Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Mon, 26 Apr 2010

Principles versus rules: HSBC Mutual Fund in India

An order passed by the Securities and Exchange Board of India (SEBI) on Friday regarding a mutual fund run by HSBC in India provides a fascinating example of the advantages of principles based regulation.

Indian regulations require that before a mutual fund makes a “change in any fundamental attribute” of any mutual fund scheme it should not only inform all unit holders but also give them a costless exit option (Regulation 18(15A) of the Mutual Funds Regulations). The regulations do not define what is a fundamental attribute so that absent any further “clarifications” by the regulator, we would have a very sensible principles based regulation.

In 2009, the HSBC Mutual Fund made the following changes in one of its mutual fund schemes, the “HSBC Gilts – Short Term Plan.”

Under a principles based regulation, there is no question that this would be a change in the fundamental attribute of the scheme. In fact, it changes the nature of the scheme so drastically that it is conceivable that many investors in the original scheme might not wish to remain invested in the changed scheme.

Unfortunately, the SEBI regulations were not truly principles based. Way back in 1998, it issued clarifications that replaced the nice principles based regulation with a set of bright red lines by giving a laundry list of things that are fundamental attributes. Neither the change of name, nor the change in the modified duration, nor the change in the benchmark index figured in this list.

The regulator was forced to accept that HSBC was technically correct in claiming that it had not changed any fundamental attribute of its scheme.

The moral of the story is that while principles based regulation is genuinely hard both for regulator and regulatees, rules based regulation is often a farce.

Posted at 19:41 on Mon, 26 Apr 2010     6 comments     permanent link


kartikeya wrote on Thu, 29 Apr 2010 12:09

Re: Principles versus rules: HSBC Mutual Fund in India

Loopholes. We are good at inventing them.

Secret Admirer wrote on Fri, 30 Apr 2010 12:26

Re: Principles versus rules: HSBC Mutual Fund in India

Dear Sir,

Many people i meet, i tell them that IIM(A) has credibility & a brand name because of Mr JR Verma & not vice versa.

Its a small compliment for your tireless hard work.


Mandar Kagade wrote on Wed, 28 Apr 2010 20:54

Re: Principles versus rules: HSBC Mutual Fund in India

I am in complete consonance with moral of the story that you derive, Professor Varma. In law and economics in fact, rules versus standards (aka principles)is a celebrated debate. However there is more to the fact that SEBI regulations are NOT principles-based than merely unfortunate circumstances. The explanation lies in the Buchanan-Tullock-North-inspired school of public choice.

As indeed you will appreciate, diffuse shareholders in the securities markets suffer from collective action dilemma. They thus cannot organize efficiently to lobby the regulator for supply of law that "suits them", whereas securities intermediaries and other market players are relatively smaller concentrated groups that can organize at relatively low cost and effectively lobby the regulator for the type of law that suits them. Bright-line regulation reflects these bargains. The MF regulations is not an isolated case-- there is also the precedent of how clause 49 came on the law-books.(cf. Armour/Lele for e.g.)Rules are in demand because rules promote lobbying and these concentrated groups have an edge in lobbying game. Put differently, bright-line regulation reflects regulatory capture.

The other sinister reason is that rules are not robust to strategic action by the actors whereas the standards/principles are robust to strategic action by actors.

Christie Ford has recently written on PBR giving example of securities regulation in British Columbia. Other authors include Julia Black of LSE and Lawrence Cunningham (per contra).

Nikhil wrote on Wed, 05 May 2010 06:14

Re: Principles versus rules: HSBC Mutual Fund in India

Thanks for writing interesting pieces regularly. You should get feedblitz so your posts can be emailed directly when you update, which would be easier for those who follow you.

mp wrote on Tue, 11 May 2010 12:46

Re: Principles versus rules: HSBC Mutual Fund in India

Beautiful example. Thanks for this post.

Jatin Mehta wrote on Tue, 14 Sep 2010 11:40

Re: Principles versus rules: HSBC Mutual Fund in India

It would be interesting to find how frequently such contradictions are dealt with by the regulatory authorities. A lot has changed in India, let alone the Indian stock market, since 1998. The rules based on regulations are surely easy, but a regulatory body like the SEBI which deals with enormous volumes of investments and investors, must have a way to incorporate changes at regular intervals, say every 2 / 3 years, to take care of such disparities. In the example cited, HSBC could very well be right in claiming that it had not changed any fundamental attributes based on the list of such attributes provided by SEBI. But the changes that were made were clearly fundamental on which an investor would have gone for the fund; even a layman without the knowledge of the financial market would comply with. To deal safely, it is advised to go in consonance with the expert advice of a broker like GEPL. You can check for their <a href="">mutual fund investment</a> advisory services.