Percy Mistry: The problems caused by state-owned banks

MUMBAI-IFC REPORT-III

The weakness of these banks is preventing changes to fix the financial system.

The previous two articles in this six-part series focused on: (i) media reactions to the MIFC Report, and (ii) the first pillar of its underlying logic, that is, the need for a second stage of deep and wide financial sector reforms to support an international financial centre in Mumbai. In this article, I focus on the second logical construct on which the MIFC report stands, in the hope that more public discussion will be focused on this critical issue. The second strut of the Report's logic contends that a major impediment to Mumbai's becoming an IFC is India's financial system being too state-dominated and consequently under-developed. It has too many critical missing markets. It has insufficiently large/strong institutions. It is too inefficient in the banking sector, which contaminates other areas of finance. India's financial system is altogether ineffectual in meeting the rapidly growing needs of its economy.

Contrary to public pronouncements, India's financial system is artificially (that is, as a matter of legislative and regulatory policy) debilitated by being:

Too fragmented across the major segments of banking, insurance, securities issuance and trading (that is, bonds, equities and derivatives), asset management, long-term involuntary savings such as pension funds, and commodity derivatives (which are financial contracts);

Too protected, rigid and relatively closed to foreign (and domestic private corporate) entry, resulting in a lack of real competition and a lack of innovation, resulting in some of the largest intermediation spreads in the world;

Too tightly compartmentalised within individual segments without the operational and financial permeability across segment boundaries that enhances the width, depth and liquidity of the financial market;

Substantially incomplete in terms of market architecture, that is, it has 'missing markets' for bonds, interest rate derivatives, currency trading and currency derivatives, credit default derivatives, weather risk derivatives, political risk and catastrophic risk insurance and derivatives;

Deficient in the capacity and size of institutional players. They are too small, too under-capitalised, too unsophisticated in terms of risk management, too technologically backward (except for our stock exchanges and depositories), and too over-staffed to be competitive on a global scale; and, finally,

Too state-dominated in ownership "" the principal reason for many of the deficiencies outlined.

State ownership (along with prolonged regulatory strangulation) has unarguably diminished the quality of Indian financial intermediation. It is responsible for the large institutional and market deformities that the Indian financial system now possesses. Areas of the financial system in which the state is predominant as owner (such as banking) are the areas in which financial firms and markets are least efficient. The state-owned banks (SOBs) made it possible for the government to finance too large a consolidated fiscal deficit for too long. In part, their dysfunctional instrumentality accelerated India's headlong rush to the edge of the economic precipice in 1991.

What have SOBs achieved since 1969? They have sucked up deposits from the rural poor, to lend more than was prudent to the government and to the licensed rich (often with poor outcomes). They have contributed to sustained resource misallocation through directed lending, resulting in a waste of scarce capital over three decades. That low growth has resulted in prolonging India's under-development, as well as its inability to tackle endemic poverty. This has happened not because SOBs are under-regulated or under-supervised. Quite the contrary. They are over-regulated to the point of being micro-managed by the RBI. But political sensitivity and malfeasance have permeated the system to the point of rendering its entire fabric dysfunctional.

But despite (or perhaps because of) such micro-management from outside, our SOBs "" while being among the largest financial firms "" remain the least capable. That would not matter if they accounted for only 10-20 per cent of deposits and banking assets. But they account for nearly 75 per cent of the banking system. In their present form the SOBs are not suitable channels for the intelligent allocation of resources for corporate or public investment through prudent banking. For all those reasons, SOBs are perhaps one of the greatest obstacles to Mumbai becoming a credible IFC.

This line of argument needs wide public discussion. Without that, the groundswell of opinion and the political consensus that is needed for inducing the exit of the state from the ownership of any financial institution, will not materialise. As a result, any prospect of creating an IFC in Mumbai will be jeopardised. More importantly, the state-dominated financial system will continue to act as a deadweight drag on the more rapid, efficient development and growth of the Indian economy by impeding genuine market forces from playing a greater role in resource allocation. That will retard efforts aimed at poverty alleviation.

In India, the G-Sec market and the corporate bond market (which is conspicuous by its absence) are seen as two distinct and separate markets; whereas, around the world, government and corporate bonds are part of one seamless debt market. The G-Sec trading platform is, amazingly, owned and operated by the central bank (which was, until the last Budget, also the public debt manager), rather than by one or both of our securities trading exchanges. Limiting the development of the bond market to the G-Sec segment does not permit the market for fixed-income debt instruments to display the full range of credit risk (and associated reward) characteristics across the normal spectrum from riskless bellweather issues (G-Secs) to much lower credit risks (with higher coupon returns) issued at the sub-prime end of the market.

Similarly, removing the remaining restrictions on capital account convertibility (CAC) "" which prevent convertibility and therefore inhibit the emergence of a free currency trading market that is a mainstay in most IFCs "" is being deferred indefinitely, because of the weakness and relative incapability of SOBs. That key constraint was identified by both Tarapore reports as a key justification for delaying CAC. Worse still, the development of stronger derivatives markets has been deliberately suppressed by the regulatory authorities because of fears that the SOBs could not operate competently in these essential risk management markets.

Because the SOBs have been over-protected by regulation, the Indian banking sector (and its wider financial system) has been denied the opportunity to grow.

Thus the SOB legacy has not just made our banking system anaemic and infirm; it has contaminated our entire financial system. By contrast, our securities exchanges, electronic trading systems and depositories are of a global standard. Such an unbalanced financial system is not conducive to the emergence of an IFC in Mumbai, without a considerable amount of remedial repair and construction work.

The author was the chairman of the committee that wrote the MIFC report. This is the third in a six-part weekly series