Maintaining regulatory balance

Besides depositors, investors in bank securities are important stakeholders, and their interests ought to be safeguarded

The financial sector in most of the economies of the world, especially the emerging ones like India, is bank-dominated. Banks are crucial because they facilitate financial inclusion through their outreach, and play an important role in directing credit to desired sectors and help governments achieve various objectives.
 

The need for a differentiated regulatory architecture for banks is obvious. They operate on an extraordinarily high leverage ratio; are permitted to accept deposits from the public; and have the backing of the central bank as the lender of the last resort.

The masses have faith in the banking system. A run on a bank can have serious economic, social, and political consequences. Naturally, supervising and regulating banks is a serious business in any country. Because of the sheer nature of their job, bank regulators the world over are perceived to be a bit conservative and risk-averse.
 

That said, at the end of the day, banks are commercial and for-profit entities that not only compete among themselves but also with other lenders and credit providers. They need to have sufficient operational flexibility, keep pace with technological advancements, and encourage innovation.
 

For the regulator, maintaining a right regulatory balance could prove to be a tricky affair — where and when to tighten regulation and when to let go? Then, there is a constant tussle of choosing between principle-based or rule-based regulation.

Coming to the Indian context, few would disagree that the banking regulator, the Reserve Bank of India (RBI), exercises tight-fisted control over virtually all the activities of the banks. In addition to the formal regulatory oversight, the RBI influences the banks’ workings through informal nudges. In fact, these nudges may often prove to be onerous for banks to comply with.
 

While regulatory oversight covers a wide range of subjects, this column limits itself to issues relating to banks’ board-level appointments and protecting the interests of investors in banks’ securities.
 

The RBI approves the appointments of the chairpersons, managing directors, and directors on the boards of all the private-sector banks, and also their tenures and remuneration. This is irrespective of the size of these banks. Many a time the RBI rejects the candidates for these positions and/or modifies their tenures, as recommended by the banks’ management. Besides this, on occasions, the regulator appoints additional directors or its representatives on banks’ boards.
 

At present, the board configurations of the top 10 private-sector banks in the country, in terms of their market cap, depict seven of the 10 chairpersons are either former RBI officers or former civil servants. These categories, supplemented by retired public-sector officers, constitute a significant proportion of the non-executive directors on these banks’ boards; this proportion goes up to 50 per cent in one bank. This makes the boards of private-sector banks look quite similar to those of public-sector banks!
 

An obvious corollary that follows from all this is reduced distance between the regulator and the regulated entities. The regulator, taking responsibility for the capabilities and integrity of the top-level personnel in all banks, creates a moral hazard problem, and this is likely to lead to an increased forbearance tendency on the part of the regulator. As a consequence, the regulator may find it difficult to extricate itself from certain possible awkward situations. In the process, it may even risk its credibility.
 

The RBI may consider taking another look at its policy on appointment matters, and perhaps restrict its role to appointing chairpersons and directors of only the systemically important banks.
 

Now let’s turn to investor protection. Banks have to be necessarily listed in accordance with the regulatory mandate. This is to bring transparency to their functioning and improve corporate governance. However, often listed banks do not make full or timely public disclosures, purportedly to contain the possibility of a run on them, thereby safeguarding the interests of the depositors, or on supposedly financial stability concerns. As a result, investors in banks’ securities may not be fully aware of the happenings in those banks. While there could be sensitivities involved, a sudden punitive action by the regulator on a bank may leave the investors high and dry. What is more worrisome is that often the RBI doesn’t pass a speaking order against the defaulting bank. Resultantly, even after the regulator’s action, the investors may be left guessing without a clear understanding of the issues.
 

Continuing with the investors’ concerns, remember the ongoing litigation relating to Rs 8,400 crore worth of AT-1 bonds issued by YES Bank and written off by the administrator appointed by the RBI while reconstituting the bank with investment from State Bank of India and some other banks. AT-1 bonds have a complex structure that goes against the basic financial principle by giving precedence to equity over debt holders in the waterfall. Logically speaking, AT-1 bonds should be so structured that if a distress situation in a bank demands that they be written down, that should be done only after wiping off the common equity Tier-I capital of the bank. The argument that the AT-1 bond is an internationally recognised instrument and is used by banks also in other jurisdictions for raising capital is of little help. In fact, the Credit Suisse collapse last year has many regulators sit up and have a second look at these bonds.
 

The sum and substance of this discussion is that besides the depositors, the investors in bank securities are important stakeholders, and their interests ought to be adequately safeguarded. The regulator needs to give this a serious thought.

Tyagi is distinguished fellow at the Observer Research Foundation and former chairman of the Securities and Exchange Board of India. Baid is professor at the National Institute of Securities Markets