Monday, 9 April 2018

When the supervisor slept

Indian Express, 9th April 2018

PNB, ICICI could have averted malpractices if banking system had a mechanism that sounded timely red alerts.

The matter pertaining to the ICICI Bank’s CEO Chanda Kochhar goes beyond the question of propriety. It follows close on the heels of the Punjab National Bank-Nirav Modi fraud case. While the first case occurred in a government-owned bank, the second incident brought focus onto a private bank. In both cases, investigative agencies like the CBI and the ED have stepped in. The common missing factor is the bank supervisor.

Banking is a non-transparent business. Depositors do not know how their money is being invested. Loans are normally given on the basis of the bank management’s judgement. The management assesses the health of a company and its business plans and on the basis of that, decides whether to give the company a loan or not. Bank depositors, the ones whose money is being lent out, do not have information about the company. Regulation and supervision of banks have the objective of protecting bank consumers, reducing the risk of bank failure and limiting the systemic risk arising from the bank’s operations to the financial system as a whole. The supervisor examines the books of a bank with these objectives in mind. The supervisor is not, and should not be, involved in each loan decision. However, the principles based on which loans are given, the integrity of the management, the bank’s audit system, its IT systems and its risk assessment models do come under the bank regulator’s purview.

Speed is critical in ensuring that regulation meets its objectives. The pertinent question is: Does the supervisor catch loans getting stressed and becoming non-performing in time for the top managers or the board to be held responsible for their incompetence or complicity?

Evidence does not seem to suggest that banking supervision in India has, so far, been timely. In an earlier article (‘Extend and pretend,’ IE, October 31, 2017), I argued that the RBI has failed to spot stressed assets in time and created a huge burden for the tax payer. The banking supervisor had allowed banks to hide bad news and permitted them to continue ever-greening loans; this led to rising NPAs. In December 2017, gross NPAs in the Indian banking sector stood at Rs 8.4 lakh crore. This crisis alone brought a recapitalisation bill of Rs 2.11 trillion to the taxpayer. The NPA figures and the recapitalisation needed are likely to grow.

The PNB-Nirav Modi case and the ICICI conflict of interest case suggest further weaknesses in bank supervision. The PNB fraud will cost more than Rs 14,000 crore. If the lack of integration between the CBS (Core Banking Solution) and SWIFT (Society for Worldwide Interbank Financial Telecommunication) allowed PNB officials to cheat, there could be more such such cases hiding in other banks.

The ICICI case revolves around a loan given to Videocon from whose promoter an immediate family member of Kochhar may have benefited. The CEO was part of the committee that made the decision to give the loan. The loan was one in which there could have been a possible conflict of interest. It subsequently turned into a non-performing one. This does raise questions about the people involved and their ethics. But the episode also shows in poor light the systems which are meant to ensure that possible conflicts of interest are brought to the attention of the banking supervisor.

An important element of the story is the speed with which a malpractice is caught by the banking supervisors. Again, there is a parallel between the ICICI and the PNB case. In the PNB (and other public sector banks) there was a lack of integration between the CBS and the SWIFT system through which money was transferred abroad for Nirav Modi. The bank supervisor appeared to have been inadequately apprised of the magnitude of the damage that this lacuna could bring upon the bank. It did not promptly see the problem when it occurred and that allowed the beneficiaries to milk the system for many years before they were brought to book. In the ICICI case, recognition of the Videocon loan as a bad asset took a long time. Both cases appear to have festered for many years before the CBI or the ED stepped in. What steps did the RBI take in the two years since the allegations were made?

In the ICICI case, the bank involved is designated by the RBI as a Systemically Important Bank. This means that if the bank gets into trouble, the entire financial system of the country could be jeopardised. This also means that this bank would have received heightened supervision by the banking regulator. Risk-based supervision implies that the RBI has a special framework for Systemically Important Banks and supervisors watch the bank more carefully. In many jurisdictions, dedicated supervisory teams are assigned to each systemically important financial firm.

The common thread in these cases is banking regulation and supervision. One key question is whether the oversight system for regulation and supervision of banks is adequate. Does the supervisor have red alerts going of when there are possible conflicts of interest? Is there a risk-based system of supervision in place? This is similar to the PNB fraud where the question was: Does the supervisor have red alerts going of for banks where the Core Banking and the SWIFT systems do not talk to each other? The RBI knew that this created risks and officials spoke about it in seminars, but what matters is whether banks in which there is no integration face greater supervisory scrutiny?

