarily fund based activities. The mutual funds and
venture capital funds directly fall under the investment services. Though
portfolio management service is advisory in nature, the regulation on
portfolio management services could be discussed under the heading of
investment services as this service is closely linked with the investment
services. Similarly, stock exchanges and stockbroking institutions have close
link with the investment activities and thus regulation on them could be
conveniently discussed along with other direct investment activities. The
80 regulatory set up consists of Securities Contracts (Regulation) Act (SCRA)
1956, SEBI Regulations and Reserve Bank of India. Before discussing the Regulatory
Framework
regulatory framework under each of the investment and investment related
services, it is appropriate to know Securities and Exchange Board of India
which is emerging as a powerful regulator of various financial services.

3.5.1 The Securities and Exchange Board of India (SEBI)

SEBI was founded on April 12, 1992, under the SEBI Act, 1992. The main
purpose in establishing SEBI by the Govt. was to stop the malpractices in
stock markets. There were malpractices such as price rigging, ‘unofficial
premium on new issue, and delay in delivery of shares, violation of rules and
regulations of stock exchange and listing requirements etc. Due to these
malpractices the customers started losing confidence and faith in the stock
exchange. Therefore, government of India decided to set up an agency or
regulatory body known as Securities Exchange Board of India (SEBI).

The objectives of SEBI are:

1) To regulate the activities of stock exchange.

2) To protect the rights of investors and ensuring safety to their investment.
3) To prevent fraudulent activities and malpractices by having balance
between self regulation of business and its statutory regulations.
4) To regulate and develop a code of conduct for intermediaries such as
brokers, underwriters, etc.

The three main functions of SEBI are-

• Protective functions- Under this function it checks price rigging that is

manipulation in prices of securities. It prohibits “insider trading” SEBI
keeps a strict check when insiders are buying securities of the company
and takes strict action on insider trading because insiders have sensitive
information about the company which affects the prices. SEBI does not
allow the companies to make misleading statements which are likely to
induce the sale or purchase of securities by any other person.

• Development Functions-It promotes training of intermediaries of the

securities market, through its flexible approach it has permitted internet
trading of securities and has made underwriting optional to reduce the
cost of issue.

• Regulatory functions- SEBI has framed rules and regulations and a code
of conduct to regulate the intermediaries. It regulates the working of stock
brokers, sub-brokers, share transfer agents, trustees, merchant bankers.
SEBI registers and regulates the working of mutual funds. It conducts
inquiries and audit of stock exchanges.

Powers of Securities and Exchange Board of India

It has the following three powers:

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Indian Financial Quasi-Judicial: SEBI has authority to conduct hearings and pass judgements
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in cases of unethical and fraudulent trade practices. This ensures
transparency, fairness, accountability and reliability in the capital market.

Quasi-Legislative: under this power SEBI can draft rules and regulations for
the protection of the interests of the investor.

Quasi-Executive: SEBI is authorised to file a case against anyone who

violates its rules and regulations. It is empowered to inspect account books
and other documents as well, if it finds traces of any suspicious activity.

SEBI has also created special wings for Primary Market, Secondary Market,
Mutual Funds, Surveillance, Research, etc. These regulations and guidelines
serve the basic structure of regulatory framework for several financial
services. The SEBI Act also provides that parties aggrieved by its order can
appeal to the Central Government within a prescribed time limit. The
regulations relating to different financial services connected with investment
activities are discussed below:

a) Mutual Funds

The mutual funds in India could be broadly classified into three groups for
the purpose of regulations governing the mutual funds. They are Unit Trust of
India, Public Sector and Private Sector Mutual Funds, and Money Market
and Off-Shore Mutual Funds. The Unit Trust of India (UTI) was established
by the Government of India as a Trust under UTI Act, 1963. Since inception,
the UTI has offered several schemes and it is governed by the UTI Act, 1963.
In 1986, the government has allowed the public sector banks to enter into
mutual fund service and within a short period of time several public sector
banks commenced their mutual fund service. In these public sector banks
mutual funds were governed by the Reserve Bank of India. In February,
1992, the Ministry of Finance issued a notification to the effect that all
mutual funds be regulated by the SEBI and allowed the private sector entry
into mutual funds service.

