Give us a bloat - I

Written by KRISHNAMURTHY V SUBRAMANIAN | Krishnamurthy V Subramanian | Updated: Jul 30 2010, 04:21am hrs
Taking cues from the undergoing efforts in the US and Europe to curb compensation in the financial sector, Reserve Bank of India has floated a plan to closely monitor bank salaries. The official circular signed by Shri AK Khound, chief general manager, RBI, starts as follows: Flawed incentive compensation practices in the financial sector were one of the important factors contributing to the recent global financial crisis. Employees were too often rewarded for increasing the short-term profit without adequate recognition of the risks the employees activities posed to the organisations. These perverse incentives amplified the excessive risk-taking that severely threatened the global financial system. The compensation issue has, therefore, been at the centrestage of the regulatory reforms. The circular proceeds to state that such monitoring of compensation practices is intended to be applied to the private sector banks, local-area banks and foreign banks operating in India.

Since feedback has been sought on this proposed regulation before July 31, 2010, as an independent commentator, it is my dharma to provide such feedback. There are two basic questions that need to be asked in deciding whether this piece of regulation would be beneficial to the Indian financial sector and, in turn, the Indian economy. We will tackle the first here and the next in the second part of this article. The first question is whether the Indian banking sector has reached a stage of development where excessive risk-taking is a particularly bothering concern In other words, does our financial sector mirror those of the developed markets so that it is imperative to mirror these countries in bringing regulation to curb excessive risk-taking Second, despite the current focus in the developed countries on curbing executive compensation in the financial sector, is executive compensation the most potent tool to curb excessive risk-taking

To understand whether we need to mimic the developed markets in coming up with regulation to curb excessive risk-taking, let us examine whether we need to move in the direction of encouraging innovation and risk-taking in financial markets or limiting the same. There are both costs and benefits to increasing the degree of risk-taking (and concomitant innovation). While the developed countries have witnessed considerable innovation in the financial sector over the last two decades, financial sector innovation in India is still in its infancy. These developed countries have already reaped the benefits from financial sector innovation and are arguably paying the costs from excessive risk-taking now. However, this is certainly not the case in India. To put it differently, while the US, UK and Europe find themselves to the right of the optimal level of risk-taking, it is a no-brainer that India lies far to the left of the optimal level of innovation and risk-taking in the financial sector. Therefore, in the Indian context, the benefits from greater innovation and risk-taking dominate the potential costs from the same.

Let me explain in detail. A key challenge for our financial sector stems from our heavy reliance on traditional commercial banking to provide credit to the corporate and household sector. While such a system may have been adequate during the early stages our development, the lack of a rich suite of products for hedging and risk management now constrains the real economy, which has become considerably more complex since the 1990s.

There are several reasons for this: First, in the absence of deep and liquid debt markets, the ability of banks to grow their loan portfolio is limited by their access to deposits. Second, even now, banks are not well placed to meet the significant needs we have with respect to long-term infrastructure financing. The size, maturity and illiquidity of such loans makes them unsuitable for traditional commercial bank financing. While our infrastructure needs are enormous, infrastructure financing remains largely dependent on bank financing, with all its attendant inadequacies and risks. Third, access to credit and financial services available to SMEs and households is still woefully inadequate. Fourth, with only 40% of the population accessing the formal banking sector, there is a significant potential to mobilise the savings of the remaining population.

When commercial banks cannot fully diversify away the credit risk in their loan portfolios, the banking sector satiate the credit needs of the above categories of borrowers. In this connection, further progress in the development of an active securitisation market for consumers and small business loans would facilitate greater access to credit, by enabling risks to be shared by banks and other investors. Such securitisations, executed prudently, would help to broaden the investor base and allow for the conversion of longer-term amortising loans into instruments more suitable for investors. This development would have the added benefit of facilitating better diversification by banks of their credit and maturity risks, while providing investors with the opportunity to earn higher yields by taking on some of the risks of underlying loans.

(To be concluded)

The author teaches finance at the Indian School of Business, Hyderabad