The immediate effect of the ICICI case will be to put an end to the demand for privatisation of public sector banks. That is not a bad outcome because to see the problem of the bad performance of Indian banks as one related only to public ownership of banks is a partial view. While ownership is a very important reason for the ills of Indian banking, the lack of adequate regulation and supervision are equally important. We first need to develop our regulatory and supervisory capability before privatising public sector banks or unleashing a large number of small banks onto the system.

Monday, 19 February 2018

Lessons from a fraud

Indian Express, 17th February 2018

PNB scandal points to unreformed financial sector, failure of risk management and auditing systems

The Punjab National Bank-Nirav Modi scandal has, once again, given rise to questions about public sector banking in India. The mixing of the business of banking with government is fraught with difficulties. Public ownership effectively reduces the RBI’s powers to punish managements and boards of banks when they fail to perform their key role of managing risk. Rules of hiring and salary, political pressures, lack of accountability and the implicit sovereign guarantee of PSBs create the wrong incentives.

While the blame-game is on for l’affaire Nirav Modi, India needs to address fundamental questions about ownership of banks and the difficulties it creates. This is not surprising given the public support for PSU banks. Public sector ownership comes with an implicit sovereign guarantee.

For instance, depositor angst about the Financial Resolution and Deposit Insurance (FRDI) bill has been mainly because it has brought into the public debate the fact that all deposits are not guaranteed. Most depositors are not aware of the Rs 1 lakh limit of deposit insurance. The realisation that deposits above one lakh may not be safe if a bank fails, even if the bank is owned by government, is creating huge discomfort. Whether a bank is involved in fraud, as allegedly in the case of the PNB, or whether it has made bad judgements about business loans, depositors have been looking towards public ownership rather than the competence of the bank management for keeping their savings safe.

Given that there are few avenues for safe financial savings, this is to be expected. On the one hand, India forces banks to hold government bonds through the Statutory Liquidity Ratio. On the other, it does not allow households to lend to the government through small savings schemes like the Public Provident Fund and National Savings Schemes beyond income tax rebates. Nor can households purchase risk-free government bonds through the stock market. Households which have low-risk appetite go through the public sector banking system to find avenues for their financial savings. The lack of other instruments in the financial sector, therefore, creates political pressure for public ownership of banks.

The PNB-Nirav Modi fraud highlights the failure of operational risk management and auditing systems. Regardless of whether it was inefficiency or fraud, what is the accountability of the management and the board of the bank? If the PNB was privately owned, would the impact of such a fraud have been only on the two officials arrested or directly involved?

It is reported that the RBI has asked the PNB to pay other banks who gave credit based on the PNB’s guarantee. If the PNB pays up and suffers losses, would it be the taxpayer who will fill in for these losses through further re-capitalisation of the bank?

How many times in the past have taxpayers paid the PNB and other public sector banks that were falling short? CAG Report No. 28 of 2017 titled “Performance Audit Union Government Recapitalisation of Public Sector Banks” says that GOI, as the majority shareholder, has infused capital of Rs 1,18,724 crore from 2008-09 to 2016-17 in PSBs for meeting their capital adequacy requirements. The government has announced that it is infusing another Rs 2.11 lakh crore into PSU banks. At the same time, bad loans in the banking sector are above 10 per cent of outstanding loans. According to the RBI’s Financial Stability Report, while NPAs are rising for both public and private sector banks, those for public sector banks could rise to as much as 14.6 per cent by March 2018.

What is the way forward? The answer may not lie in the over-simplified solution that public sector banks should be privatised. That would be part of the solution, but along with that, other reforms are needed.

First, there is a need to address the requirements of a large and increasing number of investors who should get greater access to mechanisms to lend to government. This may not even mean lower returns. Considering that today the government 10-year bond yield at above 7 per cent is higher than the fixed deposit rate offered by most banks, some could choose to invest in bonds directly through the stock market. This needs a reform of the bonds market.

Second, small savings schemes should be reformed. Direct lending to small savings schemes can be expanded beyond the tax rebate caps. Interest rates can be linked to government bond yields. Third, to address concerns about private banks the deposit insurance cap could be raised; Rs 5 lakh would cover 98 per cent deposits.

