Banking regulation and the law of unintended consequences

Photo::  Mint
Photo::  Mint


An RBI relook at regulations is an opportunity to better align this sector with our evolving economic needs

Many well-intentioned steps taken by regulators in the past are creating headaches on multiple fronts due to the unintended consequences of specific measures. Although welcome, the new Regulations Review Authority 2.0 (RRA) set up by the Reserve Bank of India (RBI) to streamline banking regulations has an unenvious task ahead of finding remedies for several such inadvertent outcomes.

Mandatory fund raising via bonds: With an intent to expand the bond market and reduce corporate reliance on bank finance, large listed entities rated AA and above were directed to source 25% of their incremental financing requirements via bonds. Recent data from the central bank and Securities and Exchange Board of India (Sebi) corroborates the fact that the country’s overall bank lending pie has reduced for creamy well-rated companies.

Together with lower capital investments due to depressed capacity utilization in the economy and resultant poor credit offtake, commercial banks have been forced to go down the credit-quality curve and lend to riskier corporates, which is a worrying unintended consequence of the aforesaid policy.

The RRA and regulators need to extend the bond market fund-sourcing benefit to all investment-grade companies and also consider progressive relaxation of the stipulated 25% reservation mandate to ensure a level playing field for all participants.

Corporate current account closures: To prevent unscrupulous promoters from diverting funds through multiple accounts and inculcate credit discipline, RBI had imposed restrictions on client current account transactions and ordered banks to close such accounts if their exposure was below 10% of customer’s overall borrowal facilities. This decision adversely affected customers who lost out on the superior services of smaller but more efficient private and foreign banks, while lenders lost good business. Even public sector banks (PSBs) were affected, as they would be required to surrender accounts of government entities if no RBI relaxation is forthcoming.

While the regulatory intention is benign, it has created a messy outcome. The RRA could suggest better digital information sharing and monitoring mechanisms among banks to enforce credit discipline, even if businesses are allowed to operate multiple current accounts.

Rethink poorly drafted guidelines: The data localization circular, first issued in April 2018, for instance, was tailor-made for payment entities and so vague that RBI had to issue detailed clarifications, confirming that multinational banks were indeed covered by it.

Similarly, another contentious circular requires all banks operating in India, not just domestic but also foreign—whether they are small banks with only a few branches or larger ones making 100 times the local revenues—to auto-generate non-performing-asset data with locally-mandated provisioning coverage. This applies even if a particular bank has a conservative global policy that requires a higher level of coverage, necessitating costly country-specific modifications in its global system architecture.

The RRA could look at revising a few such rudimentary guidelines and circulars.

Priority-sector lending: Although the intent of directed credit targets for commercial, cooperative and rural banks is noble, directed priority-sector lending can result in the possible misallocation of capital and mispricing of loans. With growing disintermediation of credit, conventional banks with high fixed-cost structures are increasingly at a disadvantage. Being obliged to lend 40 of every 100 to lower yielding and ever riskier priority-sector assets, commercial banks have lost market share to nimbler fintech and non-bank financial firms.

Worsening cost structures and the technological edge of new players could pose viability problems for traditional banks. Urban cooperative banks are contemplating ways to convert themselves into universal commercial banks to lower their priority-sector lending obligations from a proposed 75% to 40%, while small finance banks too are keen to convert into universal banks after 5 years of satisfactory operations for similar reasons.

The RRA could revisit the priority-sector lending norms to reduce directed sub-targets and overall targets for banks and/or lower the credit-risk weightages on specific short tenor, self-liquidating bank facilities. For instance, reduced risk weights on MSME bill-financing through TReDS exchanges can lower capital consumption for banks and also enhance credit flows across the priority manufacturing ecosystem.

Market challenges: The RRA should tackle evolving technology and market challenges by drawing up regulatory templates that encompass: a) a digital banking framework for universal and wholesale bank licences; b) a blueprint for a central bank digital currency as fiat money; c) a special dispensation, put in place jointly with the Centre after a feasibility study, that would allow profit-oriented crude-oil-price hedging by oil companies, which along with tax cuts could help cool fuel prices in India; and d) a policy of light regulation for the launch of prescribed banking services by neo-banks, fintech firms and other technology companies.

The central bank’s RRA 2.0 has its work cut out. It must aim to mitigate the ill effects of past regulations and simultaneously sustain the multiple benefits that accrue from extant guidelines.

Ashiesh Kapoor is a management professional, certified treasury manager and corporate banker.

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