Principal Economic Adviser Sanjeev Sanyal has made a case for focusing on supervision rather than regulation saying this approach increases efficiency and reduces compliance burden.
In a discussion paper 'Risk vs Uncertainty: Supervision, Governance & Skin-in-the-Game', he said it would be far better to have a simpler regulatory framework supplemented by active and efficient supervision.
The problem is that supervision demands active monitoring and accountability from the government department or regulatory body, he said, adding this creates a perverse incentive to keep adding more top-down regulations regardless of their effectiveness, he said.
"If you had a simple law and some degree of supervision, everything would be much better ... If you have simpler rules, there are fewer things to comply with. In simple system everyone knows what it is," he said.
Observing that a complex law leads to more discretion, Sanyal said, "We have tried to completely remove discretion by virtue of trying to create more and more regulation, which in fact, doesn't help the case. In fact, as we make it more complex, more discretion, not less."
Another point here is no amount of complex regulation is not going to solve the problem of ex-post resolution because you live in an uncertain world, things will go wrong in ways you never imagined, he said.
"So therefore, if things are going to go wrong, you have to allow for the fact that ex-post resolution is important. You therefore have to invest in judicial system. Trying to avoid the judicial system by having better regulation is waste of time," he said.
When asked about IL&FS crisis and PNB fraud, he said better supervision could have avoided these episodes rather than more regulation.
"My argument would be, we needed a better supervision, not more regulation. The regulations as they existed are good enough...If we respond by them and having even tighter regulation, it will have no impact at all if you do not back it up again with supervision," he said.
Irrespective of the quality of regulations and supervision, the fuzziness of a world of Uncertainty further requires systemic trust, he said.
"This implies revitalizing old-fashioned responses such as corporate governance, transparency, ethics and skin-in-the- game. Moreover, there should be a greater acceptance of the likelihood that things will go wrong. No amount of ex-ante planning and rule-making can compensate for efficient ex-post resolution and contract enforcement," he said.
The world of Uncertainty is fundamentally different from the world of Risk, and therefore, it requires policy tools that are also significantly different, the first discussion paper in the series said.
However, the default policy response tends to be dominated by the Risk-based approach.
The financial system provides a good illustration of the conflicts between the two approaches: supervision versus regulation, the reliability of credit ratings, risk shifting, the danger of prescriptive risk weights, genetic diversity and so on.