As far as mutual funds are concerned, SEBI formulates policies, regulates

and supervises mutual funds to protect the interest of the investors. SEBI
notified regulations for mutual funds in 1993. Thereafter, mutual funds
sponsored by private sector entities were allowed to enter the capital market.
The regulations were fully revised in 1996 and have been amended thereafter
from time to time. SEBI has also issued guidelines through circulars to
mutual funds from time to time to protect the interests of investors. All
mutual funds whether promoted by public sector or private sector entities
including those promoted by foreign entities are governed by the same set of
Regulations. There is no distinction in regulatory requirements for these
mutual funds and all are subject to monitoring and inspections by SEBI.

Some of the important regulations applicable to mutual funds are:

• Every mutual fund must be registered with SEBI.

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• A mutual fund be set up as a trust, with sponsors, trustees, an Asset Regulatory
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Management Company (“AMC”) and a custodian.

• An AMC of a mutual fund should have at least 50% independent

directors, a separate board of trustees which includes 50% independent
trustees and independent custodians so as to manage any conflict of
interest among fund managers, custodians, and trustees.

• A single mutual fund can float different schemes but they have to be
individually approved by the trustees and all offer documents have to be
filed with SEBI.

• SEBI lays down certain restrictions on the fees that AMCs can charge for
mutual funds and there is also a cap on the expenses that can be added to
the fund.

• Mutual funds can advertise, but advertisements cannot have statements

that are misleading. For instance, no mutual fund can guarantee a return
since returns depend on market performance.

b) Venture Capital Financing (VCF)

Venture Capital is a type of seed funding in which investment is made at the

initial growing stage of ventures. The Venture Capital Investors generally
place their funds in those companies, which are with new ideas, innovations
and having potential of high growth but with inherent uncertainties. Venture
Capital Investors are also called as “Angel Investors” Venture Capital
institutions participate in the equity of companies which are not in a position
to raise equity capital directly from the market due to new technology or
small size of the venture in the initial stage. The venture capital institutions
sell the equity in the market once the company establishes its standing in the
market and normally; such public offers are accompanied with a similar
public offering from the company.

In India, venture capital fund is regulated by Securities and Exchange Board

of India (Alternative Investment Funds) Regulations, 2012. Investment in
VCF is subject to certain conditions such as, each scheme of VCF is required
to have a minimum corpus of INR 200 Million and every investor is required
to invest at least INR 10 Million (except for the employees and directors of
VCF who can invest a minimum of INR 2.5 Million). Further, no scheme can
have more than 1000 investors.

The VCF can raise funds from any investor whether Indian, foreign or non-
resident Indians by way of issue of units, however, any investment in VCF by
a person resident outside India (including a NRI) is governed by Foreign
Exchange Management (Non-debt Instruments) Rules, 2019. The venture
capitalists have today emerged as the mainstream source of finance for the
innovative entrepreneurs thereby providing the requisite solution. The SEBI
regulation on VCF prescribes compulsory registration of VCF, investment
conditions, management of the company and maintenance of records. It also
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Indian Financial has an authority to inspect the books and investigate the charges and also
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take penal action against the erring VCF. In addition to SEBI regulation, the
VCFs are also governed by the Income Tax Act. The VCFs are required to
apply to the Director of Income Tax (Exemptions) to avail favourable
treatment on dividend income and capital gains. The VCFs have to fulfil
certain condition laid down under the Act to get such benefits. The
Government of India has allowed the overseas venture capital companies to
operate in India in 1995 and they require the approval of Foreign Investment
Approval Board (FIPB).

c) Portfolio Management Services

The portfolio manager is one who in pursuant to a contract or arrangement

with a client advises or directs or undertakes on behalf of the client (whether
as a discretionary portfolio manager or otherwise) the management or
administration of a portfolio of securities or the funds of the client. The SEBI
had issued a detailed guideline in 1993 (SEBI Portfolio Managers
Regulations, 1993) to regulate this advisory service. The regulation requires
compulsory registration of portfolio managers before starting their service,
terms and conditions of the schemes that could be offered, managerial
requirement, disclosure norms and periodical reporting to SEBI. The
commercial banks are also offering portfolio management service to their
customers. These services are regulated by the RBI which issued a detailed
guideline to regulate this service in 1991.

