An excerpt from Y.V. Reddy’s Advice and Dissent: My Life in Public Service on his time as RBI governor.
Our efforts to improve the financial system had mixed results. With public sector banks we tried, but we failed. With private sector banks, we tried, and we succeeded. Similarly, with rural cooperatives, we failed, and with urban cooperatives, we succeeded.
We explored specific strategies for improvements in each of the components. Public sector banks dominated our thinking, but the RBI’s manoeuvrability was limited by legal provisions that empowered the government. Private sector banks required improvements in governance and we in the RBI had the scope to achieve results. Foreign banks had few branches, but were keen to penetrate deeply into our system. However, we successfully resisted premature onslaught. The cooperative system was relevant for a large number of people, but it suffered from several weaknesses arising out of politicisation of the system. Non- banking financial companies was a large but nebulous segment within the jurisdiction of the RBI. Two of them with large public deposits posed problems that we could resolve. There was a large segment of the semi-formal financial system that was undertaking banking-like activities. These included chit funds, trusts, non- governmental organisations, and self-help groups. They were out of our jurisdiction. In brief, we in the RBI had to be conscious of the scope for and limits to our contribution to the financial system. But reforming, regulating, and supervising such a diverse segment has been a fascinating personal and professional experience.
The overall performance of the financial system depended on the functioning of the public sector banks which accounted for more than two-thirds of banking business. The standards of governance depended on the manner in which the government exercises its powers under the legislative provisions by which several banks were nationalised. The RBI’s oversight of public sector banks was focused on prudential regulation.
Public sector banks had some strengths as well as some weaknesses. They had a large network of branches. They had a large workforce, which at the time of recruitment was skilled. Their familiarity with the society and local businesses was unparalleled. Their functioning in a modern competitive environment was constrained by several factors. The officers and staff were lacking in incentives to perform. They were subject to parliamentary oversight, to the jurisdiction of the CBI and the Central Vigilance Commission, which should ideally concentrate on those issues which arise in performing sovereign functions and not commercial activities. Also, accountability to Parliament and influence of individual parliamentarians and bureaucrats are often indistinguishable.
The nominations to the boards of the banks were governed, to a significant extent, by political affiliations. The official nominee of the government on the board represented both the sovereign and the shareholder and thus exercised disproportionate power.
The chances of privatisation of public sector banks or similar reforms were, in our judgement, very dim. Their medium- term future was unclear for the entities themselves. A budget announcement to reduce government shareholding below 51 per cent by Finance Minister Yashwant Sinha had not been followed up. The government had no specific strategy on the future of public sector banks. I did not expect either a dilution of public ownership or an end to dual control by the government and the RBI over them. We made some attempts to improve their standards but with disappointing outcomes. I will narrate them to show how the system works.
We wanted the directors nominated by the government to the public sector banks to satisfy the ‘fit and proper’ criteria on par with those prescribed by the RBI for private sector banks. The government was not averse at a formal level to the RBI recommending or commenting on the ‘fit and proper’ aspects of the proposed nominee directors from the government. In practice, it did not welcome our intense due diligence. A proposal to create a roster of competent professionals who could be nominated on bank boards was made but was never responded to. After a while even the formality of a reference to the RBI when the government nominated non-officials to bank boards was done away with.
The chief executives of banks were appointed by the government, as per the legal requirement. However, a committee headed by the governor recommended the names. The committee had representation of the government and an expert nominated by it. My contention was that a regulator could accept or reject a choice but could not recommend to an owner who ought to be appointed. The government’s nominee is involved both in the process of recommending and approving. We pleaded for total exclusion of the RBI’s role in recommending chief executives by exempting the bank from participation in the process of selection. At the same time, we sought the government’s voluntary acceptance of the RBI’s role in giving clearance to CEOs selected by the government. This was in consonance with procedure in respect of private sector banks. Our proposal was not accepted by the government.
