As safe as the banks?

Eleven Octobers ago, the global economy suffered its most calamitous financial crisis since the Great Crash of 1929 which triggered the Great Depression. The epicentre of the two crises was the United States, which has, in both intellectual and practical terms, been the home of free markets for most of the last 100 years. 

Therefore, it is easy to arrive at a definitive conclusion about the excesses of markets, particularly in the financial sector, and to bat for an alternative, highly regulated vision not just for the financial sector but for economies at large. It is distant memory now, but in the months after October 15, 2008, there was much self-congratulation in the policymaking and regulatory communities in India on how their abundant caution had saved India from the worst in the aftermath of the collapse of Lehman Brothers. How ironic it is that a decade on, it is India’s supposedly well-regulated and tightly-controlled banking sector that is in a complete mess, paralysed even as the once excess-ridden banks of the West have got their mojo back. 

The truth is the fitness of the Indian banking system was never tested. After all, the mettle of a ship cannot be tested while it is in harbor. Now, it is fairly well-accepted that the worst excesses of India’s banking happened in the boom period between 2005 and 2012. In fact, if India’s regulators and policymakers had begun a process of deregulation and privatisation circa 2008, some of the malpractices might have been arrested at an early stage. But, at the time, the winning argument was in favour of the conservative approach where the banking system was dominated by government-owned entities, where competition from private sector banks was limited, and product innovation unheard of. The Indian economy is paying a long-term price.

It cannot be denied that left to themselves free markets can over-extend and lead to crisis outcomes. It has happened countless times in the economic history of the last century and a half. Karl Marx and his followers believed capitalism would be a failed system because of this. What is often under-emphasised is the ability of markets to correct themselves. Of course, on occasion this requires the intervention of the state like it did in 2008 to enable the correction to happen faster while limiting the negative fallout. It is important to note that in the end, the long-term fallout of the 2008 crisis was limited to a handful of countries, mostly in Southern Europe which lacked the structural flexibility to bounce back quickly, largely because of excessive state intervention and egregious state spending across sectors. 

In contrast, how does a closed system dominated by the state -- like India’s banking sector -- correct its crisis-like problems? The best way would be to give it a dose of the markets. If the excesses of the market need state intervention, the excesses of the state need market intervention. But the market cannot intervene without the state willing it on. And the state often does not back away. In extreme cases, like in the case of the Soviet Union and Eastern Europe in 1989-1991, the complete inability to correct economic problems led to a collapse of the political system. It was only after that that the market entered the scenario to deliver shock therapy which had its own adverse side effects.

The government of Prime Minister Narendra Modi is well-positioned to administer just the right dose of medicine to the ailing banking sector. Continuously recapitalising public sector banks is a placebo. It may make the government feel better but it won’t cure the causes of the disease. Similarly, consolidating public sector banks may make the problem seem more manageable but the underlying cause, those related to state control over banking, will not go away. The government must go one step further by bringing its stake below 50 per cent, preferably down to 26 per cent, in at least two of the consolidated banks. The shares need not be sold to any rival bank, Indian or foreign. They need not be sold to established industrialists. They should be offloaded to the public at large. The banks will get an independent board and professional management. It is only then that they will begin a genuine recovery. The government need only to look back at the ICICI experience in the 1990s.
 

Equally significantly, the government should bite the bullet on regulatory overhaul. The Reserve Bank of India, in its capacity as regulator of banks and NBFCs, has failed in its task of maintaining a stable and healthy financial system. It is possible to separate the task of regulation from the central bank. Some countries have done it. If it is to remain with the RBI, a complete mindset change — from control and regulation to competition and transparency — is required.

India cannot aspire to be a double-digit growth economy with a dysfunctional financial system. State failure needs to be taken as seriously as market failure.

The author is chief economist, Vedanta