Licenses for Establishing New Banks in Private Sector: Why This Spat?

In the recent past, many have pilloried banks—institutions that accept deposits payable on demand affording a sense of comfort of ‘capital-certainty’ to the depositors and originate loans—questioning what is so special about banks when non-banking financial institutions are today doing everything that a bank does, and at times even more, that too, better than them.

But Lord Eddie George, the former Governor of Bank of England, has expounded them differently: banks somehow continue to be somewhat ‘special’, for they are the repositories of national economy, backbone of the nation’s payment system, and are the main conduits for the national monetary policies.

In effect, banks are perceived as providers of ‘socially valuable services’ that markets cannot supply. It is, of course, a different matter that in the process banks are inherently prone to a mismatch in their assets and liabilities. It is this embedded ‘liquidity risk’ that often makes them vulnerable to ‘systemic risk’. With the kind of innovations in financial technology that we are witnessing today, the liberalization of global financial markets and the unprecedented growth in cross-border flow of capital, the size and complexity of banks’ balance sheets have grown to mind-boggling proportion that has only further accentuated their vulnerability to ‘systemic risk’.

Market-based capital-allocation, as sought by the post-Keynesian economists, might have resulted in efficiency-gains—both to issuers and investors— here and there, but such increased flow of capital across countries has only placed heavy pressure on regulators to maintain ‘responsibility’ among the market players, which, of course, is often found wanting as exemplified by the 1997 Asian crisis and the recent grotesque misallocation of capital by the US subprime mortgage lenders that rocked the global financial markets—the after-shock of which is still felt everywhere.

This only highlights how essential it is to have an effective ex-ante monitoring of banks.  For, any lax in maintaining the faith of depositors is prone to result in a ‘run’ on banks. A quarter century back Bernanke said: “In a run, fear that a bank may fail induces depositors to withdraw their money, which in turn forces liquidation of the bank’s assets. The need to liquidate hastily, or to dump assets on the market when other banks are also liquidating, may generate losses that actually do cause the bank to fail.” It’s a self-fulfilling panic, against which, virtually every industrialized country has, of course, built a ‘safety net’ in the form of Central Banks to exercise policy control, and also act as the lender-of-last-resort.

Manuel Guitian proposed a three pillar approach to banking soundness: one, ‘official oversight’; two, ‘internal governance’; and three, ‘market discipline’.  But when it comes to banks, ‘internal governance’ assumes greater significance for, parties having interest in banks are many— shareholders, depositors and regulators; banks operate with high leverage—creates liquidity for the economy by issuing liquid liabilities and holding illiquid assets; and are quite opaque— difficult for outsiders to monitor that enhances insider’s ability to shift their activities quickly and massively for own gain. That aside, they are also expected to monitor the ‘corporate governance’ in businesses financed by them to ensure that they remain ‘fiduciary’. 

And to ensure ‘internal governance’ among the banks, the ‘official oversight’ of the Central Bank must be dynamically fine-tuned and executed with promptitude. This is all the more essential, for, ‘market discipline’ in case of banks is quite often than not found elusive—as the market players are carried away by ‘prisoner’s dilemma’—in delivering the best outcome. Aren't banks then, somewhat ‘special’?

Now all the demand for wise and vigilant regulation of banks gets further accentuated if the promoters of the banks happen to be well-entrenched industrial houses of the nation, for they can get tempted to perceive the pool of funds acquired by the banks established by them as capital available to further their own cause, or might as well deploy the said capital pool to expand their own industrial empire, claiming that the said lending was subjected to the usually prescribed prudential norms by the regulator.

It is obvious that against this background, the RBI must have felt it essential to get itself empowered to supersede the boards of banks should they err in complying with the regulations. That must be the driving force behind their asking the government to amend the Banking Regulation Act, 1949 to grant it the requisite powers before it invites applications for setting up new banks in the private sector. But the government appears to be in a great hurry when the Finance Minister P Chidambaram said that “the government’s well-positioned suggestion [to kick-start the process of receiving the applications for issuing licenses] is taken up by the RBI.”  Their argument is that such powers are anyway not required immediately, for such an eventuality arises only when banks are established and run for a couple of years.

True, the need for such powers arises only after the banks are established and run for sometime, but only in the case of prospective banks. But the RBI might be interested in the said powers even to regulate the existing private sector banks, or might doubt the government’s ability/intention to pass the said amendment.  Nevertheless, there is no need for such a spat between the RBI and the government, that too, in public, for both of them are interested in having a well functioning banking system in the country. All that they need to do is to sit together and chart a course of action that is mutually agreeable, and execute it with grace.

It is time the national institutions gave up mocking each other publicly, for it does not speak well of a mature democracy.