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Structure of banking in India – seven principles
Author(s) V Anantha Nageswaran Publication(s) CAFRAL Blog Published Date 19 Jun 2014
(V Anantha Nageswaran is the co-founder of Aavishkaar Venture Fund and Takshashila Institution and is an adjunct faculty in business schools in India and in Singapore).
 
The CAFRAL conference on Banking Structure for India[1] has produced several useful insights and generated useful markers for a sound policy on banking structure and regulation.  The speech by the Governor to the Competition Commission of India earlier in May set the tone. Then, we have also had the P.J. Nayak Committee report on the state of governance of Indian banks. The CAFRAL conference too has generated ideas on the subject.
 
The decision that faces policymakers is a challenging one. They need to determine certain principles that will help them cut through arguments, counterarguments, and the intellectual clutter surrounding the banking structure.
 
Obviously, all structures have trade-offs. Universal banks have priority sector obligations. Others who rely solely on wholesale funding will have less of it. There are payment banks – the governor, in his speech to the Competition Commission, mentioned that ‘India Post’ could become one such payment bank, keeping its assets in safe and liquid and short-term securities.
 
The first principle is that any structure that chips away at financial repression has to be favoured and tried. In the last fifty years, Indian banking has been dominated by public sector banks with the government’s financial repression being its principal feature. In the last five years, it had resulted in a substantial fiscal dominance. To be sure, fiscal dominance of monetary policy was the norm before the Nineties. But, then, the economy was small. The size of the private sector was small and the credit needs of the economy were modest. Hence, the opportunity cost to the economy of fiscal dominance was, arguably, not big. But, it is a different story now. Financial repression and fiscal dominance of monetary policy are huge hurdles in the way of the banking sector from contributing more positively to economic growth.
 
The Governor recognised it in his speech:
 
“Deposits will not continue to be cheap, while the government cannot continue to pre-empt financing at the scale it has in the past if we are to have a modern entrepreneurial economy. This is yet another reason why fiscal discipline will be central to sustainable growth going forward.”
 
Hence, the central bank will be fully justified in experimenting with bank structures that do not impose SLR obligations on them. Thus, they have greater freedom in using their balance sheet to lend to real businesses and improve their lending margin. In return, they could and should be subject to higher capital requirements.
 
The lessons learnt from the financial crisis constitute the second principle of the banking structure. The crisis taught us that when banks were exposed to financial markets, they risked instability for themselves and for the economic system. It does not matter whether they were using derivatives or not, complex product structures or not. Financial markets are inherently unstable due to the operation of greed at higher prices and fear at lower prices. Therefore, banks that are exposed – either through proprietary positions or as market makers or as intermediaries for clients – to financial markets – are likely to be subject to financial stress or reputational stress or both. Recent IMF research[2] notes that large banks also created more systemic risk (but, interestingly, do not become riskier) when they engaged more in market-based activities or were organisationally complex. The intuition here is that market-based activities affected the correlation of bank risk with that of the market, but not bank risk per se.
 
Therefore, it is good to have a non-operating holding company under which many subsidiary businesses including banking are set up. It will be transparent and relatively easier to regulate. However, if these different businesses are set up as subsidiaries under a bank holding company structure, then the capital ratio for such bank holding companies – exposed to financial markets – should be considerably higher. Then, there should be clear firewalls that separate their access to retail deposits. Businesses conducted by banks that are exposed to financial markets either through proprietary trading or through wholesale funding are similar to hedge funds. There is no room nor justification for hedge funds in the banking business.
 
Competition among banks in this part of the business where they are exposed to wholesale markets (financial markets) actually depresses margins, forcing them to take on more risk with a view to squeezing out returns. Thus, they are tempted to dip ever more into retail deposits of the banking business. Thus, banks’ proprietary trading is risk to their main banking businesses. There should be no government guarantees on retail deposits of such financial institutions. Strictly separating their ‘hedge fund type’ activities from pure banking business is also a way of preventing banks from becoming too big to fail. It also means that compensation practices in these businesses have to become symmetric between rewards and penalties – higher pay but also the prospect of higher personal losses in the event of failures.
 
As John Kay puts it well, subsidising the counterparty risk of financial institutions is not acceptable because the existence of such support undermines the imposition of risk disciplines within financial institutions and the evolution of market mechanisms to deal with counter party risk.[3]
 
There is another equally compelling reason to separate ‘financial market’ activity from banks. That is the evolution of the product-driven culture in banks. One can write separately on how ordinary individuals are both powerless and clueless to resist product entreaties by sales personnel of financial institutions operating under powerful incentives to push products – whether appropriate or desirable for clients. In his report on the desirability of narrow banking in the UK released in May 2009, John Kay noted that the product-driven culture was a predictable consequence of vertical integration in the financial services industry.[4]
 
The IMF Discussion Note referred to earlier also establishes that size is a form of regulatory capture inasmuch as regulators are forced to bail out big financial institutions for fear of the systemic impact of their collapse. The emphasis should be on narrow banks.
 
In a country with about 240 million officially poor and another 360 million who could be on the borderline of poverty, financial inclusion considerations will never be too far away from the centre or core of the banking structure issues.

