Bank failures: When it comes to regulation West can learn plenty from India

The West can learn from India the art of keeping a balance between the asset and liabilities sides. But it won't

Bank failures are in the news again but fortunately not in India. In fact, Indian banks have been pretty ok despite the huge bad loan problem. This has prompted even the prime minister to say we have nothing to worry about.

This wasn't always the case. Until the early 1960s, Indian banks used to fail as frequently as anywhere else in the world. Free entry and exit were the order of the day. The depositors had no say because the caveat emptor – buyer beware -- rule prevailed. Banks kept failing. You name a bad practice, and it was there. Depositors kept getting shortchanged.

The Reserve Bank of India, set up in 1935, immediately wanted to take over bank supervision to clean up the industry thoroughly. But it was asked to wait until after the Second World War for reasons that are unclear.

In 1947 India became independent, and very quickly, in 1949, comprehensive banking legislation was passed. Even so, between 1947 and 1960, there were a few collapses. The Palai Bank was the last major bank to collapse in 1960. Its depositors got nothing. Since then, there's been no collapse that's left the depositors out in the cold.

After that failure, the RBI became very active. Since then, although it's never been given enough credit, it's done a pretty good job of preventing failures or mitigating their adverse impact because very strong regulation became the order of the day. Some would say India's banks are over-regulated.

That's because the Palai Bank case is burnt into the RBI's institutional memory. The two had been in a tussle for a long time, nearly a decade. The RBI was convinced that the bank had become inherently unstable. The management cried foul and almost suggested mala fide on the RBI's part.

The tussle intensified between 1956 and 1960, with both sides digging their heels in. Then the RBI governor, HVR Iyengar, "directed the bank in November 1958 not to declare a dividend until it managed to bring its bad and doubtful debts down to a reasonable level." In June 1960, there was a run on the bank's deposits, and the bank collapsed.

But the Palai Bank collapse had two positive effects: the birth of deposit insurance and the tightening of the RBI's grip on commercial banks because the government empowered it to forcibly merge weak banks. It's been doing that ever since to protect depositors.

Why am I recounting all this? Unlike western banks, which are poorly regulated, Indian banks are fully regulated on both the assets (loans) and liabilities (deposits) sides.

Despite that, banks get into trouble because of the skewed ownership pattern of banks. They are still largely government-owned.

This works poorly on the assets side because of political interference in loans but works well on the liabilities side because of prompt capitalisation. What the politicians take with one hand because they need the money for politics, they give back with the other because they fear the voters.

The western system doesn't understand this balance. While its protagonists champion the system's virtues in managing the asset side, which is frankly quite bad, on the liabilities side, they do exactly what India does: use taxpayers' money.

There is a larger point involved here. Intense political competition in an electoral democracy on the one hand and keeping the state at arm's length on the other are incompatible ideals. India has achieved an excellent balance, and the West has much to learn from it.

But as in so many other things, it won't.

Disclaimer: These are the personal opinions of the writer. They do not reflect the views of www.business-standard.com or the Business Standard newspaper