He proposed that Government and RBI allow private well-governed deposit-taking small finance banks to enter the business, writes TCA SRINIVASA RAGHAVAN
By 2006, after YV Reddy had been Governor for three years, a major rift had developed between the RBI and the Government. There is no conclusive proof but some of it perhaps had to do with the promises that Manmohan Singh had made to George Bush as part of what has come to be known as the nuclear deal. A critical element of that deal was the opening up of India’s financial markets and the RBI was dragging its feet because of justified apprehensions. It would be vindicated in September 2008 when the global financial markets crashed. But until then, the RBI was systematically portrayed by the government and its hired guns as a villain.
One important hired gun, or so many in the RBI believed, was Raghuram Rajan who, naturally, had no idea how he was being used by the Government. The Planning Commission, of all the institutions, now headed by Montek Singh Ahluwalia who was Manmohan Singh’s alter ego in economic policy, asked Rajan to prepare a report on how to reform the financial sector. His report, called ‘A Hundred Small Steps’ provided a clear blueprint for the future. It was an excellent report but it ran into a big problem: no buy-in from the RBI. Reddy refused to cooperate just as he had done with the report on participatory notes. It is worth noting that Rajan was widely tipped to succeed Reddy as the Governor. But in the end, an IAS officer, D Subbarao, the outgoing finance secretary whose grasp of monetary policy was not the best in the world, was appointed to the job. Before he became finance secretary he had been with the Prime Minister’s Economic Advisory Council which was headed by the highly influential C Rangarajan. like Reddy, Subbarao was also from the Andhra cadre of the IAS but unlike Reddy who had a PhD in economics, his training had been in physics. Towards the end of his tenure, he would often compare economics and physics in his speeches.
Rajan’s report had a simple plan: Open up, liberalise, include and let a hundred flowers bloom. Thus, he wrote: ‘The most important shift in paradigm is to alter the emphasis somewhat from the large-bank-led, public-sector-dominated, mandate-ridden, branch-expansion-focused strategy for inclusion. The poor need efficiency, innovation, and value for money, which can come from motivated financiers who have a low-cost structure and thus see the poor as profitable, but who also have the capacity of making decisions quickly and with minimum paperwork.’
He proposed that the Government and the RBI should allow private well-governed deposit-taking small finance banks to enter the business. Given that they would be facing higher risk, he said they would have to have ‘higher capital adequacy norms, a strict prohibition on related party transactions, and lower allowable concentration norms (loans as a share of capital that can be made to one party).’
lest the RBI grumble, which it did anyway, Rajan pointed out that these banks would be no different from the local Area Banks which the RBI had experimented with in the past. As it happens, this was not very different from what the private banks had been doing till they were nationalised. In that sense, first the RBI and now Rajan merely wanted to turn the clock back. As Rajan put it, ‘The intent is to bring local knowledge to bear on the products that are needed locally, and to have the locus of decision making close to the banker who is in touch with the client, so that decisions can be taken immediately.’
Rajan then took on those who were against small banks. ‘A large number of commentators believe, based on historical evidence, that small banks will be unviable in India. They question the honesty of small promoters, as well as the profitability of these banks given high fixed costs. This committee recognizes that small banks have not distinguished themselves in India in the past…the committee would call for substantial care in who is licensed, as well as greater regulatory oversight. There is, however, no necessary link between size and honesty, as the recent experience with large banks suggests.’ (emphasis added).
Then Rajan made a leap of faith: Indeed, the larger number of potential applicants for small banks suggests the regulator can be far more selective in applying ‘fit and proper’ criteria. There was no reason to believe this to be the case, as the experience with other such banks in the 1990s, GTB in particular, had shown. Rajan added that ‘the failure of even a few small banks will not have systemic consequences, unlike the failure of a single large bank.’ This was true, but it escaped the question of what would happen to the depositors and what the political consequences would be for the Government in power.
Excerpted with permission from Dialogue of the Deaf: The Government and the RBI authored by TCA Srinivasa Raghavan, Westland, Rs 599