Dealing with the Trilemma

Urjit Patel has been one of the most enigmatic governors of the Reserve Bank of India (RBI) in the recent past. He is known to be simple, shuns protocol, and hardly speaks. Even during the (almost mandatory) post monetary policy press conferences, he would largely let his deputies do the talking. The most blistering attack on the state during his tenure was made by Viral Acharya, his deputy, who acknowledged the blessings of Mr Patel in the speech. 

He was quite a contrast to his predecessor Raghuram Rajan who was accused of speaking beyond his brief. Therefore, it was exciting to hear that Mr Patel had written a book, because it would offer an insight into his thoughts on several issues. However, at best, this book reiterates what we knew about Mr Patel—a man of few words, a scholar with deep insights. And yes, he is paranoid and, therefore, very careful. The entire book (save for the acknowledgements) has no names and identifies events, institutions and powers in vague terms. Public sector banks are called Government Banks (GBs) and Private Banks are PBs. There are broad dates but no specificities. Most of the book is a reproduction of his writings and speeches during his tenure. We could call this the Complete Words of Patel as RBI Governor.

While his knowledge and expertise is on a wide range of economic issues — his first stint at RBI as a consultant had resulted in a couple of papers including one on pensions but he has been consistent in his work on banking. It is interesting that during his tenure there were multiple events that affected the economy but when it came to talking about them he chose banking. Demonetisation would not be a honeycomb that Mr Patel would like to poke. Writing about banking would be timely, academic and relatively risk-free. He, after all, is one of the many (but significant) voices on reform. The theme is familiar.

The basic argument that Mr Patel has been making has its roots in the discourse on banking reform and reducing dominant state ownership and control over the banks. There is an assumption that state-owned banks have a sovereign guarantee and, therefore, safe from the depositors’ perspective. But sovereign ownership also creates a sense of performance complacence. The punishment by the stock market for non-performance is blunt but it does not ostensibly harm the dominant shareholder. It is the minority shareholder who suffers at the first instance and then (if the insulation of the sovereign is removed) the saver. However, if there is a large overlap between savers and tax payers then they are paying the price for saving themselves at one end even as the cost of finance for the economy does not go down. The cost of non-performing assets and administrative overheads ultimately has to be recovered from the profits — a reason he indicates that interest rate cuts do not get transmitted.

Mr Patel talked about the impossible trilemma in a keynote address in a presentation in Stanford, where he argued that if the banking sector is dominantly owned by the state and there was a limited fiscal space, then transgressions occur and what is essentially the domain of monetary intervention permeates the fiscal space. If the state itself announces “credit budgets” (giving directions and targets on where capital formation should take place but through commercial institutions controlled by it) then independent regulation suffers. The use of a commercial organisation that is not completely autonomous for ostensibly developmental objectives that may not fetch market returns would result in stress — and that is what we are seeing with the state-owned banks. This is a problem even if we do not have cronyism, but it is accentuated when that element is added to the mix.

One effective way to deal with this is to strengthen regulation. That cannot happen unless: (a) the regulatory framework is common for all players and GBs do not have a special cover from the sovereign; and (b) ownership (or the framework of governance) moves towards “autonomy” where the banks are accountable to the markets — not only for their performance but also for raising incremental capital. Without (b), it would be difficult to achieve (a).

Mr Patel has gone to the root of the problem and discusses it in great detail. The rest of the arguments are about setting things right. One could do this by intermediate measures of reform — create insularity between the state and the bank by having an independent authority to appoint senior management; empower boards; and empower the regulator to take actions that are no different from the leeway available for private banks. 

These intermediate measures have been tried in bits and pieces at differing times. However, while we would see “reform” for a brief period, the “Empire (almost always) Strikes Back,” as Mr Patel puts it. So, this argument is not about privatisation or ownership but about having an appropriate accountability framework for the role and function of the entity that dictates the economy. If the ownership predicates the accountability framework, that needs to change. From past efforts at reform that seems to be the only way in which we do not relapse.

Is anybody listening? Well, they did not listen to the governor; would they listen to a former governor?

mssriram@pm.me;  the reviewer is a faculty member and Chairperson of the Centre for Public Policy, IIM, Bangalore