An important issue in governance is conflict of interest. Hence, we did not want our officials to be on the boards of public sector banks. We proposed amendments to the relevant laws which mandated such nomination. However, I was informed by the nance secretary that the parliamentary standing committee was keen to continue to have RBI official in the boards. I suggested that, as a compromise, the law could provide for nomination of a person with experience in financial regulation. The suggestion was accepted. So, the legal amendment did not bar the nomination of RBI officials while removing the mandated nomination of RBI officials. During my tenure, I proposed the names of retired officials of the RBI.
The government expressed policy preference to bring about consolidation in the public sector banks. Our view in the RBI was that consolidation should not be an end in itself. It should be driven by appropriate assessment of synergies by the enterprises concerned. Experience showed that many cases of consolidation of banks had failed globally. My view was that increasing size through consolidation would not solve the basic problems of the public sector, namely, standards of governance. We suggested that the government, as owner, should assess overall bene t to it as a result of the proposals for consolidation of individual cases or consolidation should be part of an overall well-worked-out strategy. Despite our advice, divestment, and consolidation were considered by the government in parallel, without much progress.
In contrast, we had excellent support from the government in improving the private sector banks, which were a mixed lot of good and bad ones. The old private sector banks were relatively small, and in the nature of community banks. Some of them had been captured by investors with doubtful credentials. The newly licensed private sector banks started off well, embracing new technologies and modern banking practices. Over time the segment became a mixed bag, with a couple of super-performers, and some causing discomfort. Two of the super-performers, ICICI Bank and HDFC Bank, were promoted and incorporated in India, but the majority of ownership was foreign.
There were several small private sector banks which did not satisfy the minimum capital adequacy requirement prescribed under the new guidelines. Several stratagems were adopted to ensure that either they increase the capital within a specified time or they get merged with a healthier bank on a voluntary basis. The RBI actively encouraged consolidation in the private sector banking system, mostly through voluntary mergers or acquisitions. Consolidation happened mainly due to enforcement of t and proper criteria on ownership and governance. In one case, however, merger was imposed, and it was a challenging task.
Soon after I joined as governor in September 2003, I had to take a view on cleaning up of the balance sheet of GTB for the financial year 2002-03. The inspection by the RBI in previous years found that there was significant misclassification of assets and other accounting irregularities to understate losses significantly. After making the corrections, the financial statement for 2002-03 showed an overall loss, but a small operating profit for the year. The balance sheet had to be in the public domain before the end of September. The proposal before me was that the RBI should issue a statement welcoming the clean-up of the balance sheet by GTB which, no doubt, was at the instance of the RBI. The danger of issuing a statement was that markets might treat it as a certificate of sound health and good conduct, which certainly was not true. At the same time, the case for issuing a statement was to ensure that there was no serious loss of confidence and consequent run on the bank as a result of the disclosure of the significant misclassifications made in the past. We issued a statement of assurance just in time, on 30 September, so that we could consider a line of action in due course, at a time of our choice. However, GTB continued to be on the list of problem banks to be carefully monitored by the Board for Financial Supervision.
In this background, the RBI was keen that the bank should be adequately capitalised and the governance in the bank improved. The GTB was not in a position to attract additional capital, but there was an offer to inject capital from a private equity rm. However, the offer sought some temporary relaxation of regulatory prescriptions. We felt that we could not start rebuilding trust and confidence in a bank with relaxations in regulations. Hence, we sounded leading private sector banks if they could take over GTB. Surprisingly, they did not evince interest. We decided to act before it was too late, and at our request, the government imposed a moratorium on withdrawal of deposits on 24 July 2004, a Saturday evening. I was con dent that once we put a moratorium on encashing of deposits, the interested parties would be emboldened to express their interest in a merger. We had in parallel identified banks which might have synergies for a merger. In the process, we had to handle an unprecedented challenge: to restrict the withdrawals from ATMs dispersed all over the country, in addition to making available sufficient cash in all branches spread over the country. These required extensive logistical efforts, but in total secrecy.
