Hollowness in banking a major concern10 min read . Updated: 23 Nov 2010, 12:30 AM IST
Hollowness in banking a major concern
Hollowness in banking a major concern
Mumbai: Former Reserve Bank of India (RBI) governor Y.V. Reddy, whose latest book Global Crisis: Recession and Uneven Recovery was released on Monday, spoke to Mint on a range of issues—from big industrial houses’ entry into banking to a crisis in the microfinance industry and bank credit flowing into non-productive sectors. Edited excerpts:
It’s now a little over two years since you demitted office. There are many who say you saved the Indian financial system from the global meltdown, but a few others feel you were anti-reform and kept the doors closed, and that’s why we escaped the impact of the crisis.
During my tenure, I did not look for credit. I just did my job.
In the public policy, knowing what to do is important, but knowing what not to do is equally important.
Is opening up an end in itself? If it is, then something ought to have been done, but (was) not done. If you aren’t a believer in opening as an end in itself, then you should believe in the outcome—whether the outcomes have been such that the growth would have been higher.
Implicitly what some people are saying is that there was inaction and, therefore, there were no accidents. That is false. Counter-cyclical policy was taken here and that was not inaction. That was action. In fact, that was unpopular action.
Let’s go to capital account—it is not that capital account was closed or opened. It was managed. It was intensely managed. That is not inaction.
Take the banking system—you know what type of banks existed five years ago. Take a look at the capital adequacy ratio of banks between 2003 and 2008. What are the general indicators of efficiency? In five years, if the efficiency has increased, that is because of the inaction?
Look at the turnover of the forex markets and compare it with most of the countries. The forex market’s volume improved manifold. Is it inaction? We took those actions that some people didn’t want us to take.
Do we have to live with high growth and high inflation? Should RBI start inflation targeting?
As far as general approach to inflation is concerned, I think two things have come out as important lessons in the context of the countries which have inflation targeting. One is that exclusive attention to price stability is not good; we should be able to take more indicators. Secondly, there is a feeling that targeting low level of inflation may create problems for counter-cyclical policies. If you want to have counter-cyclical policies, you may have to allow an inflation which is slightly higher than what it was before.
There are divergent trends in the current context. In developed economies, there is a pressure towards deflation and in developing economies, there is a pressure towards inflation. I am not so sure whether it is entirely contextual. Even in the past, the average inflation in developing economies was slightly higher than the average inflation in developed economies. At the same time, the most important thing is that for large segments of poor people inflation is something that we cannot afford. We should, at any cost, avoid high inflation or even huge volatility in prices.
Should that be achieved through inflation targeting in India? Definitely no. There are many developing countries where inflation targeting was advocated because the central bank lacked the credibility. In India, the central bank has creditability with regard to inflation, so there is no need to formally introduce a target. In fact, you are undermining the central bank by doing that.
In the Indian context, the relative emphasis will depend on circumstances within growth and stability, as we have seen, and that manoeuvrability has stood us well, and the rest of the world is actually questioning the concept of inflation targeting. It is inappropriate for us to even seriously consider it.
Are you seeing any bubble in certain pockets?
The aggregate resources are limited and if you are going to fuel the asset prices, this is a deprivation and this is the time when credit should go to more productive activities.
Money is cheap globally and funds are coming to India. Are you concerned about asset bubbles being built up?
Three years back when we talked about global liquidity driving the asset prices and there should be a policy concern, it was unpopular. Today, the global view is that is a matter of concern.
I think it is almost self-evident now that they say yes, something has to be done about asset prices when the global liquidity is driving the asset prices, and also it is recognized by what they call the counter-cyclical policies.
So, what is this something? What should be done?
You have the standard tools. The tools are available and the major issue is the judgement, apart from political, economy factors...the judgement is critical, particularly in countries where there is a huge structural transformation. You don’t have much of a historical data to be able to say at what point of time it becomes a bubble. Therefore, it is a problem. Somebody has to make a judgement whether it is becoming true…reaching the dimensions of a bubble.
Where do you see the problem emanating from?
I am not privy to the specifics. But, in general, the standard areas are the equity prices and the real estate prices. The second issue is, one has to be careful how the bank money goes to some of these sectors indirectly. Very often it goes through mutual funds, non-banking finance companies.
Look at the credit growth in the last few months—maximum credit growth was to fund acquisitions, telecom licence fees, real estate and infrastructure. That’s fine. But as far as the bank money is concerned, their main business is to fundamentally finance working capital, small and medium enterprises and agriculture.
The major area of concern is the hollowness in banking. And, especially when there are huge uncertainties and volatilities in global markets, the importance of stimulating productive activity within the economy is important.
