Interesting Readings 15 March 2018

No Banking Regulator Can Prevent All Frauds, Says RBI Governor
Urjit Patel, full speech is here. Before reading you might be tempted to count this as a cop out by RBI. However, Urjit Patel raises important issues which merit consideration in overall scheme of Banking Regulation. It is not to blame present government but to highlight the important issues. Most of the points he highlights need careful deliberations which frankly I think are beyond Arun Jaitley. (He may be a good man but mostly misled by his bureaucrats and same goes for Hasmukh Adhia).

All commercial banks in India are regulated by the RBI under the Banking Regulation (BR) Act of 1949. Additionally, all public sector banks are regulated by the Government of India (GoI) under the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970; the Bank Nationalisation Act, 1980; and the State Bank of India Act, 1955. Section 51 of the amended BR Act explicitly states which portions of the BR Act apply to the PSBs, most common thread across the omissions being complete removal or emaciation of RBI powers on corporate governance at PSBs:

• RBI cannot remove directors and management at PSBs as Section 36AA(1) of the BR Act is not applicable to the PSBs.
• Section 36ACA(1) of the BR Act that provides for supersession of a Bank Board is also not applicable in the case of PSBs (and regional rural banks or RRBs) as they are not banking companies registered under the Companies Act.
• Section 10B(6) of the BR Act that provides for removal of the Chairman and Managing Director (MD) of a banking company is also not applicable in the case of PSBs.2
• RBI cannot force a merger in the case of PSBs as per Section 45 of the BR Act.
• PSB’s banking activity does not require license from RBI under Section 21 of the BR Act; hence, RBI cannot revoke a license under Section 22(4) of the BR Act as it can in the case of private sector banks.
• RBI cannot trigger liquidation of PSBs as per Section 39 of the BR Act.
• Furthermore, in a remarkable exception of sorts, in some cases there is duality of Managing Director and the Chairman – they are the same – implying the MD is primarily answerable only to himself or herself.

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.3 I will now take a few minutes to explain why this fissure or the fault line is bound to lead to tremors such as the most recent fraud.

(...)

In contrast, the market discipline mechanism for public sector banks is appreciably weakercompared to that at private banks. There is implicitly a stronger perceived sovereign guarantee for all creditors of PSBs, and the principal shareholder – the government – has not so far been interested in fundamentally modifying the ownership structure. From an economic standpoint, this weakened market discipline should imply that the government would prefer strongerregulatory discipline of these banks, not weaker. However, as I explained above at length, and perhaps since the original idea behind bank nationalisation was complete government control over credit allocation to the economy, the situation in India is exactly the reverse: RBI’s regulatory powers over PSBs are weakerthan those over the private sector banks.

The owner of our public sector banks – the government –which has provided the IBC, the related ordinances and the bank recapitalisation package to get the churn going, might consider making further, equally important contributions by:

• Making banking regulatory powers neutral to bank ownership and leveling the playing field between public sector and private sector banks; and,
• Informing itself about what do with the public sector banking system going forward as part of optimising over the best use of scarce national fiscal resources.

It is an open issue whether centralised government control alone can be effective enough at designing and implementing governance of banking franchise comprising over 2/3rds of the sector’s deposits and assets. It would be better instead to restore regulatory and market discipline.

Read this in context of article below which suggests some ways how to operate publicly owned companies.

Functional capitalism - Scott Sumner

Scott Sumner talks about past article How capitalist is Singapore? (we linked to this in previous post). Read the article with an eye to Air India and Indian Government owned companies. The first line is : 

Singapore Airlines is majority owned by the Singapore government. Alitalia is privately owned. So which country's airline industry is better described as "capitalist", Singapore or Italy?

India's Clouseau Bankers Deserve a Bigger Stick
Andy Mukherjee says it well suggesting Arun Jaitley should accept Urjit Patel's suggestions. Though I do not agree with the privatisation part. They could well set out a road map saying Banks will be privatised in 8 years or so and then working them towards profitability.

The Return of Haim Bodek

Haim Bodek is a whistle-blower who exposed Direct Edge a stock exchange help High Frequency Traders. He is back with another expose of NYSE now. Both have resulted in fines of $14m. Also worth reading are articled linked in this one.

Waiting for the Chinese Bear Stearns

Chinese credit risks are quite severe. It is good that India is reforming its banking system. This will allow for next decade or two of growth. 

China’s Economy Is Not Normal. It Doesn’t Have to Be.

A counter-view about China. He points out that China's overall debt is not too high. He makes certain other points in favour of China too.

But the debt is not too high when using normal methods. The Chinese use outside-mechanism to create debt. It's institutions carry too much debt burden backed by the government. This debt has financed investment in factories capacity equal to global demand for many products. When trade policy turns adverse and every country protects its own manufacturing, this capacity will be a huge liability. US is rightly changing the policy and in fact is playing the conflict strategically in the economic theater. US did the same with Soviet Russia - played them economically with Star Wars program.

What should be the international reaction to Chinese debt problem?

Global central bankers should increase the risk weightage for firms dealing with Chinese financial institutions. This is the time to increase capital backing these transactions.  That is what I suggested in Subverting Capitalism & Democracy:

In  an  economic  growth  cycle,  it  seems  advisable  to  have  increasing  deposit  reserves.  As  the  pace  of  the  economy  grows, banking system should become taunt and solid. This  moves the banking system from a fractional reserve system  towards  100%  reserve  system.  Of  course,  it  would  never  reach  100%  reserve.  At  the  extreme,  reserves  may  reach  say  40%.

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