By Monday, 25 July forenoon, we could choose one of the two banks that were interested in a merger – the Oriental Bank of Commerce. The message to the banking community was loud and clear – the RBI would be prompt, severe, and effective in corrective actions in respect of any bank or banker that came to our adverse notice.
There were several criticisms of our action. One view was that shareholders suffered, but I was clear in my mind that depositors’ interests were foremost. Some complained that it was over a weekend, but then it was deliberate. A third criticism was that the public sector bank was informally forced to merge. That simply was not true. In fact, Finance Minister Chidambaram, on being informed over phone minutes ahead of public disclosure of successful identification of the bank that was to merge, said: ‘Is it with the State Bank of India?’ That was the expectation on the basis of precedents, but it was the Oriental Bank of Commerce.
Suggestions were made that we should consider the issue of new banking licences as a means of strengthening the banking system. Our stand was that the emphasis should be on improving the large number of private sector banks already existing and also consolidating them as vibrant units. Additionally, we insisted that issuing of new bank licences could be considered after amendments that we had proposed to the existing Banking Regulation Act were approved. They were meant to strengthen the RBI’s capacity to enforce appropriate t and ownership criteria and governance. New banking licences could not be approved during my period, pending passage of the relevant laws.
Foreign banks had a small share of the banking business, but had significant, in fact, critical presence in select segments of nance, such as forex markets and government debt markets. They were keen to expand their presence in India through inorganic growth, that is, by taking over control and management of existing private sector banks. They operated across borders, and across markets, through multiple organisational layers within a conglomerate. They had a network of non-banking arms operating in parallel in India. Operations in India accounted for a major source of profits for many of them for a variety of reasons, one of them being their expertise in and access to modern technology. They had a special place in financial markets, in addition to skills and competitive strengths. Cross-border presence gave them an opportunity to move financial assets across the border to take advantage of differences in regulation, taxes, and interest rates. They were also important for ow of investments that public policy seeks. In brief, the branches of foreign banks did a lot of good to public policy, but they could also undermine public, policy, especially regulation, without necessarily breaking the law.
The most important issue at the time I joined related to increasing the presence of foreign banks and raising the limits to foreign ownership in our banks to 74 per cent. Such a policy was announced in the budget speech of the finance minister. I was uncomfortable with giving priority to larger presence of foreign banks in advance of reforming the domestic banking sector. We had to work with the government on resetting priorities. We succeeded in convincing the government to defer immediate increased presence of foreign banks and to adopt a gradual approach through a roadmap.
In effect, we reset the priorities and that is a long story.
In September 2003, when I joined as governor, I found that there was only one important item in the agenda for reform before the government. That concerned increasing the permissible share of foreign ownership in Indian banks, and permitting foreign banks to acquire Indian private sector banks. The government was keen to implement the policy and was in readiness to process the legislation in the budget session of 2004 in fulfilment of the announcement in the February 2003 budget speech. The existing legislation did not deter foreign banks from setting up 100-per-cent-owned subsidiaries, though a policy to facilitate them was not in place. To acquire existing private sector banks, or to have subsidiaries with less than 100 per cent of ownership, amendment to the law was needed to allow for foreign banks to exercise voting rights in proportion to the ownership.
I opined that policy constraints on our banks should be addressed urgently, before opening them up for deep presence of foreign banks. Hence, my preference was to increase the number of branch licences of foreign banks well beyond the commitment made by us to the WTO for the present. However, the government made it clear that it wanted to implement the decision announced. The task before us was to find a way of fulfilling the commitment made in the budget speech of 2003, but ensure that in the actual sequencing of reform in banking, improvements in domestic banks took precedence.
On the basis of consultations with us, the government issued a press note, on 5 March 2004. The FDI limit in private sector banks was raised to 74 per cent under the automatic route, including the investment made by foreign institutional investors. The major input that we gave to the government was that a foreign bank should be permitted to have only one form of presence. Foreign banks, according to the press note, would be permitted to have either branches or subsidiaries, not both. They could operate in India through only one of the three channels – (a) branch/es; (b) a wholly owned subsidiary; or (c) a subsidiary; further aggregate foreign investment up to a maximum of 74 per cent in a private bank was permissible. The press note mentioned that the guidelines in this regard would be issued by the RBI. We were required to issue guidelines on liberalising foreign investment, as per the press notification in March.
