The series of financial crises that swept through many parts of the developing world during the 1990s and, more recently, the problems plaguing financial markets in the United States, the European Union and Japan have raised serious questions about the regulatory environment of the financial markets globally.

Background

Unfortunate events of the decade of nineties and the beginning of the 21^st century have led us to believe that regulators around the globe have failed to achieve their primary objectives of 'maintaining systemic stability' and 'protecting interests of the retail customer.' Be it the Brazilian, the Argentine or the East Asian crises; be it Enron, WorldCom or US-64; the retail investors have taken the brunt of it all. Economies have been wiped out.

The financial sector plays an important role in the economy of any nation. A well-regulated and well-developed financial sector is vital to achieving the most basic need of efficient allocation of scarce resources.

The main objectives of any regulator are to improve market efficiency, enhance transparency, and prevent unfair practices.

In the financial sector, the achievement of these objectives would mean increase in resource mobilisation, enhanced access to financial products and services, and sustained economic stability. The International Monetary Fund recognises the need for 'resilient, well-regulated financial systems for macroeconomic and financial stability in a world of increased capital flows.'

"The crises that have swept emerging market nations in recent years should have left no-one in any doubt about the importance of a strong and well-regulated financial sector, in dealing with capital flows that can be very large and reverse very quickly."  -- IMF Managing Director, Stanley Fisher, June 2000.

I now look at a few events that shook the financial markets and the challenges they pose to the regulators.

The events and the challenges

In the aftermath of the East Asian crisis the regulators in many countries have been engaged in reforming the international financial architecture to deal with dangers facing the financial markets which have been enhanced due to globalisation and liberalisation of economies.

The dynamic growth in capital markets following the liberalization of financial markets in many countries occurred without domestic economy and financial weaknesses as well as the regulatory and supervisory frameworks being taken fully into account.

The events of September 11, 2001 too shook markets across the globe. The main financial market response was a flight to quality as investors' appetite for risks fell. All major stock markets experienced rapid, sharp price declines in the immediate aftermath of the event.

Insuring the investors against terrorism became another challenge for the regulators.

Investor confidence is a critical factor to the growth and success of the capital market, and on a larger scale, critical to economic stability. Confidence in some capital markets has deteriorated, partly because of corporate governance transgressions that have been under global scrutiny.

Accounting controls have been on the top of the mind of regulators since a series of accounting scandals such as ENRON, WorldCom and more recently, HealthSouth, in the USA. The European Union is also looking towards tighter accounting controls after the insolvency of dairy giant Parmalat due to irregular accounting practices.

The point to note here is that the accounting scandals in the US occurred at a time when the disclosure norms in the US were very stringent and well defined. According to Commissioner Paul Atkins of US Securities and Exchange Commission, these accounting scandals have resulted in the erosion of a staggering amount of $5 trillion from the capital markets.

Investors around the globe are asking the question, 'If it can happen in the US, why not elsewhere?' The challenge to the regulator is, therefore, to reassure investors that such abuse of the system will not be allowed to become the norm.

The need to implement and follow the rules not only by the letter, but also by the spirit is evident. Hence, corporate governance has become the most debated topic amongst the regulators recently.

The Indian scenario

The Indian stock markets are now amongst the best in the world in terms of modernisation and the technology. India was among the few countries, which was not badly effected by the contagion effects of the Asian crisis of 1997. Policy makers attribute this to the slow and cautious pace of capital account liberalisation.

However, it has also been a decade marred with scams, which were huge even by international standards, revealing the many gaps in our regulatory regime.

In 1991, a group of stockbrokers, headed by key trader 'Big Bull' Harshad Mehta artificially jacked up prices of worthless securities to rake in Rs 5,000 crore (Rs 50 billion). The Sensex came tumbling down after the scam story broke out on April 23, 1992. Fortunes were lost overnight. As a result, the ambit of the Securities Exchange Board of India, the stock exchanges and regulatory financial institutions was widened.

Nearly a decade later, after a 'dream budget' by Yashwant Sinha, the then finance minister, on February 28 2001, the Bombay Stock Exchange index rose initially but thereafter crashed. Nearly 700 points were lost in eight trading sessions leading to erosion in market capitalisation of Rs 146,000 crore (Rs 1,460 billion).

This erratic behaviour was once again traced to a handful of brokers, wishing to trap a leading 'bull', Ketan Parekh, who had manipulated prices of shares of a few select companies in information technology, communication and entertainment sector.