Fourth, if the government decides that PSBs should offer risk-free deposits above the cap on deposit insurance they should be allowed to invest only in government bonds, or, do “narrow banking”. Then the implicit sovereign guarantee could effectively turn into explicit sovereign guarantee. The business of giving loans, making decisions, figuring out risk management systems, hiring competent staff, provisioning for bad loans, creating mechanisms for accountability and punishing management when systems fail can be left to private banks. Today the taxpayer pays when PSBs fail to perform these functions properly. Narrow banking by PSBs can take this burden away from the taxpayer.

The reforms of 1991 changed the way business works in India. They allowed the private sector to set up production and import without needing licences. They fundamentally took government out of the role of determining how and what should be produced. However, what they failed to do was to take the government out of the role of financing production and trade. By maintaining a largely bank dominated financial system and keeping it public sector dominated, India tried to run a market economy on one leg. The other leg, of finance, that should have supported the market economy, has been dragging the economy down. More than 25 years after liberalisation, finance is increasingly emerging as the binding constraint which emphasises the pressing need for fundamental reform.

Thursday, 8 February 2018

Union budget: Not as expansionary as it seems

livemint, 6th February 2018

Big announcements notwithstanding, the fine print suggests that fiscal deficit targets are likely to be met

The Union budget has raised concerns about macroeconomic stability, as reflected in some key budget announcements. An examination of the fine print suggests that while there may be some upside risks to inflation, fiscal deficit targets look likely to be met.

First, the full cost of the health protection scheme that promises Rs5 lakh per household per year appears to be more than what has been budgeted. Second, oil prices may rise while budget estimates seem to assume a scenario of benign oil prices and this may have fiscal implications. Third, the government has announced a 50% increase in minimum support prices (MSP) for the coming kharif crop that could lead to a higher deficit. In addition, the corporate tax rate for small enterprises has been cut to 25%.

On the first count, rolling out an all-India health insurance scheme is a challenging task. State capacity to deliver is limited. From the private sector side, good quality tertiary healthcare is still not available all across the country as would be required for this scheme. The supply response of the private sector to the incentives created by this scheme may take some time to realize.

In addition, regulatory capacity of, one, the health sector to regulate the private providers, and, two, the health insurance sector to make sure fraud does not become rampant will take time to develop.

Further, states need to come on board as well for this scheme. Many of them already have their own insurance schemes and will need to replace old schemes. The transition from old to new schemes may require time. This may mean that the new scheme will have limited expenditure in the current year. The allocation of only Rs2,000 crore suggests that this may indeed be the expectation of the government as well. This may mean that the impact on the deficit of the health insurance scheme may be limited.

Oil prices have been rising in recent days. This could put an upward pressure on fuel prices. When global oil prices were falling, the decline in price was not passed on to the consumer as the government increased excise duties. It remains to be seen whether the government will try to keep the price of oil stable. If oil prices rise, would excise be cut to cushion the consumer from the price rise? If so, how would this impact excise collections?

Further, the impact of the oil price hike on fertilizer subsidy will be another issue to contend with. The oil price hike would also mean a larger import bill and a higher current account deficit. This could possibly put downward pressure on the rupee.

In the past, it has been seen that increase in MSP has led to food inflation. Another channel through which the impact of the MSP hike could be inflationary is through a larger fiscal deficit. There are two possible models through which higher MSP is paid to farmers. One is via actual procurement of foodgrains by the Food Corporation of India (FCI) from farmers, which pays MSP to farmers.

However, given that the capacity of FCI to procure all the foodgrains listed across the country is limited, the alternative is to directly pay farmers the difference between market price and MSP. Anecdotal evidence suggests that the scheme benefits traders. In places where this scheme has been tried, it has been found that the difference goes to a large extent into the hands of traders who pay farmers low prices and collude with them to pass on the additional payment to them.

This could mean a big payout by the government but not an equal increase in the income of farmers. If “leakage” arising from this flaw in the scheme could be limited, the deficit could remain under control

In the budget speech of March 2015, the finance minister had promised to bring down the corporate tax rate to 25% over a period of four years. This promise was made on the grounds that the regime of corporate taxes in India needed to be rationalized, exemptions to be removed, and tax rates to be brought down to globally competitive levels. By the end of four years, the corporate tax rate has been cut only for smaller enterprises, which account for roughly less than 10% of corporate tax payments. The remaining corporates will still pay higher taxes.