As a first step, I focused on governance in our banking system. So, the Annual Policy Statement of 18 May 2004 indicated that keeping in view the special nature of banks it was necessary to articulate in a comprehensive manner the policy in regard to ownership and governance of both public and private sector banks. We put in public domain a draft with three elements, namely, (a) criteria for significant shareholding, that is, beyond 5 per cent; (b) for being a member of the board, and (c) additional requirements for chief executive. The guidelines were equally applicable for foreign investors under the liberalised regime announced in March 2004. We provided for transition arrangements where the existing ownership structure in any bank did not satisfy the requirements specified. The guidelines asserted the RBI’s intention to undertake independent verification of ‘fit and proper’ test conducted by banks. We did not have specific legislative provisions to enforce these guidelines, so we formally invoked powers conferred by Section 35A of the Banking Regulation Act, 1949, and gave directions ‘in public interest’. We got our point of view on the reforms in banking sector, in a draft form, in public domain, so that our view became the starting point for feedback from the stakeholders and consultations with the government.
The professionals in RBI worked closely on several drafts in consultation with market participants and the government. In the final stages, I had detailed discussions with Chidambaram. The result was a comprehensive agenda for reform and development of the banking system in India. This was set out in the budget speech of 2005-06. It said: ‘the RBI has prepared a roadmap for banking sector reforms and will unveil the same. While most proposals will be implemented by the RBI on its own authority, some legislative changes would be required to be made.’ (Para 82)
In his budget speech Chidambaram added: ‘In consultation with the RBI, I proposed to introduce amendments to the Act: (a) to remove the lower and upper bounds to the statutory liquidity ratio (SLR) and provide exibility to RBI to prescribe prudential norms; (b) to allow banking companies to issue preference shares, since preference share capital can be treated as regulatory capital under speci ed circumstances as per Basel norms; (c) to introduce speci c provisions to enable the consolidated supervision of banks and their subsidiaries by RBI in consonance with the international best practices in this regard. I also propose to introduce amendments to the Reserve Bank of India Act, 1934 – (a) to remove the limits of the cash reserve ratio (CRR) to facilitate more exible conduct of monetary policy; and (b) to enable RBI to lend or borrow securities by way of repo, reverse repo or otherwise.’ (Para 83).
This is perhaps the most comprehensive package of reforms in banking ever announced by a nance minister. The language reflects the fact that the minister and governor thought alike on this subject.
Soon after the budget speech, in fact, the same day, RBI released three documents that reflected policies already agreed with the government: a roadmap for presence of foreign banks in India; guidelines for setting up wholly owned banking subsidiaries; and guidelines on ownership and governance in private sector banks. The roadmap was divided into two phases: in the first phase, up to March 2009, foreign banks could establish by way of setting up wholly owned subsidiaries, or conversion of the existing branches into such subsidiaries. Detailed guidelines were given for establishment of such subsidiaries. The second phase was to commence in April 2009, after a review. Guidelines on ownership and governance for private banks emanated out of the draft put in public domain for feedback and consultation with the government.
The RBI’s approach to reform of banking sector was captured in the preamble to the roadmap for presence of foreign banks in India. It said: ‘The banking sector in India is robust and its standards are broadly in conformity with international standards. In further enhancing its efficiency and stability to the best of global standards a two-track and gradualist approach will be adopted. One track is consolidation of the domestic banking system in both public and private sectors. The second track is gradual enhancement of the presence of foreign banks in a synchronised manner. The policy decisions announced on 5 March 2004 on FDI, FII and the presence of foreign banks will be implemented in a phased manner. This will also be synchronised with the two- track approach and will be consistent with India’s commitments to the WTO.’
