Tackle banking?s Big Five first

The CAC-2 report lacks a strategic perspective into what is going on in Indian macroeconomics and finance. Not only is this apparent in the recommendations about currency controls, banning participatory notes and the belief that the control raj can be continued with a tweaking of the controls, the chapter on banking also shows how the perspective lacks a big picture.

India has many weaknesses in banking regulation and supervision. The banking chapter of the CAC-2 report is a detailed check-list of some of the many well-known flaws in banking regulation and supervision. The chapter is suffused with micro-management. As an example, it is proposed that RBI should force banks to have 75% of branches with online connectivity within three years, 90% of branches with online connectivity within five years and 100% of branches with online connectivity within seven years.

This is a worms eye view of the problem. It is far more important for India to take a strategic view of the situation. A strategic perspective on banking and convertibility involves five big issues.

? Convertibility means competition. The first point is that convertibility brings greater competition in banking. With convertibility, Indian firms and customers will not be restricted to holding Indian rupees with local banks. Customers will be free to shift to foreign currencies and foreign banks. This will improve service delivery to customers. We know this from every experience where India opened up to competition: the greatest beneficiary was the customer. In an identical fashion, a lot of what the CAC-2 report thinks of as policy agenda in banking (eg RBI micro-managing banks to force them to do computerisation) will automatically happen out of sheer competition in the marketplace.

? Entry barriers in banking need to go. At present, it is extremely hard to start a bank in India, and foreign banks face crippling constraints. Both kinds of entry barriers need to be removed in this world of competition. Citibank needs to have as much freedom to operate in India as Nokia and Pepsi. If India persists in trying to hinder foreign banks from operating here, they will reach Indian customers through USD denominated deposits held outside the country.

? More competition means more death. A healthy market economy is one where there is a steady flow of birth and death. Every year, some banks should die, and every year, some banks should get started. What banking policy needs to do is build a strong deposit insurance corporation, and strong supervisory capacity, so that weak banks are pre-emptively put to sleep ahead of a disruptive ending.

? A paradigm shift in regulation is called for. The biggest weakness of the prevailing framework of regulation and supervision, which is reflected in the CAC-2 report, is the spirit of micro-management. The regulator thinks that every detail of the business plan of a bank has to be written by the government. In an internationally competitive setting, this is a sub-optimal approach. A regulator focused on writing the details of a business plan will miss the big picture. A government that interferes in micro details will stifle competition and help drive Indian customers overseas.

? Banking regulation and supervision has to move out of RBI. The fifth piece of strategy for Indian banking policy is the creation of a modern and focused Banking Regulatory and Development Agency (BRDA) with no ties with the central bank. The job of the central bank should be to do monetary policy?and to do nothing else. The placement of multiple tasks with the RBI has burdened the agency with numerous conflicts of interest, which have led to poor performance. If banking regulation and supervision were placed in a separate BRDA, setup on the lines of Sebi/Irda/PFRDA, then this would achieve a performance which has eluded us thus far.

Whether we like it or not, India is inexorably entering a world of deepening de facto convertibility. In the case of banking, the present approach has profound problems. The checklist of the CAC-2 report is based on protecting the status quo. What India needs, instead, is a strategic perspective which involves these five issues. The ministry of finance needs to make a concerted effort to go after such an agenda, while explicitly recognising that India?s interests are not the same as those of RBI as reflected in the CAC report.