News

Alternative Approaches to Regulating Financial Institutions

"Proposals on different approaches to regulating the financial sector "

The traditional model of regulating the financial sector primarily concerned with rules and regulations has not and will not work for the region. This approach has been slow in fostering economic advancement and has excluded a large portion of the population from participating in the economy. This is evidenced by the sluggish economy, low levels of access to banking services and facilities among the citizens.

At the same time, across the region and in most of sub Saharan Africa, regulators are trying to catch up with the changes in the sector. In a short time period, we have witnessed the emergence of new regulations and strategies that are geared towards keeping the regulator relevant in this sector. In Uganda for example, a suite of new regulations has been drafted to include Islamic banking and agency banking. In Kenya, there was a decision by the Central Bank to cap interests’ rates which move was highly criticized. With regulators doing their best to regulate the financial sector, the regulations do not seem to address wholesome issues within the sector.

However, rules and regulations serve an important role especially in developing societies that are agrarian.  Even in these countries one has to be mindful of over regulation, because it tends to create resultant alternatives such as mobile money which had until the recent imposition of a percentage tax on any transaction, lowered the number of transactions done in the bank.

These regulations are usually inadequate in defining what constitutes a financial institution. With the emergence of new technologies, the business functions undertaken by any company can potentially qualify it as a financial institution irrespective of whether it is regulated or licensed under the Financial Institutions Act or similar regulation. An example would be telecom companies, would they qualify as money lenders or banks by virtue of the fact that they accept deposits and extend credit through their mobile money platforms? Does a function automatically make an entity a financial institution?

An alternative to a regulation based approach would be a principles based approach which is fluid in nature. In this approach, the regulator sets guidelines that point to a certain desired outcome with minimal oversight and reporting requirements. However with low levels of financial literacy, this approach presents a number of risks. The choice between the two approaches is not an obvious one. For Uganda’s case, despite the robust financial laws post 2004, we have witnessed a closing of many banks since 2004. On another limb, more financial institutions have opened businesses since 2004, which could be credited in part to the rules and regulations that have created an enabling environment.

To decide which approach is best, we must inquire what the rationale for regulation is. Financial regulation serves numerous purposes, but most notably protection of consumers of financial services. Financial regulation is also intended to steer the economy in whichever direction the government desires. It can be used to control forex in the economy and to monitor liquidity. It can be used to enhance trade and to boost specific sectors in the economy. It may also be used for political ends.

Whichever approach is used, the regulator still has to grapple with the basis or the model of regulation. Regulating the sector could be based on the legal status of the institution. This means that an organization’s legal status determines the regulator which is tasked to oversee its activities. For example if the status is that of a bank, the regulator would be the Central Bank, if it is not a bank, another regulator would be appointed even if the services are akin to the workings of a bank. Regulating the sector institutionally offers convenience and a sense of control which is advantageous to the regulator only. As alluded to earlier, the similarity in function of institutions could mean that an institution could have the identity of one or more institutions. It can be firmly suggested that an institution which offers insurance and banking or quasi – banking services should obtain a license from the Central Bank and from the insurance regulator, or a telecom which accepts deposits and extends credit should be regulated by the Central Bank in addition to the regulator for telecoms. The pandemonium that could result from this is quite obvious and businesses would resist this.

If regulation based on the legal status is not practical, then the business function could be the basis of regulation. Supervisory oversight should be determined by the business activities/functions that are being transacted without regard to the legal status. Therefore each type of business in an institution could have its own regulator. However this still presents a number of problems.

An integrated approach would be the preferred option. Under this approach, a single regulator offers oversight and business regulation for all sectors of financial services. This approach is efficient in a small market but maybe rendered useless in a rapidly growing economy. From a number of experts however, a unified regulator has been mooted as ideal to bring about consistency and uniformity. Uniformity however cannot be achieved when there are a number of local conditions to be taken into account, flexibility is required in order to accommodate all players.

There is no one size fits all approach, due care must be taken to accommodate different local conditions. Regulation is useful and in making this regulation, a case by case study looking into the actual need/changes of the financial sector as well as the rationale for regulating the sector will be useful in enabling a functional system.

Author, Henry Owen

Associate at Shonubi Musoke & Co.