Banking on confusing signals

What ministry of finance & RBI do today leaves little room for genuine discretionary banking

The previous two articles in this series dealt with the urgency of liberalising India?s financial system beginning with insurance. Although India?s stance on foreign investment in banking is not as bad as it is in insurance, its posture on foreign banks, FDI in banking, subsidiarisation, new banking licences to established corporate investors, financial inclusion, macro-lending limits, etc, send out confusing signals. It does little to help encourage sound banking, attract more FDI and more foreign banks. It doesn?t do much to bolster the rapidly eroding capital base of the banking industry (except at public expense) or boost the banking system?s ability to expand credit delivery in line with the growing needs of the economy on a prudential basis without heightening systemic risk.

The key problem in banking is one of regulation, where RBI is more a problem than the solution, ensnared as it is by legacy and history into providing a highly discriminatory, unfair and tiered structure of regulation. That structure results in: first, protecting and micro-managing state-owned banks (SOBs) to protect the government?s equity investment and its implicit guarantee obligations to all depositors in SOBs; second, protecting the interests of domestic private banks, although paradoxically these supposedly ?domestic? banks are now almost all 74% foreign-owned by FIIs though they are still domestically managed; and third, artificially restricting the entry and expansion of foreign banks that India so desperately needs by imposing requirements for subsidiarisation and for financial inclusion that even the SOBs after nearly 50 years of operation have not been able to meet.

Worst of all, the current system encourages more new domestic private entrants into the already over-crowded banking space when India?s actual need is for fewer, stronger and larger private banks with a gradual phase-out of SOBs in order to get unlimited deposit liability risk (of nearly 100% of GDP) off the public fiscal balance sheet. The government can no longer afford the R25,000-30,000 crore that will be needed every year to augment the equity capital of the SOBs to stay in line with Basel III norms.

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Thus, India?s strategic approach to restructuring its banking sector is the direct opposite of what it should be, i.e. not to crowd in more private domestic banks while imposing impossible conditions on them, but to privatise SOBs more aggressively and phase them out, to apply impartial and equal regulation to all banks regardless of their ownership, and dramatically expand the entry of foreign banks to meet India?s vastly expanded foreign capital needs for the next 20-30 years.

Finally, it has to be recognised that what the ministry of finance and RBI do today leaves little room for genuine discretionary banking. With SLR and CRR requirements absorbing 30-35% of any bank?s portfolio, and a further 40% being channelled into ?priority sector? lending (though neither the finance ministry nor RBI have a clue about what priority sectors actually are or should be, except in populist, politically-driven terms), this leaves bankers with discretion on less than 25-30% of their portfolio. It also creates a moral hazard for the government when their mandated lending turns sour and results in NPAs.

Of that ?discretionary? 25-30%, as far as the SOBs are concerned, their managers are influenced by political directives to lend to politically-connected entities if not to entities owned by politicians and their families. Do Vijay Mallya and Kingfisher Airlines resonate in that context? Or all the infrastructure tycoons who are now over their heads in hock to SOBs? Is that any way for the banking system of one of the world?s largest economies (and a potential future superpower) to function?

Similar observations could be made on the plethora of other players in the financial system. But let?s not overload the circuits all at once. Each of these sub-segments deserves individual scrutiny in other articles. The harm done by the latest MCX exchange fiasco and the lack of probity of its FTIL promoters (an accident that we all knew was waiting to happen) is too obvious to reiterate. This was an entirely avoidable episode that does India no credit at all.

It is clear that all of India?s exchanges need to be internationalised and become part of global exchange networks that must eventually allow 24-hour trading of all scrip and be expanded to include the trading of all debt securities and exchange traded derivatives as well. That will require more capital, knowledge and much better exchange management (as well as real-time monitoring and surveillance) than we have now but are doing little to develop to the extent we should.

India?s investment banks also leave much to be desired. The best ones are all foreign-owned but inwardly focused. Thus, India is losing out on major service export opportunities, particularly to west/central Asia, east Asia and Africa as natural catchments for investment banking services. They, along with India?s array of specialist investment and asset management firms, also need to be internationalised to a much greater extent. They need to develop much stronger and deeper Asia-specific expertise to tie India more closely into the north Asian, east Asian and Chinese economies.

India?s securities firms are still dominated by small, sub-optimal brokerages that provide invaluable services to smaller private clients who cannot afford the fees of the larger firms and foreign investment banks. They need to be consolidated to a greater extent and brought up to operating at international standards in their capitalisation and the specialised services they offer. Alternative investment managers in India are not as developed, nor as globally clued-in, as they should be.

So, there is a huge financial system liberalisation agenda to be addressed. That cannot be done in one article or in a short span of time. It needs sustained effort with a clear strategy and game plan for each compartment. But India?s aim should be to, by 2020, have a financial system that is as capable as that of any country in the world.

That requires the Indian political system and government not to be obsessed by who owns what or by the supposed need of the state to own everything or most things in finance or other parts of the economy. We need to remember that: ?Jab sarkar banti vyapari, tab janta banti bhikhari?.

India has the basic human capital it needs to liberalise its economy and financial system. What it does not have as yet is the moxie, the soft know-how, the managerial and organisational capability, the global credibility, the international network connections, the quality of regulatory system and structure, nor a sufficiently pervasive culture of good corporate or public governance that emphasises the restoration of ethics, probity and consumer protection in corporate and public behaviour. It needs to make all this happen.

That is a difficult challenge to be presented with. But it is by no means an impossible objective for India to achieve. Innovative, out-of-the-box thinking on the part of key secretaries in the finance ministry and the Union government needs to be encouraged and supported rather than confronted by all the usual obstacles (including lack of political consensus). If the upcoming general election is to be as seminal in changing India?s politics as wise psephologists attest, it will prove to be a damp squib if it does not precipitate transformation and liberalisation of India?s economy and financial system.

Percy S Mistry

The author is chairman, Oxford International Associates Ltd

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First published on: 16-04-2014 at 02:35 IST