I think it is time for some countries—and I am not restricting to India, it may even be United States—to consider selective credit controls and the credit allocation to sectors. It may appear to be too retrograde, but these are extraordinary times when you have to stimulate (productive sectors).
The public policy has to take a more hands-on approach, with regard to credit allocation and credit dispensation, and credit priorities.
In your book you have explicitly recommended tax on capital flows.
If you look at the past few months, globally there is a concern with regard to capital flows to developing economies and a number of countries have introduced more active capital account management, etc. In that context, I was trying to say that the challenge for policymakers is more complex in India. In many other Asian countries, they have current account surplus. When you have current account surplus, you can introduce capital controls more confidently. But in India, when we are having a current account deficit, you have to be very careful that the markets don’t overreact. So you are to some extent dependent on some capital flows, but not too much of flows. That requires very delicate handling.
When you are in a predicament, the solution in mind should be: I will manage capital account very actively and when you manage actively, you can do something to attract as well as not to attract (capital flows). The capital account is managed in a proactive fashion and, therefore, it is better to insist that we keep options open, and we will continuously manage.
Is a Tobin tax part of that management?
One is saying that we keep the option open and we may introduce (tax) and even if introduced, we may introduce different rates. In my view, that is part of having an instrument for capital account management. Once you believe actively in capital account management, you must say I am prepared to use any instrument.
During the crisis, the government and RBI worked in close coordination, but now we are seeing the differences.
When there is a crisis, the government takes a leading role because it is too important, and huge coordination is required. All over the world, the central bank might have been the first line of defence, but the sovereign has to take the final call. It has fiscal and semi-fiscal implications and, hence, the government will inevitably be in the driving seat in times of crisis.
Once you start the exit policy, there will be tensions. There can be difference in judgements.
There is an underlying time dimension. The political leadership as well as the financial markets would like to have the comfort of continuing the stimulus and avoiding risk. So, their approach is short-term. But the central bank’s approach is medium-to-long-term, and they would not like to lag behind. This is the tension.
It seems that you are not comfortable with big banks and industrial houses coming into the picture. Are you in favour of small banks?
Not entirely. I think financial inclusion requires very innovative solutions. Fundamentally, if public policy can intervene in the financial sector for stability, I believe they can also intervene for development.
Second, and a more important issue, is the size. I think, very clearly, it is shown (that) too big is not only too big to fail, but (would) also become too big to regulate. We should take a formal view that no bank should have assets more than a particular level.
What should be that level?
Well, that is a matter of detail. Whether it is 5%, 6% or 7% (of industry) can be discussed.
Are financial inclusion and competition mutually exclusive?
Financial inclusion, if it is to be achieved, should be achieved through the banking system and not through the new banks.
What about industrial houses’ entry into banking?
The same logic would apply, but not by itself. One can even argue that there should be a limit, in any case, in the size of the bank. The question is the regulatory framework. I think one fundamental principle could be the principle of unlevel playing field. After the crisis, everybody agrees that if they are systemically important institutions, they should be subject to a different regulatory regime. If you accept the principle of unlevel playing field, the ownership becomes relevant. Depending on the ownership also you can articulate the regulation. If the ownership keeps changing, then the regulations can also keep changing, and I think we should accept that as a new paradigm.
So you are saying that if industrial houses are allowed to set up banks, they should come under a different set of regulation?
In general principle, yes. This is true even for an NBFC (non-banking financial company). One has to be extremely careful. And remember, there are two ways of looking at it in the Indian situation. You already have industrial houses owning NBFCs, mutual funds and insurance firms. So, one argument is that in any case they own (financial intermediaries), why don’t they own bank also? The other argument: Isn’t it bad enough they own so much in financial sector, and why would we make it worse by giving bank also?
What is your argument?
It must be clear by now.
One year back you spoke about the high interest charged by for-profit microfinance institutions (MFIs).
I was actually quite worried in 2009, with the way the whole procedure was going. The strength of MFIs is informality and intimate contact between the lender and borrower. These are the two principles which made it unique. Once you institutionalize it as large institutions, these two principle are gone.
One of them is a listed entity.
That’s more important. So what they are doing is profit maximization. The Nobel laureate (Bangladesh’s Grameen Bank founder Muhammad Yunus) himself has said any for-profit MFI is a moneylender and I entirely agree with him.
My answer has two sides. One, don’t ignore moneylenders as though they don’t exist. They exist informally; they should become semi-formal, and later, they should be integrated with the formal fold. The moneylenders should be subject to regulation; effective regulation. The RBI has also been advocating that in the past few years.
The government has not passed a well-thought-of moneylenders’ legislation. The for-profit MFIs should be treated exactly on par with moneylenders, under the Money Lenders Act. In fact, moneylenders in some way have to live in the society and, therefore, they cannot be too aggressive, but impersonal institutions can afford to be aggressive.