Self-created problem

The Reserve Bank has imposed caps on inter-bank liabilities; this is likely to restrict the business strategies of many banks, particularly foreign and private banks. At first blush, the RBI is right in saying that an extensive structure of inter-bank deposits induces the risk of a "domino effect" when one bank fails. The foundation of a safe and sound banking system is a framework of rules where banks that get into trouble die without bail-outs; to the extent that the death of one bank endangers others, it is more likely that a bail-out will be offered.

At the same time, in the Indian setting, there is an important economic role for such inter-bank transactions. Some banks""particularly the state-owned ones""have strong deposit-sourcing abilities while being weak at building quality asset portfolios. Other banks""primarily the private and foreign banks""have a weak deposit base and are often better at building high-return asset portfolios. Indian economic growth is enhanced when the state-owned banks source deposits and, in turn, lend these to private/foreign banks for deployment in the economy. Such beneficial transactions will be deterred by the new RBI rules.

It is possible to achieve both goals ""of avoiding bail-outs and achieving economic efficiency""through a two-pronged strategy. First, deposits or loans are a poor mechanism through which to achieve these transfers of resources from one bank to another since they have no collateral and are non-transparent. Such transfers are better achieved through straight bond issuance and particularly through securitisation. If the rules prohibit a bank from placing more than 0.5 per cent of its total assets in the bonds of any one bank, then safety is achieved. Much more important, though, is securitisation. When the UTI Bank makes securitised pools of car loans, and the State Bank of India buys these instruments, the net result is that deposits sourced by the SBI end up backing the UTI Bank's strengths at forming portfolios. Securitisation is "bankruptcy-remote", so that the buyer (the SBI) cares only about the performance of the car loans and not about the survival of the UTI Bank. Growth in both these directions has been stalled because of India's monumental failure in achieving a bond market and a securitisation market.

The second line of attack goes to the heart of the problem. Why is it that state-owned banks have an edge in sourcing deposits? The root cause is the entry barriers thrown up by the RBI, especially in the way of banks with the ability to build more quality assets if they have access to deposits. Also, we are running at a rate of roughly 0.2 new banks starting up per year, which is low for an under-banked country. All foreign banks, put together, are permitted to open 18 outlets in India per year. Such policies are grossly out of touch with a new India where McDonald's may soon be opening 180 outlets per year, and (even more importantly) are out of synch with the needs of a rapidly growing economy. Some of the leading private banks have been penalised for their misdemeanours in the stock market by having their branch expansion plans frozen for a while; it is in the interest of the economy to allow them to expand their network faster. As long as state-owned banks have the deposits but not the portfolio-formation acumen, it is important to devise financial engineering through which their "dumb money" can be put to the best use. The most important channel of progress, however, will be to have much easier expansion rules for all qualified banks.