One reason for not going ahead with the reform has been the difficulties in removing exemptions. If the finance minister had gone ahead with reducing the corporate tax rate for all enterprises without removing exemptions, collections would have suffered. While it is a pity that the reform has not been attempted, the effect of the rate cut on the deficit would be limited since only a small share of tax collections will be affected.

One clear impact of the budget will be higher personal income tax collections on account of the long-term capital gains tax, dividend distribution tax for mutual funds and the increase in education cess. As the GST (goods and services tax) regime is simplified, we may also see a pickup in GST collections.

What does all this mean for inflationary expectations and monetary policy?

Over the past one year, the monetary policy committee (MPC) has repeatedly raised concerns about the fiscal deficit. Whenever rates have not been cut despite inflation being around or even below the target of 4%, the MPC has pointed to fiscal slippages and possible higher borrowing due to the Seventh Pay Commission, and higher house rent allowance. Though the MPC may have concerns about the fiscal deficit, if the limited capacity of the government’s delivery mechanisms is taken into account, the MPC should not be overly concerned. This can create space for an accommodative stance of monetary policy.

Behind the plunge

Indian Express, 8th February 2018

High volatility of stock markets is a response to global movements, domestic concerns over disruptions

The last few days have seen stock markets witness a sharp fall and high volatility. Developments in the Indian markets are related both to global financial markets as well as to domestic policy. Markets also factored in the effect the budget would likely have on the RBI’s monetary policy decision.

One important perception in recent months has been that the market was perhaps overvalued. The last 10 years of data show that the “trailing” price-to-earnings ratio of a broad measure of companies was historically high. In other words, earning growth has been stagnating, but markets have continued to expect that earnings would pick up. This expectation kept stock prices high. The feeling that there may be an asset price bubble appears to be part of the rationale for bringing back the long-term capital gains tax in the budget. If the intent was indeed to bring about a correction in equity prices, by putting tax and additional compliance costs for households, then the process appears to have started. A dividend distribution tax on dividend paid by mutual funds is similarly expected to make equity mutual funds less attractive. The process of correction has been more than helped by global market movements.

Global markets moved sharply after there was a surprise increase in US pay-roll data. The US job market numbers showed an addition of 2,00,000 jobs in January 2018. Along with the increase in jobs, primarily in the private sector, wages witnessed a more than expected increase. This led to the expectation that the US economy may be picking up faster than expected. Inflationary pressures due to higher economic activity and the increase in wages may lead the Federal Reserve Bank monetary policy to be tightened faster than previously expected. As a consequence, interest rate increases could be more than what the markets were expecting. This change in the perception about future liquidity conditions appears to have hit US financial markets and with them, markets across the world. Indian markets, too, moved down.

At the same time, there were concerns that the RBI would adopt a tighter stance of monetary policy. In the policy announcement on Wednesday, February 7, the RBI has kept the policy rate unchanged. However, the Monetary Policy Committee has raised concerns about inflation. Its projection of inflation is higher than the target rate of 4 per cent, suggesting that it may think about raising interest rates at some point to bring it down. Any perception that interest rates would rise and liquidity will tighten tends to make the stock market less attractive.

According to the Monetary Policy Committee, risks to inflation arise from the effects of higher house rent allowance, higher custom duties, higher minimum support prices for kharif crops, higher oil prices and global commodity and financial markets.

A key concern is the fiscal deficit. The RBI notes that the fiscal slippage as indicated in the Union budget could impinge on the inflation outlook. It adds that apart from the direct impact on inflation, fiscal slippage has broader macro-financial implications, notably on the economy-wide costs of borrowing which have already started to rise.

The RBI has pointed to commodity prices, which have been rising in recent days. There could be an upward pressure on fuel prices. This could have a direct impact on the subsidy bill. Further, when global oil prices were low and declining, the benefit was not passed on to the consumer. The government increased excise duties. If the government tries to keep excise the same, to maintain its revenue, there may be inflation. If, on the other hand, it cuts excise, the fiscal deficit may rise. Both are reasons why the RBI may raise interest rates. Only if global oil prices do not rise will neither of these happen.