Units of US-64, the flagship scheme of Unit Trust of India --the largest public sector mutual fund in India, dropped from a peak of Rs 19 to Rs 5.81 in January 2002. Middle class people and retirees were the hardest hit because of the irregularities.

The recurrence of financial 'scams' periodically exhibits the helplessness of regulators, particularly the SEBI and the Reserve Bank of India [Get Quote]. "It is easier to build a modern stock exchange from scratch than change century-old trading practices," says Jayanth Varma, a former board member at SEBI. Traders loathe any change in the market because many thrive on its imperfections.

Against this backdrop, the regulatory bodies are making endeavours to bring up the Indian market to international standards. It is working towards making India a global benchmark for capital market development.

The road ahead

Today-- with the 'feel good' factor about India in the global arena rising, increased confidence of the investors in the Indian market, Sensex looking more attractive than ever before, foreign exchange reserves at an all-time high of more than $140 billion -- is the most vulnerable period for the regulators of the Indian financial sector, particularly SEBI and RBI.

Major steps towards reforms, liberalisation and globalisation have been taken in the 1990s, now the hiccups need to be sorted out. Maintaining stability is of prime concern. The time seems ripe to address the gaps in the regulatory framework, when the times are relatively good and peaceful. Prevention is better than cure.

Some of the issues that need the regulators' attention and action in the Indian financial markets are:

Participation and education of retail investors: Encouraging and protecting the rights of retail investors is an important issue. In Indian markets it is a challenge to get these investors to participate in the securities markets.

Also, as new instruments like the derivatives are being introduced in the market, the emphasis on investor education should also be enhanced. Then the issue of providing a level playing field for these investors also remains so that there is continued confidence in the market.

Liquidity: Even though the shares of companies listed on major stock exchanges are fairly liquid, the options market suffers from illiquidity.

Enhancing liquidity in the options markets to facilitate trade at reasonable prices is required to encourage investors to hedge their portfolios and to facilitate companies to manage their risks.

Accounting and financial reporting norms: Financial disclosure requirements in India are not at par with international accounting practices in spite of attempts made by the Institute of Chartered Accountants of India. Good accounting and corporate standards need to be backed up by high moral and ethical standards by accounting and the corporate world.

Corporate governance: With sophistication in the marketplace, the demand for improved corporate governance by public companies will also increase. Ensuring high confidence of the investors in the business so as to improve investment levels through good corporate governance is a must.

Adopting a suitable framework of corporate governance and the extent of observing the framework in practice is an issue that requires to be addressed.

Technology: Regulators must keep up with the sophistication in market technology and new market structure. Enforcement cases will become more complicated as market manipulation and other misconduct are now also conducted on the Internet, making it more difficult to be detected.

A robust system ensuring good surveillance against cyber crime should be updated from time to time. Also, whether a demutualized exchange should be regulated as any other listed company, or as a utility, will be a challenge for the regulators.

Integration with other financial markets: The adoption of international best practices, sharing more information with the regulatory bodies globally and co-operation with international bodies is important. Global benchmarks should be adopted through education, assistance and advisory services to its members.

Organisations such as International Organization of Securities Commissions, the Bank of International Settlement, the Joint Forum and the Financial Stability Forum have led initiatives to introduce best practice or international benchmarks in regulation to counter global vulnerabilities such as weaknesses in market foundations, uncertain growth prospects, difficulties in surveillance and enforcement of financial conglomerates and increased investor risk aversion.

Conclusion

Former prime minister Atal Bihari Vajpayee summed up the requirement of the Indian financial markets, after the Ketan Parekh scam came to light. He told regulators to make markets safer for investors and called for more rigour in the market place.

"We need markets that are known for their safety and integrity. We need knowledgeable investors. And we need to build a sustainable, high-growth economy which will ensure better living conditions for our people, now and in the future," Vajpayee said.

"I urge all of you -- regulators, market intermediaries and investors -- to join hands to make our capital market the safest places to invest in the world," he had said. "While the technology and the regulatory framework of capital markets has improved, I am pained to say the standards of corporate governance have not kept pace. We have come across far too many instances of companies that have raised money from the market by creating hype and then defrauding their investors," he said.

Former finance minister Jaswant Singh added that more teeth recently given to SEBI offered it the legal right to impose sterner penalties on violators of stock market rules.

Investors will be the ultimate beneficiaries of all these changes in the marketplace. Investors will have more choices and information on investment products, easier accessibility to any market they wish to trade on, and better and cheaper services from intermediaries.

The new generation of investors will become increasingly sophisticated as market information becomes widely available. However, the complexity of the new markets also means that investors must know their own risk appetite before entering the market.