Beyond banker bashing

The lesson from the West for India is that banking should be kept simple

The report of the UK parliamentary commission on banking standards, ambitiously titled "Changing banking for good", was released in June 2013. This article lists a few salient conclusions of the report and reflects on their implications for Indian banks.

The report comments caustically that banking history is littered with past disasters based on a "consensus of self-interest or self-delusion". According to this report, the absence of financial penalties or any other sanctions engendered a lack of accountability and that "serious regulatory failure" contributed to the dropping of banking standards. Interestingly, the report observes that the British government's priorities should include "relinquishing political control", leaving the setting of appropriate leverage (equity/assets) ratios to regulators. The report correctly identifies the equity-to-assets ratio as the "single most important tool to deliver a safer and more secure banking system". The report acknowledges that banks will continue to enjoy an implicit government guarantee because they are either too large or too complex, so it recommends allocation of greater accountability to auditors.

 

It is significant that the 10 members of this commission, drawn from both Houses of Parliament and across all political affiliations, were able to make consensus recommendations. In the context of the report's proposals, Chancellor George Osborne is reported to have indicated that the UK's Financial Services (Banking Reform) Bill could include provisions for criminal charges against bankers who are "reckless". Further, regulators may have powers to defer bonuses by up to 10 years.

Moving to the continent, euro zone banks continue to stagger under their debt overloads, which amount to about 250 per cent of the euro zone's GDP. These banks are struggling by another metric too: their average price-to-book ratio is below one. Across the Atlantic, in the United States this ratio is above one, since US banks were recapitalised faster. However, there are concerns about the universal banking model in the US too. Senators John McCain and Elizabeth Warren recently proposed legislation to introduce a revised version of the Glass-Steagall Act (Sections 20 and 32 were repealed in 1999) to again segregate investment from regular banking.

The Reserve Bank of India (RBI) issued its seventh biannual Financial Stability Report in June 2013. The report states blandly that "risks to the Indian banking sector have increased since December 2012". Concurrently, the report states that India has made "steady progress in implementation of G20/Financial Stability Board-led global reforms" with respect to Basel III, over-the-counter (OTC) derivatives and regulation of systemically important financial institutions.

The RBI's capital requirements for banks are higher than Basel III standards - for example, instead of the Basel III norm of six per cent Tier I capital as a fraction of risk-weighted assets, the RBI has prescribed seven per cent. Banks are required to meet these requirements in a phased manner by the end of March 2018. Additionally, the RBI has stipulated 4.5 per cent as the leverage ratio (Tier I capital as a proportion of total assets) even as the Basel Committee on Banking Supervision is yet to finalise this benchmark.

Going by past volatility in asset prices, these capital requirement levels are inadequate. Drilling down, what is important is how total assets and equity are estimated. For example, the US' Generally Accepted Accounting Principles (GAAP) allow for netting of assets and liabilities on derivatives portfolios, which results in a lower number for total assets. However, the International Financial Reporting Standards used by European banks do not allow such netting since counter-party credit risk can be significant for OTC derivatives. Using the GAAP methodology for estimating total assets could induce complacency because it results in lower assets, and consequently a higher equity-to-assets ratio. The point is that accurate calculation of capital adequacy ratios depends on accounting rules and practices.

In India, the ground reality is that several large projects have stalled and growth has slowed. For these and other less transparent reasons, non-performing assets and restructured assets have grown, particularly for Indian public sector banks. And it has been reported that to enable public sector banks to meet capital adequacy guidelines , the central government would have to provide about Rs 91,000 crore ($15.2 billion).

At a popular level, the London Review of Books carried articles in two successive issues dated July 3 and July 18, 2013, excoriating the reluctance of banks to reduce leverage and change their attitude of "heads we bankers win and tails taxpayers lose". The extent of anger against bankers who refuse to reform is revealing.

Instead of banker bashing, it would be more constructive towards mitigating the consequences of future disasters if banking were to be kept simple. Capital requirements could be beyond those prescribed under Basel III. However, this would be of little comfort if capital adequacy norms were not met and yet compliance were recorded through complex fudging.

It has been reported that the RBI has received 26 applications for new banking licences. One of the objectives for allowing additional private sector banks is that this is needed to improve efficiency and financial inclusion. It is possible, although it is not immediately likely, that new private banks would be able to increase the size of the deposit base faster than would have been possible with existing banks. As regards the objective of enhancing financial inclusion, new private sector banks may not have the ability or profit motivation to provide banking services to large numbers of small depositors.

It is interesting, therefore, that the Department of Posts too has applied for a banking licence. It would be difficult, but not impossible, for it to acquire the required expertise and risk capital if it were to team up with a robust public sector bank. Of course, no public sector bank can afford to absorb all the staff of the Department of Posts. So personnel policies for such a new bank would have to be thought through carefully to prevent inevitable insolvency down the road if this is not done at the outset. On the plus side, from the perspective of enhancing financial inclusion, the Department of Posts has impressive reach; it has about 150,000 post offices as against State Bank of India's 15,000 branches.

To end on a positive note, the new private banks will hopefully mobilise additional deposits and widen financial inclusion. We also need to think imaginatively to use the Department of Posts in partnership with an existing public sector bank. Additionally, we need to urgently consolidate public sector banks to help them face competition from new private sector banks.

---

The writer is India's high commissioner to the UK.
Views expressed are personal.
j.bhagwati@gmail.com