How flawed Western wisdom underpins Indian banking ‘reforms’

The Public Sector Bank (PSB) recapitalisation plan announced by the government has sparked off renewed debates on the shape and future of Indian banking. The big policy and philosophical question is — what should the Indian banking system look like in the future? Unfortunately, we are saddled with seriously flawed assumptions on what constitutes “reform” in India — some of them borrowed wisdom from the West, yet some more are ideological postures. Let us look at some of the key postulates.

One, the idea of having fewer, (much) larger banks. It’s an old idea, but embedded firmly across the political divide, and was first mooted by P Chidambaram as Finance Minister. Chief Economic Advisor (CEA) Arvind Subramanian reiterated its salience a few days ago. Ironically enough, this is one idea where India is bucking the global trend. Since the global financial crisis in 2008, regulators globally have become extremely wary of banks that are too large. The reason for that is intuitive.

First, larger the bank, larger is its footprint, and hence greater the damage to the wider economy should it fail. Second, Risk Management 101 dictates diversification is a key mitigant of risk, while concentration is a contributor to it. Ergo, smaller, more numerous banks are preferred to larger, fewer ones, from a systemic risk management perspective. Globally Systematically Important Banks, or GSIB — a list of essentially Too-Big-To-Fail (TBTF) institutions — have been identified, and they are required to have more stringent control around capital and risk. In this context, the idea of having larger Indian banks is bizarre, because its stated aim would be to merge small banks into fewer TBTF ones, thereby increasing risks to the system!

Two, assumption of public ownership of PSB to taxpayer-funded “bailout” through recapitalisation. It has been established many times over the years — banking obligations, when banks are under stress, automatically devolve to the taxpayer, irrespective of ownership. Whether Korean banks post the 1997-98 Asian Crisis, US/European banks post the 2008 global financial crisis, or Indian banks many times over (remember Global Trust Bank, Bank of Rajasthan?) — in a crisis, banks need to be bailed out by the government, irrespective of whether they are owned privately or publicly. Banks aren’t ordinary corporate enterprises — failure of a bank has large social impact. Further, increasing complexity of the financial system means there are snowballing effects of a bank failure that are difficult to assess. Therefore, the taxpayer liability isn’t an issue of ownership, but the quality of regulation to ensure risks are appropriately managed.

Three, privatisation as a panacea for all ills. This is an ideological position — based primarily on faith rather than reason. The assumption is the issues afflicting PSB are on account of its state-ownership, which somehow make them structurally vulnerable to taking poor-quality decisions, sometimes compromised with integrity issues. From Leendert Neufville in Holland in the 18th century to a range of Asian banks in the 20th century to American and European banks in 2008 — history is replete with privately-owned banks collapsing on the weight of poor decision-making. Regulatory investigations in the last few years in private sector banks have shown up numerous cases of moral turpitude too. Even in India, large private-sector banks have been found out making poor-quality decisions on transparency, risk-management and governance. In other words, there is too much data disproving the hypothesis of superior governance of a privately-owned banking system.

The question then is, what should policy-makers focus on? The focus should be at the core of the issue, i.e., risk. Banks are fundamentally risky enterprises, allowed a level of leverage in their capital structures and a level of interconnectedness with large parts of the economy that no other commercial enterprise (barring perhaps insurance) is allowed. The example of Lehman Brothers is illustrative. It was a mid-sized bank with no retail deposits — and its collapse engendered a crisis to the global financial architecture. No wonder, banks have a social compact of “backstop” from the taxpayer.

That is where the real issue lies — not in ownership, not in size. Regulators should be concentrating on mitigating that risk on society. Fundamentally, it means converting banks into utilities — essential institutions, but ones that don’t take risks that can put society at risk (similar to, though not the same as, a telephone company). Solutions lie in the domain of smaller (not larger) banks, higher capital requirements, lesser risk-taking, greater state oversight (and not lesser via privatisation) and higher governance. In other words, make banks (and banking) a boring affair. Unfortunately, most of the oft-discussed, clichéd solutions today are taking the other direction — taken to their conclusions, they will increase the risks to the system, and make it even more vulnerable to future taxpayer bailouts.

Through history and literature, bankers have rarely been boring. From the usurious Shylock in Merchant of Venice to the murderous Patrick Bateman in American Psycho to the philandering Humphry Wellwood in The Children’s Book — bankers are usually flamboyant, somewhat unscrupulous characters. The real objective for regulators would be around converting bankers (and banks) into Mr Banks, the benign, boring Bank of England official in the Mary Poppins books. That, and not ideological positions around size and ownership, is what will shape for a safer, better banking architecture for India in the future.

The author is Managing Partner of ASK Wealth Advisors. Views expressed are personal.