The other key concern is the increase in MSPs of crops in the budget. In the past, it has been seen that an increase in miniumum support prices has been correlated with high food inflation. This was in a system in which the key foodgrains procured were wheat and rice, both of which were important elements of the consumption basket. Now almost all crops are part of the list of crops to be procured. Higher procurement prices could feed into higher food prices. Alternatively, if they are sold to consumers through the Public Distribution System at below the cost of procurement, there will be an increase in the subsidy bill. This could push up the fiscal deficit and again be inflationary.

The huge increase in the coverage of the health insurance scheme in terms of both the population covered and the amount of payout means that health insurance premiums paid by the governent could rise if the scheme is implemented as promised. The fiscal impact of this in the coming year may be small due to the lack of the government’s capacity to deliver, but as the system is put in place and people start using the scheme, there may be a significant expenditure increase.

At the same time, it is not clear that the impact of the GST on additional revenue will happen immediately. It is not just that compliance takes time, it is also hard for producers in the informal sector to suddenly become 12 per cent or 18 per cent more productive so as to be able to pay higher taxes and survive in the formal sector. These disruptions, which will have long-term gains for the economy, may lead to difficulties in the short run. This again mean risks to the fisc.

Even if this year’s fiscal targets are met, thanks to the government’s limited ability to spend and some good luck on global prices, it is only for the official fiscal deficit targets. Items like bank re-capitalisation bonds that do not show up as additional borrowing in the budget, and are not part of the fiscal deficit, nonetheless impact bond market conditions. Rising long-term interest rates and failed bond auctions by the RBI indicate that bond markets are already seeing a tighening even without a monetary policy announcement.

Thursday, 11 January 2018

The 6.5% warning

Indian Express, 11th January 2018

Almost all steps in the strategy to revive investment are likely to be slow and painful. There are no shortcuts

The GDP forecast for FY 2018 of 6.5 per cent does not come as a surprise. The introduction of a Goods and Services Tax, even in its cleanest and simplest form, would have inevitably led to disruption in any economy. In India's case, multiple rates and a complex structure have made compliance cumbersome and created gaps in the supply chains. As the government simplifies the GST regime in response to the difficulties being faced on the ground, this problem will likely get solved. The bigger challenges for the economy are the problems that have just begun to be solved.

The central puzzle is the decline in investment. Investment did not start declining immediately after the global financial crisis in 2008, but with a lag. For a couple of years, the economy was held up by expansionary fiscal and monetary policy, and the momentum of the previous years. But since 2012, the demand shock seems to have caught up with us. Investment in the Indian economy has declined from 34.3 per cent of the GDP in 2011-12 to 27 per cent of the GDP in 2016-17. The first advance estimates on national income show that investment as a per cent to GDP has further fallen to 26.4 per cent in 2017-18.

During these years, a number of solutions have been tried to revive investment, but with limited effect. First, the decline was understood to be a consequence of the policy paralysis under UPA 2. A large and increasing number of stalled projects was seen to be the reason for the slowdown in investment. There was consequently an attempt to address this issue by reviving stalled projects. Even though the number of stalled projects was reduced with active government intervention and inter-ministerial coordination, the difficulties of private investment did not go away. Stalled projects were perhaps an outcome of underlying problems and not the cause. Therefore, addressing them did not raise the growth of private investment. The outcome to watch for tracking investment is projects under implementation. These started declining in 2011 and have still not picked up after six years.

Next, it was felt that private investment could be increased by raising public investment. Even though the government's ability to raise capital expenditure was limited, there was expected to be a crowding-in effect, and the increase in public investment was expected to lead to an increase in private investment. This strategy had limited effect. Public investment increased but at a much slower pace than expected. The government’s ability to write good contracts and give out projects was limited by bureaucratic hurdles, government contracting systems and procurement rules.

Meanwhile, bank financing had also run into trouble. Banks had lent to companies who were no longer returning their loans or paying interest. Corporate debt restructuring, that gave borrowers additional time to pay back after the crisis, had not helped. Bank money was stuck and they could no longer lend. Credit growth had slowed down. The way out was sought in going after the bad guys or the "wilful defaulters". The others were to be given a longer rope. This strategy did not get money back to banks.

First, it was very hard to identify the bad guys who had run away with the money. Even when the Vijay Mallyas were identified, the banking system did not get the money back and bank lending did not pick up. The good guys who were given time to return the money kept pushing repayment dates further, and they were given new mechanisms to keep kicking the can down the road. Banks failed to recognise poorly performing assets as non-performing and the regulator was lax. The net result was pretty much a bankrupt banking system stuck with bankrupt companies.

