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Process Reforms: Enabling decision-making under uncertainty 187

risk that she labelled “complexity risk.” For instance, the legislation requires bank boards to be
responsible for 184 additional activities, which may be unnecessary — or even impossible.

6.14 This reveals that having more stringent regulation may actually mean that exercise of
discretion on the ground is more, not less. Thus, it is clear that in a world full of uncertainty and
complexity, it’s not possible to substitute effective supervision with more prescriptive regulation.
Note that employing third-party supervision cannot substitute the process of simplifying
regulation to lower opaque discretion because as argued above verifiability of efforts and actions
by any third party is minimal when contracts are incomplete. Therefore, the question then arises
is how can we allow for discretion such that is not misused and leads to effective supervision.

THE PROBLEM OF REGULATORY DEFAULT

6.15 From the discussion in the previous sections, it is clear that there is a need to create simple
regulation and complement the same by providing flexibility and discretion to the supervisor.
However, if the legal and institutional frameworks do not explicitly limit mushrooming of
regulations, policymakers may naturally drift towards more regulation, even if it is sub-optimal
for the economy. While analyzing the principal-agent problem, Holstorm & Milgrom (1979)
argue that multi-dimensional tasks are ubiquitous in the world and agents have to divide their time
among various duties. In such cases, agents choose the tasks whose outcomes are measurable.
For instance, if there is an incentive pay for teachers based on their students’ test scores, then
teachers will focus on the narrowly defined basic skills that are tested on standardised tests
and not on the various aspects of student learning. In effect, they will focus on what can be
effectively measured. Similarly, as regulation can be easily measured while supervision cannot
be measured easily, regulators and decision-makers would prefer to substitute supervision with
more and more regulation. After all, regulations provide criteria or checklists, making it easier
for regulators to follow and reduce their accountability later on. On the other hand, it is difficult
to quantify the amount and quality of supervision. Naturally, policymakers by default tend to
favour prescriptive regulation. This creates a perverse incentive to keep adding more top-down
regulations regardless of their effectiveness. The following section discusses this in detail.

(a) More regulation is added over time regardless of its effectiveness

6.16 Since regulation is a more mechanical, top-down approach, it often becomes the default
response of policymakers. This has promoted the culture of ‘regulate first, ask question later.’
(Australian Government taskforce report, 2006)
6.17 Several such examples abound in India. The Commerce Ministry’s Report of the High-
Level Advisory Group (2019) noted a maze of complex and stringent regulations to stop ‘round-
tripping’ of funds. The report highlighted that ‘the baggage of round-tripping cannot be used
to stifle the financial services sector any more than using the risk of a traffic accident to stop
construction of a key highway’. Another example is the unintended consequences of ever-
increasing bank regulations which has led to shifting of market activity to “shadow banks” (also
called “non-bank financial intermediaries”) where the scope for regulatory arbitrage is higher,
especially as banks become more averse to lend to high-risk borrowers and/ or small borrowers.
Increasing regulation in one part of the financial system has shifted risk to the less-regulated,
less- transparent part of the financial system (Sanyal, 2020).