Keep it strict

The Reserve Bank discussion paper on entry into banking is an important and valuable step forward in the process of building a sophisticated banking system. There is no doubt that the RBIs historical experience has involved too few banks coming in. And yet,this does not mean we must open the floodgates. Ordinarily,in economic policy thinking,more competition is always better. But there are places,such as banking or critical financial infrastructure,where this reasoning breaks down. There is the risk of unscrupulous promoters milking the bank and taking it to bankruptcy. The Indian state is unable to allow a bank to go bankrupt and,in such a scenario,is likely to then come in with fiscal support which protects depositors. Therefore,promoters can steal from the state.

The debate on whether industrial houses should be allowed into the sector addresses only a part of the problem. A bank connected with an industrial house can engage in inappropriate lending to related parties. But an unscrupulous promoter can also undertake inappropriate lending. The real problem is not with the fact that there can be related-party lending by house banks of industrial houses. The real problem is that powerful industrial firms in India are more likely to bring political and media pressure to bear on regulators to get them to bend the rules. These identical issues are being faced by SEBI and have led to the Bimal Jalan committee on ownership and governance of exchanges.

Ownership and governance,and fit and proper tests,are hence of the essence. If the objectives of an ownership and management structure are in the wrong direction,then the weaknesses of courts and regulators in India are going to lead to trouble.

It may be too much to ask for high quality regulation,so that unfit and improper lenders can be constrained to do the right thing. It is essential to force a sound ownership and management structure at the outset,and enforce strong and proper tests upfront,so that the outcomes are likely to be good,given even the most pessimistic assumptions around about capabilities to enforce regulations and act upon bad practices.