It's the incentives, stupid

Business Standard, 9 March 2020

Conservatives have argued that the existing policy machinery of Indian finance is broadly fine. The difficulties of Yes Bank are a reminder that there are significant difficulties in the policy apparatus. It is important to not slip into personalising the failure. The personnel in the government and RBI have tried to battle with the difficulties with intelligence and determination. The failure lay in institutional capacity, in the impersonal working of incentives and information. The solutions lie in institutional reform.

Market-based credit risk measures show that Yes Bank was in a difficult zone from 2011 to 2014, and then from 2018 onwards. And yet, in the data of March 2019, it reported a nice capital adequacy ratio (CAR) of 16.5%, a value that was clearly wrong. There was failure in both, the legislative function of banking regulation (i.e. the design of regulations) and the executive function of regulation (i.e. the implementation of regulations, also termed "supervision").

The endgame may have been precipitated by an exit of deposits. The incipient stages of a bank run are extremely unpleasant; policy makers get a flurry of difficult days with little time to think and carefully design. But there was no need for the authorities to wait till this endgame. There was ample time in which the resolution could have been planned. While we recognise that India lacks the `resolution corporation' that would do a tidy resolution for some financial firms, the bespoke resolution of Yes Bank and IL&FS look more messy when compared with previous experiences with bespoke resolution in UTI (2001) and Global Trust Bank (2004).

How might this event change the prior of economic agents? Private persons might trust the disclosures and credit-worthiness of private banks less, and trust electronic payment systems less. If mistrust clusters around a group of stressed private firms, it could morph into contagion through reduced access for these firms to credit and deposits. The incentive implications of these changes might prove to be more important for the economy, in the long run, than the immediate disruption.

In the mainstream discourse, the collapse of a firm is seen as the failure of individuals, both in the firm and in policy institutions. We should be skeptical about the theory that the event is caused by some bad human beings. A more abstract view is more insightful, which sees the individuals as merely playing out the role for them in a vast drama, where each person is responding to incentives.

The human actions that added up to the failure of Yes Bank were responses to incentives. We bemoan the willingness of people in India to go through a red light, but persons of Indian origin do pretty well at respecting traffic lights when driving in other countries. Human beings are roughly the same everywhere, the key thing that matters is the incentives that we are placed under. The most important post-mortem required after Yes Bank is not the investigation and fault-finding of individuals: we should worry about the flawed incentives at work.

Why do individuals in private financial firms seem to repeatedly do bad things? Why do individuals in policy institutions seem to repeatedly make mistakes? In both cases, what is going on is responses to flawed incentives. The bad incentives that have given us an important financial crisis in India from 2011-2012 onwards are alive and well, and without the required financial reforms, the crisis will fester.

How do we improve banking regulation? RBI requires clarity of purpose: to deliver CPI inflation of 4%, and to deliver safe and sound banks. RBI should be divested of peripheral work, and get going on the path to capability on these two functions. While the RBI board correctly has a majority of independent directors, there is a need to put the board in control of the organisation design. It must hold the management accountable, and control the legislative function. The legislative, executive and judicial functions require good governance procedures that are encoded into the law. As with all other financial agencies, RBI needs CAG audit and appeals at SAT. Sound formal processes for reporting, RTI and budgeting are required.

How do we improve resolution? India has begun on the IBC journey in 2016. There are, however, two groups of financial firms where the IBC process is likely to fare poorly: the firms which have made strong promises to unsophisticated households (banks and insurance companies) and systemically important firms (e.g. HDFC). For these two groups of firms, what is required is a specialised `resolution corporation' which will look beyond the interests of lenders in order to find a tidy burial for the failed financial firm.

These key ideas were worked out in the Indian research community from the 1990s onwards, in the expert committee process from 2007 to 2010, and then translated into a draft law by FSLRC, led by Justice Srikrishna, over 2011-2015. This process of policy analysis saw important flaws in Indian financial economic policy, and designed the corresponding institutional reforms. The puzzle before policy makers is that of assembling teams that will carry through legislation, where sensible compromises are made through the standing committee process but the essential ideas are protected, and then of assembling teams that will build new financial agencies and reform existing ones.

A subset of the Indian policy community has argued that the key flaw in Indian finance is the large size of public sector banks. While I am no friend of public sector ownership, it is important to be concerned about the consequences of low state capacity in financial regulation. Economists have long argued that the one thing more troublesome than a public sector bank is a a poorly regulated private bank. The best sequence that can be envisioned for the next 25 years involves learning how to do banking regulation, then opening up to entry by private banks, and finally privatising public sector banks. For the years with low state capacity in regulation, a small banking system is in our best interest.

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