Urjit Patel is right: But Reserve Bank of India should introspect as well

The recent scandal about fraudulent letters of undertaking (LoUs) has once again brought into the public eye the question of governance and regulation of public sector banks (PSBs). There has been considerable criticism of the banking regulator, the Reserve Bank of India (RBI), for failing to put in place mechanisms to ensure that bank processes are not subverted in the manner that they appear to have been in the Nirav Modi case. There is some merit in this as the central bank should look into why it did not conduct a follow-up audit after issuing directions to banks to link SWIFT (Society for Worldwide Interbank Financial Telecommunications) electronic messaging with their core banking systems. It is only now that all PSBs have decided to do so by April 30.

But the broad points raised by RBI Governor Urjit Patel in his speech on Wednesday are unexceptionable. Mr Patel has pointed out that incentives for PSBs are skewed by a combination of preferential regulation and their particular governance structure. While private banks are subject to market discipline and regular forms of supervision by the banking regulator, both of these criteria are weaker when it comes to PSBs. Given that PSBs are, in any case, subject to a softer budget constraint than private banks because the Union government implicitly guarantees their operation, the governor pointed out that regulation associated with PSBs should then be more stringent than that imposed on private banks. Yet this is not the case. The laws governing PSBs essentially weaken the RBI’s regulatory powers over them. For example, it’s odd that the RBI can fire the CEO of any failing private sector bank, remove directors, supersede its board, or force a merger. It can do none of those things with a PSB.

He is also right in arguing that a system in which one part of the banking sector is not subject to proper regulation is unsustainable. Fraud, crises and bailouts are the inevitable results. The ultimate authority over any financial institution should be the regulator — but this is not the case with PSBs. Mr Patel also pointed out that changing this fact would be the most feasible approach to PSB reform. Yet it is not the only way, or the best way. As the governor also implicitly argued, fundamental governance reform is the real way to ensuring PSBs become more reliable participants in financial markets. While Mr Patel stopped short of the word “privatisation”, he does mention the possibility of “diverse ownership structures”. Yet it should be obvious that the logical culmination of any such governance reform is a banking system that is largely private, and in which all major players are subject to equivalent regulation from the RBI.

It is understandable that the government may not be eager to embark on such major reform at this late stage in its tenure. Yet Mr Patel’s argument that the absence of market discipline will lead to continued crises — and the consequent political hits to whichever government is in power — should cause the government to think more carefully about its business-as-usual approach to public sector banking. The governor is absolutely right in highlighting this problem, and his proposed path to fixing it is deserving of close attention.