Guidelines issued by SEBI in 1993 have been replaced by a new set of

guidelines viz. Securities and Exchange Board of India (Portfolio Managers)
Regulations, 2020. As per these guidelines portfolio managers shall not
accept funds or securities worth less than Rs. 50 lakhs in respect of new
clients w.e.f 1-10-2020. As per the new regulation, the minimum net worth
required for a portfolio manager which was originally Rs. 50, lakhs in 1993
has been revised to Rs 5 crore. Regulations 2020 requires every portfolio
manager to appoint a custodian, irrespective of Assets Under Management
(AUM), except portfolio managers who provide only advisory services.

d) Stock Broking

The stock brokers who are the members of recognised stock exchanges
enable the investors to buy and sell securities in the secondary market. They
also act as a broker to the companies which want to raise capital in the
primary market. The stock broking service is regulated by the Securities
Contracts (Regulation) Act, (SCRA)1956 and its Rules 1957, SEBI (Brokers
and Sub-brokers) Regulation 1992, and the by-laws of Stock Exchange where
the broker is a member. While the SCRA regulates the stock exchanges, the
Securities Contracts (Regulation) Rules, 1957 prescribes the qualification for
membership of a recognized stock exchange, books of accounts to be
maintained by the members and the minimum number of years the
documents and books are to be maintained. The SEBI regulation requires
84 compulsory registration of members of stock exchange and prescribed net-
worth requirement and capital adequacy norms, books and records to be Regulatory
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maintained and code of conducts to be adopted by the members. The SEBI
also has the powers to inspect books and records and investigate the investors
and other brokers complaints against the stock broker. The sub-brokers are
also governed by the same regulation and SEBI requires them to be registered
through a member of stock exchange under whom the sub-broker will
transact business. The by-laws of the stock exchange is in the nature of self-
regulation and varies from exchange to exchange. It generally prescribes how
the members have to conduct the business and deal with other members of
the exchange. It also prescribes how disputes between the members, and
members and investors are to be settled. In addition to the above three
regulations, the members of stock exchange need to have a working
knowledge on the Negotiable Instruments Act, 1881, Indian Stamp Act, 1889
as in force in their respective states, and provisions relating to Goods &
Services Tax. (GST) released by CBIC (Updated as on 27.12.2018)

Certain new regulatory guidelines those were issued on 20-6-2019, 1-8-2020

and 30-03-2021 briefly stated they are as under

a) Trading member/ clearing members are barred to raise funds from

pledging securities of clients lying in the ‘client collateral account’,
‘client margin trading securities account’ and ‘client unpaid securities
account’ even with their consent.

b) The new rules will penalise brokers who fail to collect margins up-front
for intra-day trades. This will end the practice of brokers allowing clients
to conduct leveraged intraday trading in cash segment, without depositing
the required margins.

c) Stock broker who acts as an underwriter shall enter into a valid agreement
with the body corporate on whose behalf it is acting as underwriter.
Further every stock broker acting as an underwriter shall maintain certain
books of account and documents.

Activity 3.2

a) Explain the role of RBI, IRDA and SEBI as regulators.

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b) What are the main functions and powers of Securities and Exchange
Board of India?

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Indian Financial ...................................................................................................................
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c) What do you understand by the term stock broking? Are there any
regulatory guidelines for this sector? If yes explain in brief

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3.6 REGULATIONS ON MERCHANT BANKING

AND OTHER INTERMEDIARIES
There are several intermediaries associated with management of public and
rights issue of capital. While the Merchant Banker is the main
intermediary, Merchant bankers as defined under the SEBI (Merchant
Bankers) Regulations, 1992, have traditionally been in charge of conducting
due diligence on all documents relating to the offer prior to IPOs, FPOs,
and even right issues. They felicitate in making arrangements regarding
buying or selling of securities as well as provide advisory service
and portfolio management service to their clients.