The third principle has to do with the fact that financial inclusion is a necessity in an economy where close to 50% of the population is either poor or slightly above the poverty line. At the same time, financial inclusion through rural branches and co-operative banks, etc., have not been successful. Hence, alternative structures have to be considered. It is good to see the Reserve Bank of India remain open to innovative solutions like BC, mobile banking, etc. As they grow in size, they can and should migrate to other forms of license.
 
The fourth principle is that banking has been intimidating for India’s poor. Therefore, it should be conducted as much as possible in local language as in English. Hence, regional institutions and localised or specialist institutions are important elements of the new banking structure.
 
The fifth principle is that no one size is going to fit all in a country as vast as India with its rural-urban divide and with its rich-middle-poor divide too. Hence, the Reserve Bank of India must be prepared to experiment and adopt or abandon, as appropriate. The Governor indicated as much in his speech before the Competition Commission.
 
The sixth principle is that any institution that is involved in the creation of money and credit in the economy – whether operating under a banking license or not – must come under the supervision of the Reserve Bank of India. Non-bank finance companies that engage in deposit taking and providing debt financing for all manners of end-use (second-hand cars, trucks, etc.) must come under RBI supervision. The same applies to housing finance companies – whether they are engaged in financing the purchase of affordable homes or other homes. The paper on Banking Structure for India[5] released by CAFRAL in March 2014 does well to make an unambiguous statement on this.
 
The seventh principle of the appropriate banking structure for India is that regulation and capital requirement should be tailored to the sources of banks’ funding. Financial institutions that do not access low-cost retail deposits (and hence are not subject to priority sector obligations) must be subject to higher capital requirements. Banks that access low cost funding (retail deposits) must have safe and liquid assets to the full extent of their deposits.
 
Further, external wholesale funding must be a matter of exception and not the norm. Foreign currency interbank exposure is a huge risk for the macro-economy, given that the global environment remains vulnerable to large spillover effects generated by asymmetric and unprecedented monetary accommodation in the developed world. Further, domestic economic fundamentals constantly keep changing.
 
China has total reserve assets of nearly USD4.0trn dollars as of March 2014. Yet, its net international investment position is only around USD1.74trn (as of end-2012). There is clearly a private sector external liability of around USD2.2trn. Of course, total reserve assets were ‘only’ USD3.34trn as of end-2012. China’s inter-bank external liabilities are estimated at around USD1.0trn or more. Much of it has to do with short-term borrowing for engaging in carry-trade in anticipation of Yuan appreciation. Now, these liabilities pose a threat to banking stability in China because of Yuan depreciation – either engineered by monetary authorities or dictated by fundamentals or both.
 
Therefore, regardless of the banking structure chosen, capital (or, reserve or provisioning) requirements must be dynamic and sensitive to changing risk assessment of the balance sheet of the banks.
 
Final remarks
It is worth noting that John Kay in his report said that “competition where possible, regulation where necessary, and supervision not at all, should be the underlying principle”. At the same time, on the role of competition, it is good to remember the caveats expressed by William White, presciently in 2003:
 
A whole decade of deregulation and of rapid technological change has led to increased competition globally in the financial services industry. At the same time, financial institutions have been increasingly encouraged to hit high "hurdle" rates for profits, even when increased competition made such ratios harder to achieve. In this environment, particularly given the secular growth of public sector safety nets and financial institutions supported by the public sector, it would not have been surprising if private sector financial institutions were drawn into imprudent behaviour.[6]
 
In other words, the Reserve Bank of India is quite right to experiment with new banking structures given the urgent and compelling need to foster inclusion, for diffusion of bank credit to deserving small and medium businesses[7] and to sidestep financial repression imposed by hitherto imprudent fiscal policies.
 
In the process, it is important to safeguard economic system from the fallout of bank failures[8] arising out of acts of omission and commission on the part of individual institutions and that risk takers enjoy positive and bear negative consequences of their actions.


[1]Conference on Banking Structure for India, March 20, 2014, Mumbai
[2]‘Bank size and systemic risk’, IMF Discussion Note May 2014
[3]John Kay: ‘Narrow banking – the reform of banking regulation’ (March 2009)
[4]Kay records perceptively: “when bankers talk about innovation in financial markets, they are almost always talking about new products in wholesale markets (sometimes about new sales techniques in retailing) and almost never about improvement in the provision of core financial services.”
[5]Paper on Banking Structure for India by CAFRAL
[6]Source: International financial crises: prevention, management and resolution, Speech by William R White, Economic Adviser, Bank for International Settlements,  at a conference on 'Economic governance: the role of markets and of the State',  on the occasion of the Annual Congress of the Swiss Society of Economics and Statistics, Berne, 20 March 2003.
[7]John Kay: “Any attempt to influence lending through capital controls is likely to be a further stimulus to regulatory arbitrage, escaping the control and creating profit opportunities through useless complication. The most important policy measure which would help address this instability to stimulate a wider and more diverse range of lending institutions.”
[8]John Kay: “The appropriate public policy objective should not be to secure financial stability but to minimise the costs of financial instability to the non-financial economy.”

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