Does the ordinance solve the banking crisis?

Business Standard, 15 May 2017

Bureaucracies are prone to failure. Clarity of purpose and accountability are essential for obtaining performance. The decisions that are required when dealing with a bad loan require energy and profit-motivated thinking. It is hard to do this in PSU banks, and it is harder to do this at RBI. We know how to build RBI to do monetary economics and banking regulation. We do not know how to build RBI to make commercial decisions. It is unreasonable to ask RBI to get into the drivers seat when dealing with bad assets.

The bureaucracies in banks have fumbled on dealing with NPAs. In response, we want to give overriding power to the bureaucracy at RBI. We should pause and ask: Why do we believe the bureaucracy at RBI will make the right decisions?

Dealing with an NPA

Dealing with an NPA is not a simple matter. The debtholders have to sit across the table and negotiate about a possible restructuring. They have to evaluate what recoveries can be obtained if the Insolvency and Bankruptcy Code (IBC) is invoked. They have to stoke the pipeline of private equity funds and strategic buyers who might toss in a bid if the IBC is invoked. They have to form a rational sense of the NPV that can be realised by going down the IBC route, and settle for a deal offered by the borrower if the cash offered is higher. If there is no deal, then IBC has to be invoked, and decisions have to be taken between the multiple offers on hand. Every possible course of action is a risky one.

This work is entirely in the domain of profit-motivated commercial decision making based on a speculative view of the future. What bids will arise through the IBC route? How much money will be obtained and when? How trustworthy is the shiny new IBC machinery? How much of a discount do we accept, when comparing an offer of hard cash today, in exchange for the uncertainties of the IBC?

All over the world, banks tend fare poorly at this kind of work. Banks in India are particularly bad at this, as RBI regulations have converted banks into bureaucracies that blindly follow micro-managing regulations. The essence of finance is the ability to look into the future, form speculative views, and manage risk. This is largely absent in Indian banks. This problem is particularly found at PSU banks, who are the least thinking bureaucracies, through the twin influence of RBI and MOF.

The right place for this work is a private equity fund. A private equity fund is fully private, is not hindered by regulation, is able to make sound decisions quickly owing to the absence of bureaucracy, and has strong financial incentives for the decision makers. The right way forward is for banks to sell bad assets to private equity funds.

The wrong place for this work is the RBI. RBI is a bureaucracy, more so than PSU banks. How will commercial decisions get taken in such an environment? How will speculative views about the future be formed? How will the choice between two risky paths be taken? Who will be blamed when things go wrong?

Processes within RBI

The basic rhythm of a regulator is the three process manuals that govern the legislative, executive and quasi-judicial branches. In its legislative function, RBI must operate a process manual that governs how regulations are written. In its executive function, it must operate a process manual that gives out licenses, conducts investigations and detects wrong-doing. In its quasi-judicial function, RBI must operate fair procedures through which an independent mind will hear both sides and write a reasoned order that will stand the test of appeal at the SAT and then the Supreme Court.

These three processes are surrounded by two additional processes of board governance, and the loops of reporting and accountability.

We have a huge task in front of us, in building an RBI that will have five sound process manuals and live by them. But atleast, in these five areas, we have a body of knowledge and international experience on how this is to be done. The draft Indian Financial Code has the blueprint of these five process manuals. We have the broad picture on what has to be done, and now confront the change management, of the RBI reforms that get us there.

Even in the most ambitious plans for RBI reform, there is no plan to make commercial decisions inside a regulator. We don't know how it can be done. There is no body of knowledge or international experience that guides us on how this is to be done. There is no document like the Indian Financial Code which has the blueprint for how to do it.

The biggest threat in banking regulation is the pressure within RBI to hide bad news at banks, as faltering banks reflect poorly upon bank regulation by RBI. This problem will be exacerbated if RBI has made commercial decisions about NPAs.

It is unfair to place these new burdens upon RBI. RBI has its hands full, learning how to do inflation targeting and learning how to regulate banks. This is not a time to increase the burden upon RBI's top management, particularly when this increased work (making commercial decisions about NPAs) will make it more difficult to do banking regulation.

A public administration perspective in policy formulation

Sound policy making requires thinking through gritty management questions in public administration. We should not just wave our hands in the air and say "Let's have RBI do it". We should think more about how it will actually happen. This requires envisioning incentives, skills, process manuals and conflicts of interest.

State capacity in India has, too often, been damaged by mistakes on the mandate of agencies. RBI's emergence as a capable central bank and banking regulator is hampered by the unlikely combination of functions which have been placed within it. The new additional role will be performed poorly and will hamper the core business of building a sound RBI.

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