In parallel on the same day, we announced a liberalised policy for overseas presence of Indian banks and foreign banks’ presence in India, to express our intent for an element of reciprocity in the process. The policy of issuing branch licences to the foreign banks, consistent with our obligations under WTO, was codified with specific indication that due weight would be given to the treatment of Indian banks in the home country.
For the RBI, and for me, the set of guidelines issued in February 2005 counts as the most satisfying service to our banking sector. In the process of devising our approach, my relationship with foreign banks was not smooth. In fact, the Financial Times of London commented on my attitude on 1 September 2004. But the global financial crisis, in some ways, indicated my approach. My experience with foreign banks in India led me to speak in Basel in June 2012, before a gathering of governors, and say: ‘In the prevailing environment of global financial markets, some large global financial conglomerates are larger and, perhaps, more powerful than some of the central banks.’
‘Cooperation has failed, but it must succeed’ is a statement that I read for the first time over fifty years ago. The concept is too appealing to be taken lightly. We wanted cooperatives to succeed. We tried and spent money on rural cooperatives and failed. In the case of urban cooperative banks, we merely innovated and succeeded. How and why?
The rural cooperative system with large nationwide network was critical for credit dispensation in rural areas, and most of them were not functioning satisfactorily. Some of them had negative net worth, meaning they were not solvent, and yet they were permitted to accept deposits and dispense credit. Their functioning in terms of prudential supervision was carried out by a separate body, National Bank of Agriculture and Rural Development (Nabard), though the regulation part was left with the Reserve Bank. There was close coordination between Nabard and the Reserve Bank.
Urban cooperative banks, on the other hand, were both regulated and supervised by the RBI. Urban cooperative banks stood discredited after the Ketan Parekh scam involving a few of them. Some of the urban cooperatives had to be wound up and the claims from the Deposit Insurance Corporation were the highest recorded in our history. Some of them were defunct. Some of them were weak. Most of them were stagnant.
The rural cooperative banking system was expected to provide a range of banking services, in particular, deposit taking, short- term lending, and medium- to long-term loans and investments for agriculture-related purposes in rural areas. A countrywide network of cooperatives with a federal structure consisting of village-, district- and state-level cooperative banks had been developed over time. However, it was plagued with serious problems, particularly due to politicisation of cooperatives with the connivance of the state governments concerned. There had been several attempts in the past to revive the dormant cooperatives in the system and revitalise them. They were not successful. The government appreciated the need to make another attempt. We were committed to improving the banking system, particularly for the rural areas and the common person. But how?
The government appointed a task force on cooperative credit institutions in August 2004 under the chairmanship of Professor Vaidyanathan to recommend measures for revitalising the cooperative credit system. It made several recommendations and the government provided budgetary support to implement its recommendations. The major players for bringing about changes were the state governments. They were keen to avail of the funds provided for revival of the cooperative credit system, but less than enthusiastic about bringing about necessary changes in governance structures and practices to revive the system. The Union government while providing finances was compelled due to political circumstances to gradually dilute the conditionalities that were proposed by the task force. Initially, I was chairman of the implementation committee that became defunct soon. In most parts of India, cooperative banking has become a captive of political parties, and the Union government and the RBI worked together to use fund allocation as a leverage to improve the system but political compulsions prevailed. Not much has changed in most parts of our country.
In contrast, the initiatives that we took in the RBI on the urban cooperative banking system have been successful – thanks to state-level innovative arrangements for voluntary collaboration among the stakeholders. The urban cooperative banking system was virtually in a mess by 2004. The weaknesses were exposed in 2001 with the outbreak of a scam in which Gujarat cooperative banks were significantly involved.
The representatives of urban cooperative banks met me and explained that many of the sound banks were being penalised due to these legacy problems. They convinced us that many of them were well run and provided nance to small- and medium-sized businesses. We accepted their contention that there were many banks that needed to be encouraged; that there were some which had the potential to become viable; and there were a few which should be wound up. We were willing to review our regulatory prescriptions and even support enhancement of skills as well as technology upgradation, if they ensured closure of bad banks and adoption of a reform package for potentially viable ones. The industry association agreed to collaborate, but solutions need the involvement of state governments.
