Central bank’s sermon from the mount

Report on banking trends points to a financial system skating on thin ice

S S Tarapore

The Reserve Bank of India’s Report on Trend and Progress of Banking in India 2000-01 takes stock of the financial sector reform process, but while providing an excellent status report, it also subtly indicates for whom the bell tolls. With characteristic moderation, the report narrates a perspective of the prerequisites of a stable, robust and efficient banking system. In many ways the report writers face an impossible task. For whom is it written and what is the level of understanding of the target group? The report is meant to be directed at academics, policy makers, the bureaucracy, legislators and the general public. Given the mixed bag target group, the report faces frequent difficulties of levelling with its audience.

It propounds that with increasing globalisation and a blurring of distinction between different segments of financial intermediaries, there is a growing recognition that safeguarding the health of the financial system is of paramount importance if financial stability is to be maintained. While the report attempts to set out the policy initiatives during the year, the reader could safely skip this part as it is a repetition of earlier policy statements and stock-taking reports. But what about the supervisory initiatives and operational measures taken to strengthen the banking system?

The report reveals that during the year under review, the Board for Financial Supervision reviewed inspection reports of 27 public sector banks, a consolidated report of local head offices of the State Bank of India, 26 private sector banks, 50 foreign banks and six financial institutions. By all counts, the BFS has been working extremely hard. In the context of the unreasonably severe rap taken by SBI’s New York office for a relatively minor infringement, one is the led to ask whether the BFS’s labours revealed any infringements and the action taken thereon. The search for information on adverse action proves futile as the report reveals no information.

It merely gives a glimmer of hope that the system of Prompt Corrective Action is not still-born and that the scheme will be implemented. The concern one has is that the RBI has approached the owners of the banks (the government) for clearance of the PCA ostensibly on the ground that some of the actions under the PCA regime require approval of the government. This apart, the blanking out of information on infringements would leave one with the fact that we have a zero-infringement financial environment.

Unfortunately, it is well known that infringements are endemic in the system. The public has the right to know whether there were infringements and whether the RBI had imposed any penalties. In all probability, the RBI has a soft heart and has not imposed penalties this year. If the RBI wants to wax eloquent about transparency, then it is incumbent upon it to reveal the facts about infringement and action taken. The RBI would be advised to start imposing penalties for infringements and widely publicise the adverse action. This is the only way to ensure effective supervision. Supervision sans adverse action is totally ineffective.

The report talks about risk-based supervision and the setting up of a project implementation group. One hopes that banks/FIs are gearing up to deal with the new system. The fear is that the risk management system in banks/FIs is not integrated into operations and compliance is in form rather than substance. Again, the New Basel Capital Accord is far too complex and we in India need a child’s guide for the use of banks and FIs.

The real value added in the report is in the tabular information, both in the text and the appendix. Table I provides meaningful information on bank recapitalisation (Rs 20,446 crore), capital written down (Rs 6,334 crore), and capital returned to government (Rs 691 crore). The report does well to stress that recapitalisation does not prevent banks from getting into trouble again — in fact, it distorts the incentive structure. The report argues that recapitalisation of weak banks using public money is a costly and unsustainable option. Apart from the three weak banks, the other public sector banks would require an additional Rs 10,000 crore over the next five years. In this context, the report supports the proposed legislation to reduce public ownership in banks to a minimum of 33 per cent.

While the RBI provides morale-boosting statements on improving efficiency, it does well to point out in Appendix Table -II.6(D) that the 19 nationalised banks showed net losses when adjusted for interest on recapitalisation bonds. The message to the authorities is that the financial system is skating on thin ice and we just cannot afford to further burden the banking system.

While providing copious bank-wise data, the report holds back information on the bank-wise credit deposit ratio and the incremental ratio. This is a serious lapse. In the wake of the Madhavpura Bank episode the report devotes considerable space to the urban cooperative banks. The report does well to elaborate upon the differences between the regulatory framework for commercial and cooperative banks (Box-III.3 on page 80) while Box III.4 on page 81 focuses attention on weak cooperative banks. If only the Madhava Rao Committee had been listened to, perhaps the agony of the recent episode could have been avoided.

In the context of the hype about universal banking the report does well to provide a detailed comparative position of banks and FIs with respect to regulatory parameters (Table IV.1 on page 105-111). The message is that a hurried merger of FIs and banks could be hazardous.

In recent years, the RBI has been giving increasing attention to institutions other than banks. This is indeed necessary in the context of changes in the financial sector. In the next report the RBI would do well to provide a comparative analysis of primary dealers based on their balance sheets. The PDs have a close relationship with the RBI and a comparative analysis will provide advance warnings on problem areas and point to the need for early preventive action.

All things taken together this year’s report continues to scale greater heights. It is difficult to continue moving to a higher perch and the future report writers have an unenviable task.