Illustration: Jayachandran/Mint
Illustration: Jayachandran/Mint

Urjit Patel’s speech shows the limits of regulation

RBI's role should be seen in tandem with three other deep problems: perverse incentives for bankers, internal controls and corporate governance

Nirav Modi case has once again opened a chasm between the finance ministry and the Indian central bank. Reserve Bank of India (RBI) governor Urjit Patel said in a powerful speech last week that various legal constraints make it difficult for the banking regulator to discipline banks that are owned by the government. Public sector lenders account for three-fourths of the Indian banking system, far more than in any other market economy.

This is not the first call for banking regulation that is ownership-neutral. A similar point was made by the Financial Sector Legislative Reforms Commission as well as by former governor Raghuram Rajan in a speech in August 2016. There is no doubt that all banks should be governed by the Companies Act and the Banking Regulation Act, rather than specific acts of Parliament such as the State Bank of India Act of 1955 and the two Acts that nationalized banks in 1969 and 1979. “This legislative reality has in effect led to a deep fissure in the landscape of banking regulatory terrain: a system of dual regulation, by the finance ministry in addition to RBI," Patel said.

Finance ministry officials have hit back by saying that the RBI has enough powers over public sector banks, while it is the government that has limited oversight on operations. However, what Patel has said deserves closer attention, rather than looking at his speech as one side of a blame game being played out by the two masters of our financial universe. No regulator can evade the responsibility of not catching a fraud of this size but it is also incorrect to say that the scam at Punjab National Bank is only about lax supervision. It is now quite clear that the lender had not followed the instructions sent by the RBI to banks in 2016. The argument that Nirav Modi could milk the banking system only because the regulator was not alert could lead to calls for even more intrusive supervision by the RBI, leading to the risks of regulatory overkill. There are already early demands for what could end up being excessive intrusion.

Most of the public debate in India over the past two weeks has naturally focussed on the role of supervision and regulation by the RBI. The role of regulation should be seen in tandem with three other deep problems: perverse incentives for bankers, internal controls and corporate governance. Each of these were also highlighted in the aftermath of the 2008 financial crisis that began with the collapse of Lehman Brothers.

First, the perverse incentives at the heart of Indian banking are as follows. Bankers are often under pressure from the government to pump up lending volumes, there is little downside when the loans turn bad since the taxpayer foots the bill. Success is judged by loan origination rather than the quality of the portfolio.

Second, the internal controls inside bank branches are weak, and recent global experience shows that many banking frauds take place in the grey areas where databases as well as regulatory regimes overlap.

For example, the problem at Punjab National Bank went undetected for so long because the SWIFT messaging system was not linked to the core banking software, precisely the sort of grey area where fraud becomes more possible.

The corporate governance problem is that bank boards are passive. Improved corporate governance was a key element of the Indradhanush plan for banking reform that was announced with so much fanfare in 2015. The Bank Boards Bureau that was expected to lead the change on the corporate governance front has been a failure.

The upshot: RBI cannot wash its hands of what has happened, but the optimal response should not be calls for a heavier hand of regulation or footloose investigations that scare other bankers from even honest lending. Instead, there should be a harder look at the perverse incentives that lie at the heart of the Indian banking system, the lack of data analytics to detect outlier lending activity, the risks of credit bubbles in a banking system dominated by the government, and the overall institutional framework of the Indian financial system.

Finally, too many people accused Patel of lacking independence after the demonetisation episode. He has since spoken out against attempts to interfere with the working of the monetary policy committee, held interest rates despite the pressure to cut them, warned about the fiscal risks from farm loan waivers, and spoken about the excessive taxation of capital incomes. The RBI governor has in the past few months proved that he is his own man.

The working relationship between New Delhi and Mumbai has been smoother in the recent past compared to what happened over the past decade. However, the recent spat could be the first salvo in a longer battle unless finance minister Arun Jaitley and Patel move quickly to prevent any further tensions.

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