If the cooperation between the state government and the Reserve Bank of India was essential, I concluded that it had to be a state-specific solution. In other words, the RBI had to devise an institutional mechanism within the legal framework that would promote urban cooperative banks in states which were willing to support and encourage healthy banks and discourage unhealthy ones. Despite serious reservations within the RBI, I suggested that we enter into a formal memorandum of understanding with those states which were willing for coordinated action to improve the urban cooperative banking system. Under this memorandum, an advisory committee with representatives of the state governments, RBI and the urban cooperative banks themselves was constituted for each state. This unique experiment in institutional arrangement for coordination succeeded beyond everyone’s expectations.
Andhra Pradesh and Gujarat were the first to sign the agreement in a competition between their chief ministers. The signing in both cases reflected their personalities and styles. That was how the urban cooperative segment which was on the verge of collapse was saved; it has survived, and it is thriving.
To serve the needs of local areas, there was a network of regional rural banks jointly owned by the Government of India, state governments, and nationalised banks. They were allowed to survive through periodic infusion of capital. Local area banks, an experiment akin to RRBs, but in the private sector, was virtually given up.
For us, the major challenge was in dealing with deposit- taking NBFCs. In the NBFC sector there was a category called Residuary Non-Banking Finance Companies. This category raised several concerns with regard to their deposit-taking activities, and compliance with the ‘Know Your Customer’ criteria. The business model itself was unviable unless inappropriate banking practices were adopted. We took a decision to tighten the regulation to an extent that the category would cease to exist. We also felt that it was necessary to provide them an opportunity to exit from this model to avoid disruption. Out of five RNBCs, three quickly exited and two were remaining. These two (Peerless and Sahara), however, accounted for over 60 per cent of the total NBFC sector.
One of them planned for gradually moving out of this business as per a mutually agreed path. The second one, Sahara, had been dragging its feet, which finally resulted in a legal battle that went up to the Supreme Court. Some, though not the whole of the drama in our dealing with them, has been chronicled in a book titled Sahara: The Untold Story by Tamal Bandyopadhyay. At one stage, I received a hand-delivered letter, purported to be from the chief of the company, saying they had heard that I believed my life was under threat from them. I was assured that there was no basis for such fears. I handed the letter over to my deputy governor and told him to keep it, and forget about it. However, the objective of virtually eliminating these companies, which were a threat to the integrity of the financial system, has been successful.
A memorable case involving NBFCs was linked to a chit fund that was part of a media empire, namely, the Eenadu group. The case had political overtones. It began when a complaint was received from a customer of a chit fund (an HUF registered under the chit fund act) that agents of an NBFC within the group were compelling chit-fund holders to invest in deposits with the NBFC, though the latter was forbidden by the RBI to take deposits. The NBFC was taking cover under an ambiguous wording in a letter from RBI. By this time the deposits of this NBFC had ballooned to over Rs 2,500 crore. The choice before the RBI was difficult. Effective action against such unauthorised acceptance of public deposits was clearly warranted. But any such action could have resulted in the large number of depositors being hurt. Any precipitative action would have made it impossible for the management to refund the deposit even if they had adequate assets. On the other hand, not moving against the errant behaviour gave an impression that the regulator was not enforcing the law. A decision was made to make the group agree to refund the deposits as and when they matured and not accept new deposits as a pre- condition for not precipitating action.
It was also necessary to recognise that the RBI’s reputation was itself at stake since it did not take action when this activity was growing phenomenally over several years. Taking advantage of some of the High Court judgements in dealing with non-banking financial companies, it was decided to give greater weight to the interest of the depositors. So, RBI was content with prompt return of all deposits on maturity and immediate exit from deposit taking. However, the state government concerned was clearly in favour of severe action against the errant conglomerate. It tried unsuccessfully to take legal action against the entity.
