India - New wine from an Old bottle

The finance ministry’s tenancy rights to the RBI governorship distort policy and regulation.
The twenty-second governor of the RBI has just been named. Since 1977, all incumbents, other than Dr Rangarajan, have served as secretaries in the ministry of finance. The new governor continues this tradition. The real problem is not about quality. The appointees, including the latest one, who has strong credentials as an economist, have been outstanding individuals. But the unquestioning acceptance of bureaucratic progression from the finance ministry to the RBI distorts policy and regulation. How will a finance ministry mandarin turned RBI governor fulfil his dharma of countering the fiscal profligacy for which he was at least partly responsible? How will he take a disinterested view of banking regulation when the greater part of the sector was under his ownership control till recently?
We need a firewall between the finance ministry and the RBI. On monetary policy, with the FRBM Act, the new debt management office and the Rangarajan reforms on how the deficit is financed, some progress has been made. Even here the need to contain the government’s borrowing cost may clash with the interest rate that the macro situation demands.
But when it comes to banking we have a long way to go. We do not have an independent regulator for the banking system akin to what we have for the capital market in the Securities and Exchange Board of India (Sebi). This function is exercised by the RBI, with a heavy hand, according to many bankers. Yet, other than the first governor, Osborne Smith, none of his successors have been professional bankers, except, at a stretch, the Emergency appointee, K R Puri, who came from LIC. Even the RBI cadres have not had much of a chance and, excluding a few stop-gap incumbents, the only person from the RBI’s cadre to hold the post was M Narasimham, who was in it only for seven months.
There is an overlap of ownership and regulatory functions that bedevils the RBI’s relationship with banks. The 1969 nationalisation was a political move and the Government did not really have the capacity to exercise its new ownership responsibility. That is why, despite the subsequent development of the banking division, now the department for financial services, the RBI continues to play a role in the management of the public sector banks.
The regulator cannot be the owner of the entities being regulated and we must separate public ownership from the public responsibility for prudential regulation. Equally the regulator should not become a policy maker and take positions on matters like the role of private sector or foreign banks. The new governor must leave all ownership functions to the finance ministry. He is not there to protect the owners of banks. His job is the regulation, hopefully with a light hand, of banking as an industry to protect the interests of bank users and the general public.
The other problem is the lack of variety in the services on offer. The two rounds of nationalisation put more than 80 per cent of commercial banking under single ownership. The government and the RBI have a relatively fixed view of what “good banking” means and have enforced this “Identikit” approach to banking development leaving limited flexibility for the managers of banks. Little by way of innovation gets past the controllers in the RBI and finance ministry. Add to that the short tenure of most public sector bank heads and the result is a singular lack of entrepreneurship.
This need not be the case. The example of the domestic private sector banks, which have been more innovative, holds some lessons. These banks are governed by their boards and not by unaccountable bureaucrats. They are led by entrepreneurial leaders who could have supplied the new Master of Mint Road but, alas, were not even considered.
Indian banking is entering a period of structural change with consolidation and globalisation. This needs less of regulation and more of entrepreneurship in the form of innovative and dynamic CEOs who get more than the usual 1-2 year tenure. A more structural solution through the spreading of public ownership amongst multiple entities is probably a political non-starter. Hence, in the broader interest of financial development the finance ministry must leave all supervisory responsibilities to the boards of the public sector banks and limit its own role solely to the constitution of these boards.
A more entrepreneurial and heterogeneous banking system will be better for all customers, particularly those at the bottom of the pyramid. This happened in capital market services after the government stepped back.
The slew of microfinance institutions that have come up in recent years on private initiative are an example of what is possible. But their impact is limited. They cannot provide deposit or money transfer services, for instance, even though they may be better positioned to do this at an acceptable cost. Do all banks have to be cast from the same mould? Can we not contemplate a class of private banks mandated to provide only some services, capitalised at a lower level than the Rs 300 crore required by current regulations but restricted in their range of risk taking activities?
At the other end of the service spectrum we need to move fast to provide the corporate sector with domestic options for the financial services that they now have to buy abroad. The recent start of the currency futures market and the promise of interest rate futures are examples. But for these new markets and products to develop, domestic banks and other financial service providers must be allowed to operate as freely as their foreign counterparts. They can bring domestic liquidity into these new markets and help to ensure more orderly market conditions.
A more open, globally competitive financial industry will be better for Indian industry and could well be the next big thing after IT and BPO for aspiring youngsters. A road map is available in the Percy Mistry and Raghuram Rajan Committee Reports. This is an area where a governor drawn from the banking industry could have lobbied effectively for the industry in the corridors of North Block.
The new governor, like all RBI heads, has to keep growth without inflation as his primary goal. But one hopes that he will also nudge the financial system closer towards more open competition that serves the needs of all deserving demanders of credit, depository or investment services.