The logjam can no longer be ignored. The Bankruptcy Code and the Financial Resolution and Deposit Insurance Bill are a strategy for addressing this problem. They are critical elements of trying to untangle the mess we are in and to address the huge problems being faced today in the banking and corporate sector that have brought investment to a sharp decline. These are not popular measures. Nor are they quick-fixes. The 12 cases that the RBI has sent to the the bankruptcy process could lead to haircuts and losses that cause a number of banks to become unable to meet their capital adequacy requirements in the coming quarter. To prevent this from happening, Rs 2.11 lakh crore is being put into bank recapitalisation. This money could well have been spent on infrastructure or public investment. But until a better plan is ready, the immediate need to allow exising banks to function is the first step.

However, looking forward, as bankrupt companies and bad loans will be resolved by the bankruptcy process, bank losses will rise and putting budgetary resources into loss-making public sector banks will become increasingly infeasible. The creation of a Resolution Corporation will allow banks to be sold to other buyers in an orderly way. The FRDI bill is currently being examined by a Joint Parliamentary Committee and is likely to be passed after taking into account the fears and concerns.

Another critical requirement for investment growth is the availability of non-bank finance. There has been discussion about a corporate bond market that could provide funds to industry, particularly big industry. Yet, no country has been able to develop a liquid and well-functioning corporate bond market without a risk-free benchmarket rate provided by a government bond market. The creation of a well-functioning government bond market with a public debt management agency and integration with equity markets was proposed in the March 2015 Budget. This proposal was rolled back to give the RBI time to work with the Ministry of Finance on a transition plan. As a critical element of facilitating finance for investment, this work needs to be prioritised.

Almost all the steps in the strategy to revive investment are likely to be slow and painful. A sustained pick-up in investment and growth can be expected only once these essential elements are in place.

Tuesday, 31 October 2017

Extend and pretend

Indian Express, 31st October 2017

Banks can play that game no more. But recapitalisation is not the reform that is needed to prevent a recurrence

The problem of rising non-performing assets of banks has been simmering beneath the surface for many years. Until now, it was possible to sweep bad news under the carpet. But the pressure arising from bad loans going through the bankruptcy mechanism has made it difficult to continue the game of extend-and-pretend. Recapitalisation of banks is, however, not a reform. It uses taxpayer money to cover up the failure of institutions. To prevent a recurrence of such failure, it is important to reform not just governance, but also regulatory oversight.

The problem of hidden bad assets is pervasive across the entire banking system. Both public and private sector banks are part of the story. If one bank had been undertaking fraudulent accounting practices and hiding problems, it could have been blamed, and its management punished, as in the case of Satyam and the conviction of Ramalinga Raju. If the problem was limited to public sector banks, we would have found solutions in their governance. Private banks have also been hiding bad assets. The present NPA crisis appears to be as much a failing of the banking regulator. For many years, despite its unquestioned powers to regulate, supervise and inspect banks, the regulator did not take action against banks that were hiding their bad assets. Instead, it proposed one loan restrucuturing scheme after another. None of the schemes, like CDR, SDR, S4A succeeded and stressed assets grew in number and value. It is only now, when credit growth has collapsed, that solving the problem cannot be postponed further and the regulator has become strict.

There has been a lot of discussion about restructuring public sector banks. However, this misses the point that private sector banks are also in a similar situation. The question to ask is: Why did the banking regulator fail to take action against banks that were hiding bad loans? The RBI is a regulator that interferes with bank operations more than any other banking regulator in the world. Given its policy of giving hardly any new bank licences, the RBI has only a small number of bank books to examine. So why did it fail in this core function?

A charitable explanation could be that its staff is of poor quality. It is ill-equipped to inspect bank books. Why did the RBI not see the problems, like late payment of interest and principal, evergreening of loans, mechanisms that banks created to keep bad loans from been classified as such until 2015? Many regulators, particularly abroad and some in India like SEBI, hire practitioners from the industry to be part of supervision teams. Is it that the RBI does not have adequate lateral entry and depends on people who have not been on the other side, and thus keeps getting outsmarted?