Merchant Bankers are also responsible to ensure that companies, that are
listing their stock to the public, make adequate disclosure of information to
prospective buyers. During the time of submission of the draft red herring
prospectus, these merchant bankers are required to file a due diligence
certificate. SEBI has entrusted Merchant Bankers with pivotal role in Initial
Public Offerings. With a view to provide investors relevant information about
the primary market issuances by investment trusts (InvITs), an investor
charter has been prepared by markets regulator Securities and Exchange
Board of India (SEBI) Through its latest guidelines that has come into effect
from January 1, 2022. SEBI has asked all registered merchant bankers to
disclose on their websites, the charter for private placement of units by
InvITs proposed to be listed. Additionally, in order to bring about
transparency in the investor grievance redressal mechanism, the regulator has
directed merchant bankers to disclose on their respective websites, the data
on complaints received against them or against issues dealt by them.

SEBI has laid down a detailed regulatory framework to govern intermediaries

in the capital market and avoid the possibility of default. Various categories
of intermediaries are regulated through the following SEBI rules and
regulations:

86 • The SEBI (Stock Brokers and Sub- Brokers) Regulations, 1992;

• The SEBI (Depositories and Participants) Regulations, 1996; Regulatory
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• The SEBI (Bankers to an Issue) Regulations, 1994;
• The SEBI (Merchant Bankers) Regulations, 1992;
• The SEBI (Portfolio Managers) Regulations, 1993;
• The SEBI (Registrar to an Issue and Share Transfer Agents) Regulations,
1993;
• The SEBI (Underwriters) Regulations, 1993.

These regulations provide detailed requirements to make intermediaries

eligible for registration along with the compliance requirements that need to
be fulfilled during the entire course of functioning, the nature of registration
being perpetual or subject to renewal, the required code of conduct during
functioning in capital markets. The regulations cover guidelines for
maintenance of books of accounts, disclosure requirements, procedure for
inspection of accounts and documents, investigation and inquiry process for
any alleged default, the conduct of adjudication or disciplinary procedure,
orders to enforce the decisions and appeal against such orders.

Table 3.3 : A bird’s-eye view of Regulation on Financial Services

Activity 3.3

a) The merchant bankers are the main intermediary in stock market.

Explain the role played by them relating to capital market

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Indian Financial b) How does SEBI protect the interest of investors?
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c) Apart from merchant bankers who are the other intermediaries in the
capital market?

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3.6 SUMMARY
Financial services industry plays an important role in the economic
development of the country. If there is any collapse in the financial services
industry, it adversely affects the economy. The developments in the East-
Asian countries where the failure of banks and other financial services firms
have thrown out millions of people from their jobs. The Global Financial
Crisis of 2008-2009 is another example of a financial crisis which led to
financial market crashes – either widespread or within specific industries –
housing market crashes and bank runs. A bank run happens when large
numbers of bank depositors panic and seek to withdraw, all at once, all their
funds on deposit with their bank a financial crisis commonly leads to a
notably severe period of overall economic recession. The securities scam of
1992 and Primary market scam of 1994, in India have affected the industries
to raise capital from the public and reduced the level of investments in the
economy.

In order to ensure that there is no adverse effect on the economy, the financial
services industry is the most regulated segment of the economy all over the
world. The objective of the regulation is not to control the growth of the
industry and on the contrary allows growth as well as freedom to operate
subject to fulfilment of certain conditions. Despite strict regulations, the
industry has recorded high level of growth all over the world and efficiency
and innovation are the key to the success of the industry. Thus the objectives
of the regulations are to ensure orderly growth of the industry, protecting the
investors and other participants of the markets and using the industry for the
development of the economy.