Promoting an NBFC for development of infrastructure was one of the last acts of the RBI in founding institutions for development. The company was meant to be an institution predominantly funded by the government and the RBI but effectively managed as a non-government company mainly to promote infrastructure financing. I was an enthusiastic supporter of this idea, and in fact, the organisation was designed by a committee under my chairmanship in 1996. I noticed, as governor, a discomfort in that RBI was a partial owner of an NBFC which it was regulating. These concerns became accentuated once the company decided to get its shares listed in the stock exchange as part of a public issue. We took a stand that such an approach would make it a profit- seeking institution and it would be inappropriate for the RBI to continue to be an owner. The RBI also had reservations about the capacity of the institution to discharge its developmental functions once it became a profit-seeking institution. Since the government overruled the objections of the RBI about the initial public offer, the RBI decided to offer to transfer its shareholding to the government, which it accepted.
Towards the end of my tenure, I realised that despite all our efforts to expand the role of credit through formal channels and micro-finance entities, the credit needs of the widely dispersed informal sector could not be met in the near future by the formal financial system. If moneylenders were inevitable, the system should be able to utilise them, but with sufficient safeguards. I was aware of the legislation on moneylending in many states. I was also aware that the laws were not well formulated and were seldom taken seriously. It was essentially a state subject. If there were a reasonably effective law, regulation and enforcement at state level, we could use the moneylenders also as a part of the financial system. In a way, we had already favoured multiple, but competing, channels of outreach of financial services. Our idea was to push supply of credit through multiple channels and thus provide ease of access.
I mentioned my intention to consider the option in one of my informal conversations on the financial system with Prime Minister Manmohan Singh. I was afraid that he would dismiss it outright, but he was willing to briefly discuss the pros and cons. That was enough for me to announce the constitution of a working group to recommend a model money-lending legislation for consideration by the state governments. The working group had representatives of select state governments. The model legislation was sent to all the states for consideration. I was disappointed, but not entirely surprised that the model law was universally ignored.
As mentioned, between the government and the RBI, we settled on an agenda of reform of the banking sector. Together, we did our best with mixed results. But an important component of the financial system is capital markets and the banking system has a stake in it. The government and the RBI had difference of opinion, especially during the second half of my tenure, on the relative emphasis between banks and capital markets in the development of the financial sector. The government, in alignment with prevailing beliefs and global wisdom, focused on the development of equity markets and corporate bond markets. It wanted banks to participate and contribute to the process. It wanted derivatives to be encouraged. It wanted greater scope for global conglomerates in our financial markets. We were not comfortable with the emphasis on capital markets that could potentially inject risks into the banking system instead of diversifying risks.
We were keen to maintain the integrity of money markets, a crucial market for transmission of monetary policy. We were mainly concentrating on development of money, government debt and forex markets. We were cautious in integrating them through nexus products often described as B-C-D (Bond-Currency- Derivatives). Derivatives in forex markets should ideally help corporates hedge their forex exposures. But we were not sure whether our corporates had adequate inhouse expertise to assess the usefulness of such derivatives. So, while permitting banks to offer such products, we said that the banks should be convinced that customers were made aware of the implications. We put the onus on the banks to ensure consumer awareness. Yes, we were less than enthusiastic about sophisticated products. Our approach was: people should understand financial innovations or banks should be able to make people understand them. But we could not approve products that people did not understand.
