Raghuram Rajan (University of Chicago Professor) – BQ Conversations With Former RBI Governor Raghuram Rajan (Nov 2020)

Chapters

Abstract

“Rethinking Corporate Entry into Banking: Navigating Risks, Governance, and Regulatory Challenges in India”

The Reserve Bank of India’s (RBI) recent proposal to allow corporates into the banking sector has ignited a complex debate, highlighting significant concerns over governance, risk management, and regulatory capacity. This article delves into the multifaceted aspects of this contentious issue, focusing on the inherent risks of self-lending, concentration of economic power, and conflicts of interest. It explores the historical context of banking and commerce intermingling, the practical challenges of regulation and supervision, and the necessity for robust and transparent accounting practices. The article further examines alternative solutions to banking expansion, the overarching problems of ownership-agnostic governance, and the risks of backdoor entry, while considering the RBI’s current supervisory and enforcement capacity and the pressing issues highlighted by the Yes Bank case.

Main Ideas and Expansion:

RBI’s Working Group Proposal and Historical Context:

The RBI’s working group has suggested opening the banking sector to corporates, a significant shift from its historical stance. Historically, the RBI has prohibited full-fledged corporates from entering the banking sector, except for financial companies. This move contrasts with the experiences of Japan and Germany, where similar integrations led to negative consequences. The proposal demands careful consideration of India’s past experiences, where initial forays into corporate-owned banking were eventually rolled back.

Dr. Raghuram Rajan’s Concerns:

Dr. Raghuram Rajan, a former RBI governor, voices critical apprehensions. He warns of potential self-lending risks, economic power concentration, and conflicts of interest. Rajan’s perspective is crucial, considering his expertise and experience in navigating the complexities of India’s financial sector.

Principles of Banking and Commerce Intermingling:

The debate isn’t new; it mirrors discussions in the United States and other countries. Rajan and other experts express concerns over self-lending, financial instability, and the concentration of economic power, emphasizing the risks in India’s current regulatory and supervisory environment. Historically, in countries that have allowed banking and commerce, severe crises have occurred.

Practical Challenges:

India faces substantial hurdles in regulation, supervision, and transparency. The complexities of monitoring financial flows within intricate corporate structures and the lack of transparency in accounting practices present formidable challenges to safeguarding the banking sector against malpractices.

Alternative Solutions:

The article explores other avenues to expand banking capacity, including through professional financial houses and reforms in public sector banks. The focus is on long-term reforms to enhance credit growth, such as improvements in credit information and recovery, and the Insolvency and Bankruptcy Code (IBC).

Ownership Agnostic Governance Problems:

Governance issues are widespread, affecting both public and private banks. While private banks have shown some success in transforming governance, public sector banks (PSBs) remain a significant concern. The article highlights the necessity of comprehensive governance reforms across the banking sector, with a particular emphasis on PSBs.

Backdoor Entry Risks and Strengthening Supervisory Capacity:

The risk of backdoor entry into banking through payment banks and NBFCs is a critical point of contention. Payment bank licenses were initially intended for payments and inclusion, with no access to credit. Later, payment banks were allowed to consider a banking license after five years, but only for financial companies, not industrial houses. The assumption that industrial houses with payment bank licenses can migrate to full-fledged banks is erroneous. NBFCs cannot offer deposits like banks, distinguishing them from banks. Allowing industrial houses to convert NBFCs to banks can lead to problems due to the trust associated with bank deposits. The article stresses the importance of learning from recent financial sector mishaps, underscoring the need for the RBI to enhance its supervisory and enforcement capabilities before considering major policy shifts.

Yes Bank Issues and Improving Compliance:

The Yes Bank case provides a pertinent example of the challenges within the existing system. Rajan’s comments on improving compliance and addressing current issues within the banking system, including the necessity of automating data transfers and enhancing understanding of banking practices, are particularly relevant.

Central Board Influence and Technical Recommendations:

The role of the central board in influencing RBI regulations, especially in the context of this proposal, is analyzed. The article evaluates the validity of some technical recommendations, like rationalizing holding company structures and reviewing promoter holdings, while questioning the timing and rationale behind the proposal.



In conclusion, the proposal to allow corporates into India’s banking sector is laden with complex challenges and risks. The article underscores the need for a comprehensive and cautious approach, prioritizing the improvement of the existing regulatory and supervisory framework. The focus should remain on addressing the root causes of issues in the current banking system, ensuring financial stability, and safeguarding the interests of depositors and the broader economy. This nuanced exploration highlights the necessity of a balanced and informed decision-making process in the evolving landscape of India’s banking sector.

Updates from the Supplemental Source:

ILFS and Yes Bank Issues:

– Raghuram Rajan raises concerns about the role of auditors, regulators, and supervisors in monitoring the progress of ILFS.

– Rajan emphasizes the need to investigate Yes Bank’s practices to understand their reported profits while reporting low losses.

Addressing Regulatory Challenges:

– Rajan suggests focusing on improving compliance and effectiveness of regulations for existing banks before addressing conflicted banks.

– He cautions against introducing new problems with new regulations without resolving current issues.

Central Board’s Influence on RBI Regulation:

– Rajan’s response to a question about the composition of the committee that made recommendations on RBI regulation acknowledges the central board’s influence.

– He notes the presence of two central board members in the committee, suggesting a shift in the board’s involvement in RBI matters.

Fixing Problems and Technical Recommendations:

– Rajan supports fixing existing problems and implementing technically feasible recommendations, such as rationalizing holding company structures and reviewing promoter holdings.

– He emphasizes the need to focus on addressing the core reasons for considering new regulations.

Notes by: Random Access