A V Rajwade: Regulatory anomalies

Is it that the central bank does not have adequate specialised staff for some of the newer areas of banking?

Most business economists in Asia give full marks to the Reserve Bank for its supervision of the banking system in India, in comparison with the rest of Asia. One concrete manifestation is that the re-capitalisation of the banking industry has cost the exchequer a much smaller amount, in absolute terms as also as a percentage of GDP, compared to many Asian economies, including Japan. (To be sure, the Indian economy and the banking system have not experienced a BoP crisis on the scale of the East Asian experience of the late 1990s.) There have been few major bank failures also (but banking aggregates as a percentage of GDP remain low). While the Reserve Bank deserves the praise it gets, there are a number of specific issues where the regulatory regime needs to remove anomalies and effect improvements.

Take, for example, the question of exchange-traded interest rate derivatives. In theory, a few contracts were introduced with much fanfare in the middle of 2003, but failed to take off. The principal reason was that commercial banks, which are by far the largest players in the bond market, were allowed to use exchange-traded derivatives only for hedging. Inasmuch as all the banks have long positions in government securities, they could have only sold the derivative contracts. With nobody on the opposite side, the market never took off. The irony of the regulatory regime is that, while banks cannot take trading positions in exchange-traded derivatives, they are free to do so in the OTC derivative market. This seems perverse, all the more so when exchange-traded derivatives are far safer than their OTC counterparts!

Consider another example. For measuring the market risk on bond portfolios, the central bank has prescribed the use of modified duration. The modified duration is used to estimate the price change in the value of a bond, arising from higher yields. Regulations require the price change to be calculated based on a 1 per cent yield change at the short end, but 0.6 per cent for longer maturities. This seems to be borrowed from western markets, where the yield volatility is more at the short end, and less at the long end. On the other hand, empirical evidence in India is exactly the opposite""yield volatility at the long end is more than at the short end. Surely we should not be borrowing western models and numbers without testing them empirically for conditions in the Indian market? (The same criticism is applicable to the decay factor of .94 used for calculating EWMA-based value at risk.)

The securitisation market, which is so necessary for the growth of certain sectors like housing and infrastructure finance, has witnessed significantly reduced activity after the RBI came out with its guidelines on securitisation. While part of the reason could be a change in the interest rate scenario, surely the regulatory prescription that banks cannot account for profit on securitisation upfront, has also contributed to the death of the market. The restriction seems less than logical: on the one hand, the guidelines prescribe that there should be no recourse to the originator in the case of securitised assets; if so, why should the profit not be accounted upfront?

Turning now to regulations about the foreign exchange market, recently the Reserve Bank allowed import duty payment (economic) exposures to be hedged in the forward market. On the other hand, it refuses to permit other economic exposures to be hedged. This too seems perverse: after all, import duty exposures are small, while every company in India, producing or consuming commodity kind of goods whose prices in the domestic market are governed by the import parity principle, is facing large economic exposures to the dollar: rupee exchange rate. These need to be managed, particularly when the rupee continues to manifest two-way movement. So what is not a pressing problem (exchange risk on import duty payment) is mitigated, but what is genuinely needed is disallowed! And this is despite both the Committees on capital account making recommendations on the issue.

Recently, the RBI allowed greater access to Indian companies to the maintenance of foreign currency accounts. If the idea is to facilitate such access, surely the stipulation that banks cannot pay any interest on such accounts, should simultaneously have been abolished? It is perverse that we continue with the ban on paying interest, which was introduced in an entirely different set of circumstances (i.e. when the rupee was under pressure), even when the environment has taken a U-turn for the last four years.

Consider housing finance. On the one hand, housing finance is part of the priority sector; on the other, the regulator has increased the capital ratio and general provision. What is the intention""to encourage as a priority or to discourage? What is the comparative NPA level in housing finance and other priority loans? Again, the reduction in the limit on bank funding of standalone NBFCs, i.e. those which are unconnected with a bank, seems unnecessarily harsh and restrictive.

I also find some of the regulations unnecessarily complex, for the present stage of the market and the kind of business banks do. A few examples: capital adequacy (horizontal and vertical disallowances); derivatives accounting (the separation between below and above 90 days; the rigidity about portfolio hedges, etc.); the plethora of micro-level percentages on cancellation and rebookings of forward foreign exchange contracts.

Many other examples could be cited, but I suppose that the above list gives an idea of the kind of regulatory quirks, contradictions and irrationalities that exist. Is it that the central bank does not have adequate specialised staff for some of the newer areas of banking? Is it that the decision makers have drowned themselves so much in paper work that they have little time to think? Is it that, in the process, they miss the woods for the trees? Is it that there are too many steps in the decision-making ladder and that, if somebody expresses a negative opinion on a point, the system is reluctant to override it? Perhaps some introspection and review of the systems, quite apart from the specific points I have mentioned above, would be useful, and strengthen the central bank's reputation.

avrajwade@gmail.com