The government was keen that the banks should play a more active part in capital markets. The belief was that the capital markets have to be developed to enable economic development. We, however, felt that our banks, particularly public sector banks, were not yet equipped to participate in capital markets actively. We also felt that the purpose of capital markets is to develop non- banking intermediation and thus diversify risks. The banks had expertise in providing working capital, and there was shortage of working capital for most of our economic agents. As such, we felt that banks should focus on their core competence. The statutory preemptions restricted the capacity to compete with other forms of intermediation. Therefore, the priority should be to remove the policy constraints on the banking sector. In particular, opening up of our financial markets to foreign players without removing the constraints on our banking sector would make our banking unviable. Finally, the confidence of most of the savers was in the banking system. The activity in capital markets in our country is dominated by foreign institutional investors and domestic insurance and mutual funds with marginal involvement of households. Mutual funds themselves had to depend on bank nance. Despite increased volumes in the capital markets, the participation of retail investors continued to be low in the capital markets. In brief, we resisted the attempts to use the bank deposits as the main instruments for development of capital markets.
We had no hesitation in restricting the total exposure of banks to capital markets. We took recourse to raising the margins for lending against shares, depending on the movements in markets. We suggested that policies be approved by the board.
Development of the corporate bond market was another area of priority for the government in the belief that financing of infrastructure would be enabled through the bond market. We also were keen to develop the corporate bond market. One of the suggestions was that the RBI should allow corporate bonds to be used as instruments in the repo markets. The repo and reverse repo market being the most critical element for conduct of monetary policy, we gave the highest importance to the integrity, reliability and robustness of the money markets. We had discomfort with regard to the corporate bond market because most of it was privately placed and even if listed, the trading was very low. Hence, it was difficult to assess the liquidity as well as the market price of many of the corporate bonds. The RBI was therefore keen that the corporate bond market should first become genuinely market based before it became eligible for repo.
Chidambaram said in his budget speech 2006-07, ‘A sound banking sector meeting international norms has emerged.’ There were, no doubt, differences of opinion on the relative roles of the capital market and banks, and their linkage. The government was keen to enhance the ow of foreign savings to accelerate development and viewed the financial system as the best channel. The RBI took the view that over 90 per cent of our investment was financed domestically and hence we were focused on appropriate level of domestic savings. In addition, we were of the view that the financial sector only facilitates but does not lead development, and that globalisation of nance should be managed with caution than enthusiasm. An influential part of the intellectual opinion and that of global financial conglomerates favoured a path that was different from what we in the RBI believed. The government was also sympathetic to this alternate approach as illustrated by the appointment of the Percy Mistry Committee and Raghuram Rajan Committee.
The role and functions of the RBI in the financial system became a matter of intensive discussion. The issue of carving out of regulatory functions, in particular banking, was raised. The RBI felt that at the current stage of development, there was merit in keeping the regulation of banks with the monetary authority. Similarly, we took the view that the regulation of government securities market should continue with the RBI till the government was in a position to complete its borrowing programme without financial repression (that is, prescriptions that require holding securities at a level beyond the prudential considerations). In fact, we wanted these to be clarified in law, by suitable amendments. We were in favour of divesting the public debt function from RBI, but only after debt levels and fiscal deficit were brought down to a reasonable level.
The critical issue that stalled progress in the financial sector had less to do with ideology and more to do with structural imbalances in the macroeconomic situation in India and the institutional rigidities within which the financial sector was operating. As explained in detail, structural imbalances relate to the fiscal deficit which necessitated financial repression. The banks continued to be compelled to hold government securities. The rigidities in institutional structures relate to the constraints under which the banking sector, notably, the public sector banks, have to operate. Large capital in flows further constrained our capacity to reduce the statutory preemptions. Financial sector reforms racing ahead of the reforms in macroeconomic management and institutional structures had the potential to destabilise the economy and make the banking system vulnerable.
I had narrated at the beginning of the chapter the assessment of the financial system in 2003. We, the government and the RBI, did redefine priorities for reform of the banking sector, and focused on improving the domestic financial sector. Broader issues relating to the role of the banking sector in the financial system came to the fore. Legislative actions to strengthen and modernise the policy environment were initiated and many, including one on the payment system, were enacted. But most of the basic structural issues of the financial system, especially that of the public sector component of the banking system, remained unaddressed. I am disappointed; but had the satisfaction that we reset the priorities in the reform of the financial sector, especially the banking sector, and strengthened private sector banking.