Are we regulating risk or merely regulating market activity?

ENHANCED RBI COLLATERAL NORMS: IMPACT ON CAPITAL MARKETS

AS THE NARENDRA MODI

Government completes 12 years in office India's macro-economic indicators present a largely reassuring picture. The fiscal deficit and current account deficit remain manageable, GDP growth continues to outpace most major economies, unemployment has moderated, and inflation, despite pressures from global geopolitical tensions and elevated energy prices, remains broadly under control. The principal vulnerabilities lie in the rupee's depreciation and India's persistently high import bill.

Another area that deserves attention is foreign capital flows. Attracting sustained foreign investment requires more than favourable macro-economic conditions. Global investors allocate capital based on relative returns, and in the near term Indian equity markets have not always compared favorably with some international peers. If India wishes to attract larger and more durable flows, it must continue to strengthen the domestic investment climate, maintain a competitive tax regime, simplify compliance requirements, and nurture healthy financial intermediaries. Equally important is ensuring that regulation strikes the right balance between prudence and market development.

It is in this context that the government's recent tax reforms for foreign portfolio investors in government securities assume significance. The measures seek to create a more competitive environment for overseas investors while deepening India's sovereign bond market. Yet attracting capital requires a broader, ecosystem-wide approach. One question increasingly being asked by market participants is whether financial regulation is focused on managing risk or merely constraining activity. That debate has gained relevance with the Reserve Bank of India's revised framework governing credit facilities to capital market intermediaries, scheduled to come into effect on July 1.

The amendments are intended to strengthen prudential safeguards around bank financing linked to capital market activity. That objective is entirely legitimate; effective regulation must identify risks early and ensure that credit is deployed responsibly. The question, however, is whether the revised framework adequately reflects the actual risk profile of the entities and activities it seeks to regulate.

This issue is particularly relevant for stockbrokers, clearing members, proprietary trading firms, and other intermediaries that operate within exchange supervised and clearing corporation-backed frameworks. These entities rely on credit facilities and bank guarantees to meet exchange obligations, provide liquidity, facilitate price discovery, narrow bid-ask spreads and reduce trading for COSTS investors, including foreign portfolio investors.

 The discussion is often framed around proprietary trading, but the term covers a broad spectrum of activities. At one end are participants taking concentrated directional positions in anticipation of market movements. At the other are firms engaged in arbitrage, hedged strategies, liquidity provision and market making. Both may trade on their own account, yet their risk profiles and contributions to market efficiency differ substantially.

India's capital markets have navigated some of the most turbulent episodes in modern financial history, including the global financial crisis, sovereign debt stresses, the pandemic-induced market shock, and repeated bouts of volatility. Throughout these episodes, exchange-related credit facilities, including bank guarantees furnished by brokers and intermediaries to exchanges and clearing corporations, have generally exhibited limited instances of default relative to overall exposure. Outstanding exchange-related bank guarantees are estimated at over 1.2 lakh crore yet the segment has not demonstrated the kind of sustained credit stress typically associated with elevated lending risk.

The risk profile has also been strengthened by a series of regulatory reforms over recent years. These include upfront margin collection, peak margin reporting, daily segregation and upstreaming of client funds, restrictions on the use of client assets as collateral and intraday margin monitoring Together, these measures have significantly enhanced market discipline and reduced the potential for systemic stress.

Moreover, the entities affected by the revised framework operate within highly structured and continuously monitored environments. Transactions are subject to real-time margining, daily mark-to-market settlements, collateral requirements, and oversight by exchanges and clearing corporations. Risks are measured and managed throughout the trading cycle rather than assessed periodically. These safeguards do not eliminate risk, but they materially influence its nature and magnitude.

Banks, too, conduct independent credit assessments before extending facilities to market intermediaries, evaluating financial strength, governance standards, risk management systems, capital adequacy, and historical performance. The broader banking data provides additional context. According to RBI figures, gross nonperforming assets, 2.3% in industry and 2% in ratios, stood at 6.1% in agriculture services and 1.2% in personal loans during FY25. By comparison, NPAs associated with capital market intermediary exposures have historically remained negligible.

This is not an argument for special treatment. Rather, it is an argument that regulation should be calibrated to evidence. Financial regulation routinely differentiates between activities based on risk characteristics. There is merit in applying the same principle here. Market-linked activity is often viewed through the lens of volatility, leading to the assumption that market risk automatically translates into credit risk. In reality, the two are not always synonymous. The issue is not whether prudential safeguards should be strengthened. The RBI is right to ensure that bank credit is used responsibly. The issue is whether regulation can become more precise in distinguishing between different forms of market activity while recognizing that leverage and liquidity are essential components of well-functioning capital markets.

As the July 1 implementation date approaches, these questions deserve careful consideration. The strongest regulatory frameworks are those that align policy with evidence, encourage responsible risk-taking, and support market development without compromising financial stability. That principle should guide this debate as well.

Global investors allocate capital based on relative returns, and in the near term Indian equity markets have not always compared favorably with some international peers.

The risk profile has also been strengthened by a series of regulatory reforms over recent years

(The author is National Spokesperson, BJP)