The regulations can be broadly classified into structural regulations,

prudential regulations and investor protection regulations. While the
structural regulations cover the main types of activities that different forms of
institutions are permitted to engage in, the prudential regulations aim to
ensure capital adequacy, liquidity and solvency of the institutions. The
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investor protection regulations are designed to protect the investors from the Regulatory
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frauds, malpractice and collapse. There are three forms of regulations that
govern the financial industry. At the macro level, the legislation passed by the
Parliament gives a general regulatory framework and stipulate the
government agency which is in charge for administrating the provisions of
the Act. The regulatory agencies set up by the government like SEBI frame
several regulations at micro level and these regulations, guidelines and
notifications constitute the second form of regulation. The third form of
regulation is in the nature of the industry association frame the operating
system of the industry, code of conduct to their members and procedure for
settling the dispute between the members.

The Banking Regulation Act 1949, Insurance Act 1938, and Securities
Contracts (Regulation) Act 1956, provides macro level regulation on
banking, insurance and securities markets transactions. The Reserve Bank of
India, Insurance Regulatory Authority and Securities and Exchange Board
of India are the major regulators of the industry. They have issue a number
of regulations, guidelines, notifications, clarifications, etc., that govern the
activities of the financial service providers. The stock exchanges, Merchant
Banking Association, Foreign Exchange Dealers Association, Equipment
Leasing Companies Association, etc., have formed separate by-laws and
regulations that govern their members. All these regulations play a vital
role for the development of the financial service industry.

3.8 KEY WORDS

Structural Regulation determines the type of activities that different forms
of institutions are permitted to engage in.

Prudential Regulation covers the internal management of financial service

providers in relation to capital adequacy, liquidity and solvency.

Investors’ Protection Regulation determine the nature and level of

disclosure to be made by the financial service providers to the investors.

Banking Regulations consisting of Banking Regulation Act, 1949 and

Directions from the Reserve Bank of India, govern the activities of the
banking companies.

NBFC Regulations are those directions given by the RBI to regulate

different forms of Non-banking financial companies.

Insurance Regulatory and Development Authority (IRDA) set up as

autonomous body under the IRDA Act, 1999 To protect the interests of
policyholders, to regulate, promote and ensure orderly growth of the
insurance industry and for matters connected therewith or incidental thereto.

SEBI is a statutory body that regulate the securities markets and their
participants with a main objective of protecting the interest of investors.
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Indian Financial SEBI Regulations are set of regulations and guidelines issued by the SEBI
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on various investment institutions and market intermediaries.

Self Regulations are those framed by various industry association that

govern its members activities, code of conduct and settlement of disputes
between them.

3.9 SELF ASSESSMENT QUESTIONS

1) Why scams and defaults occur quiet frequently in the financial service
industry despite regulations?
2) How do you classify the existing regulations governing the financial
service industry on the basis of their scope?
3) What is the role of regulations in a free market economy?
4) How does SEBI regulate fund-based and fee-based activities?
5) What are the objectives of self-regulations? Do you feel self-regulations
are better than formal regulations?
6) What steps have been initiated by RBI to regulate electronic payment
transactions?

3.10 FURTHER READINGS

Brian Anderton, 1995, Current Issues in Financial Services, Macmillan Press:
London.
K. Subramanian and T.K.Velayudham, 1997, Banking Reforms in India:
Managing Change, Tata-McGraw Hill Publishing Co., New Delhi.
L. M. Bhole, 1992, Financial Institutions and Markets: Structure, Growth
and Innovations, Tata-McGraw Hill Publishing Co., New Delhi.
M. A. Kohok, 1993, Financial Services in India, Digvijay Publications:
Nashik.
M.Y. Khan, 1997, Financial Services, Tata McGraw-Hill Publishing Co.:
New Delhi.
Meir Kohn, 1994, Financial Institutions and Markets, McGraw-Hill Inc.:
New York.
Peter S. Rose & James W. Kolari, 1995, Financial Institutions:
Understanding and Managing Financial Services, Richard D. Irwin:
Chicago.
SEBI Act and SEBI Regulations.
Scale Based Regulation (SBR): A Revised Regulatory Framework for
NBFCs- RBI circular dated 22-10-2021
https://www.sebi.gov.in
IRDA Annual Report 2020-21.

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