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Dilution of efficiency-based principles has implications for all borrowers, not just the chronically unhealthy

Amartya Lahiri writes: The dilution of efficiency-based principles for banking has implications for all borrowers, not just the chronically unhealthy.

Written by Amartya Lahiri | Updated: October 14, 2020 8:59:15 am
The Reserve Bank of India in Mumbai. (Bloomberg Photo)

Financial markets are a key artery of modern economies. Banks along with bond and equity markets oversee the matching of savers with borrowers. Without the matchmaking services of financial markets, businesses would be restricted to investing out of retained earnings alone. The tasks performed by these markets are non-trivial. They have to satisfy the return appetites of savers by looking for projects with the highest returns while simultaneously doing due diligence to minimise their risk exposure. As can be imagined, these two goals are often contradictory which makes the regulatory oversight of these markets a fundamental element of a country’s financial infrastructure.

Two recently published books reveal the sustained hollowing out of the financial architecture in India over the past five decades, a process that continues unabated. In “Quest for Restoring Financial Stability in India”, the former deputy governor of the Reserve Bank of India (RBI), Viral Acharya, dwells at length on the fiscal dominance exercised by the central government over the central bank and its regulatory functions. In a very related spirit, Urjit Patel, former governor of the RBI, paints a sharp but dark picture of the fiscalisation of the entire banking infrastructure in his book “Overdraft: Saving the Indian Saver”.

A major theme of Acharya’s book is the rampant subjugation of the financial and monetary infrastructure to the fiscal interests of the government. There are many examples of such fiscal dominance in India. The obvious one is the conduct of monetary policy. Since bank assets are marked to market, cuts in interest rates induce treasury gains for banks that effectively recapitalises them. Consequently, rate cuts are preferred by governments needing to inject capital into public sector banks (PSBs) with NPA overhangs. For similar reasons, liquidity injections, which raise bond prices, are preferred to liquidity absorptions. Indeed, fiscal compulsions can induce liquidity policies that undercut the rate setting by the MPC as the two arms often work towards opposing goals. This contradiction is further complicated by the fact that the RBI is also the debt management agency for the government with one of its key tasks being to sell government bonds at the highest possible price.

Acharya refers to this fiscal dominance as a theory of everything in India, including the regulatory framework. Pressures for regulatory forbearance in recognising NPAs often arise from the government wanting to avoid having to recapitalise PSBs. The same incentive potentially also accounts for stock exchanges in India having a 30-day disclosure norm for registered borrowers who default on their bank loans. The standard in developed capital markets is immediate disclosure. But that would induce an overnight rating downgrade of the concerned borrower thereby triggering additional capital provisioning needs for the lending bank. He provides more such examples, including the raiding of central bank capital.

Patel’s book expertly brings out the conflicts inherent in the state owning the banks that control about three-fourth of total banking assets in India. The primary problem with PSBs is that governments have used them as tools for macroeconomic management. PSBs are regularly used for resource mobilisation to finance fiscal deficits. We also have the farcical situation wherein the government often announces credit policies rather than having the banks allocate credit based on risk-return management criteria. Indeed, PSBs are the favoured instrument for meeting employment targets, supporting farmers through loan write-offs, etc.

This kind of state interface with the business of financial intermediation naturally induces extreme levels of moral hazard in the behaviour of both debtors and creditors. PSBs are not incentivised to exercise due diligence since they expect regulatory forbearance and recapitalisation in the event of rising NPAs on their books. In contrast to the “constructive ambiguity” that sometimes surrounds prospective bailouts of banks in developed economies, Patel calls expected bailouts in India “destructive unambiguity.” All sides of the market expect bailouts and are seldom unpleasantly surprised.

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The dilution of efficiency-based principles for banking has implications for all borrowers, not just the chronically unhealthy. Creditworthy borrowers pay the risk premia to cover the riskiness due to unhealthy borrowers. The worsening risk pool of borrowers is partly to blame for the fact that long term borrowing rates have remained stubbornly high despite repeated rate cuts by the MPC over the past 18 months.

There are three obvious problems with the existing architecture. The first is the state ownership of banks. The second is the chronically high fiscal deficit run by the consolidated public sector. The third is the widespread perception that market regulators work under close government direction. The interactions of these three factors have rendered hollow the existing financial infrastructure of the economy.

Dealing with this will require, at a minimum, three reforms. First, there has to be a wholehearted attempt at privatisation of PSBs.

Second, the RBI needs to be relieved of its public debt management role. Third, the RBI has to be empowered to act independently of the government. It is untenable for government-owned banks to be regulated by an agency that is itself reporting to the government.

While legislating regulator independence would be the long run fix, a good start would be to stop the practice of appointing favoured bureaucrats as heads of regulatory institutions. The career progress of these individuals is typically based on their ability to implement political instructions. Hence, their very appointment destroys perceptions of competence and independence of the regulator.

There is a complacency in policy circles surrounding the political and economic prospects of India.

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Hence, one expects little action on financial sector reforms over the near term. It bears repeating, though, that the growth of firms, which is a key driver of productivity and growth, requires well-functioning financial markets. India has a lot of work to do.

This article first appeared in the print edition on October 14, 2020 under the title ‘A hollow credit architecture’. The writer is Royal Bank Research Professor of Economics, University of British Columbia.

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