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Posted by: Uma Shashikant on Mon, May 20th, 2013

Regulatory Arbitrage

The Economic Times reported a story on regulatory arbitrage today. The SBI chairman suggested that home loans by non-banks should come under RBI, instead of remaining with the National Housing Bank (NHB). He pointed out that having two sets of regulators for the same product can create regulatory arbitrage. The CEO of HDFC made a case for continuing with the NHB. The arbitrage arises when RBI asks banks making home loans to follow a set of rules, while NHB may ask non-banking home loan companies to follow another set of rules.

 

Regulatory arbitrage refers to the practice where an entity takes advantage of the differences in two different sets of rules. It refers to practices that exploit loopholes in laws and rules, where the practice itself cannot be termed as illegal, but advantageous to some parties. Usually lawmakers try and plug the loophole to prevent a regulatory arbitrage.

 

For example, mutual funds dividends are exempt from taxation. However, mutual funds may earn their income from interest, by investing in bonds, as is the case in a debt fund. Interest income in itself is taxable. This creates a regulatory arbitrage. The interest earned by a mutual fund, when passed on to the investors as dividend, becomes exempt. While both acts of earning an interest, and passing it on to investors are legal and correct, the combination offers a regulatory arbitrage. Investors can earn an exempt dividend income by investing in a debt fund, than directly in debt and earning a taxable interest income. This is an example of regulatory arbitrage.

 

The government has tried various things over the years since dividend become exempt in 1999, to plug this regulatory arbitrage. The ability to earn a tax-exempt dividend in a debt fund directly makes a bank deposit or any other interest-bearing product unattractive as compared to a debt fund. The dividend distribution tax (DDT) was introduced to plug this loophole and reduce the regulatory arbitrage. DDT was imposed on all funds whose source of income was primarily not in the form of exempt dividends. As of now, if a fund invests less than 65% of its corpus in equity, it is deemed to be making most of its income from non-dividend or debt sources and is therefore subject to a DDT. DDT rates have been changed in various ways, and as of now the applicable rate is 25% for all non-equity funds, if the investor is an individual and 30% if non-individual.

 

Regulatory arbitrage arises when it becomes tough to bridge the gap created by different laws and rules, enacted within their own context, but applicable to entities that may be subject to more than one of them. Some loopholes remain, while others are plugged ending the ability to make profits from such arbitrage.

Job Neroth on Tue, May 21st, 2013 8:39:24 pm

Yes, the SBI Chairman is right in asking for a level playing field in the Housing loan market. Right now, companies like HDFC Ltd - which comes under the NHB - does not need to (and also won't) follow RBI guidelines on home loan lending under the Base Rate. This is against the spirit of the RBI guidelines to provide transparency to customers on the interest charged to them. In the regard, HDFC and other companies under the NHB falls far short in being transparent. This regulatory arbitarage results in an unfair advantage for these companies under the NHB, while also following anti-consumer practices... which has been changed by the RBI in case of banks under their purview.

prakash on Tue, May 21st, 2013 6:27:01 pm

In case of housing loan,Banks are subjected to CRR and SLR requirements and hence source of funding of housing loans becomes costlier but in case of HFCs,there is no such requirement.However for HFCs,CASA deposits are not available for funding and hence they have to access higher interest source of funding.I presume SBI Chairman is referring to these issues when refering to arbitrage.He is right.

Sachin Sunder Poojary on Tue, May 21st, 2013 2:50:20 pm

Yes,In india we are facing an extreme regulatory arbitrage in terms of various products floating in the market. It creates ambiguity in terms of visibility of governance and creates loopholes in the law and rules regulating the products. hence it effects not only the productivity of the economy but also increase customer dissatisfaction in terms of clarity and understanding the market. But in reality, markets and various products are interlinked and for each product we have different regulators, and thats where it creates the problem and ambiguity. Most importantly all regulators need to be streamlined by removing dual taxation, alligning rules and laws, removing ambiguity and proper governance structure.

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