A second, less charitable explanation could be that bank inspection did reveal the bad asset problems. But the inspectors kept quiet. Finance Minister Arun Jaitley has said the problem was hidden under the carpet till 2015. In other words, the regulator knew that there were bad assets, but did not press upon banks to declare them non-performing. The regulator did not take action when banks continued to extend-and-pretend. Loans were not declared NPAs despite non-payment of interest or principal. Bank inspectors looked the other way when banks gave additional loans to defaulting clients to service these loans. If this was the problem, should there not be a question about why the regulator behaved in this manner? A bad loan is a rapidly depreciating asset. The RBI was the only authority with oversight over banks, and allowing extend-and-pretend increased the cost to the taxpayer of recapitalising banks. Who was responsible, who is accountable?

Whatever the correct explanation - incompetence, complicity or the attempt to hide its own inadequacy - there is no question that the banking regulator, by failing to do its job, has burdened the taxpayer with higher costs. The cost of solving the NPA problem has grown every year that the RBI has hidden it, and the burden on the taxpayer has increased.

The RBI has an annual spend of Rs 13,000 crore at present. It is the only regulator that is not subject to a CAG audit. In the name of independence, the RBI has become unaccountable. All institutions that spend public money need to be accountable, and one that fails in its job cannot be excused for any reason. A mistake as big as one requiring Rs 2.11 trillion of taxpayer money should be followed by an analysis of the failure of the government agency explicitly tasked with preventing this very situation.

In view of the earlier PSB recapitalisations and bank regulatory failures in the past, the Financial Sector Legislative Reforms Commission (FSLRC) had proposed changes to the governance, regulation making, supervision, inspection and data collection in all regulators, including the RBI. The FSLRC also proposed a resolution corporation with powers to inspect banks. While the Financial Resolution and Deposit Insurance Bill that aims to create a resolution corporation for banks has been tabled in Parliament, it does not give it the power to inspect banks and thus to create checks and balances to the RBI’s power. Without additional supervision, and without checks and balances, the RBI will continue to be the only supervisor of banks. The resolution corporation will step in only after the RBI declares a bank has failed.

Regulatory failure across the world has led to changes in regulatory regimes, in laws and in institutions. Creating checks and balances is a necessary element of the reform process. Independence and accountability are two sides of the same coin. Regulators must have both.

In conclusion, in the discussions about the reform that should accompany recapitalisation, it is important to remember that it is not enough to reform public sector banks. The problem of hiding NPAs is also present in private sector banks. The failures of banking regulation must be addressed and checks and balances created.

Friday, 1 September 2017

Maximum pain

Indian Express, 1st September 2017

Objectives of demonetisation could have been served better by doing a cost benefit analysis.

The RBI Annual Report reveals that almost all demonetised notes have been returned to the central bank. This number does not include the old notes with District Central Cooperative Banks for the short window when they were allowed to accept deposits. It also does not include the notes within Nepal. The shortfall of Rs 16,050 crore between the notes in circulation when the notes were demonetised and those that were returned, could therefore also be made up once these notes are returned to the RBI.

It should come as no surprise that almost all the notes have been returned, including the stock of black money held as cash. To the extent that it was possible to exchange money legally, individuals did so. When cash limits for withdrawal made it difficult, friends and families participated. The inconvenience of long queues was overcome by household staff. A private company offered booking of "chhotus", who would stand in long queues for people for Rs 90 an hour until their turn came. Bank employees were averse to being unhelpful to regular customers and found ways to serve them. Innumerable ways were found to work around the changing rules of exchange, cash limits, indelible ink and specified uses of old notes.

Those who could not exchange money legally found money changers. Innumerable anecdotes, media reports and arrests of bank staff tell stories about how this was done all over the country. When the government announced that old notes could no longer be exchanged, but only deposited, new ways of changing the stock of unaccounted cash emerged. Individuals with bank accounts, including Jan Dhan accounts, and companies showing cash accrual from sales came into business. Large amounts could be laundered through this route as it did not involve immediate cash payouts by banks, since cash shortages still persisted with the RBI and banks scrambling to remonetise the economy.

It was to be expected that even if people have to pay tax on their hoarded cash, and a change fee, they would prefer to do that rather than lose the whole amount. Data from Prowess, a database of companies in India, shows that in the quarter of demonetisation, when purchasing power had fallen sharply, net sales by companies rose significantly. At the same time, the number of tax payers and tax collections rose. The tax department is said to have found thousands of shell companies which were possibly engaging in the activity of depositing money in their accounts during the demonetisation period, claiming that it was cash from sales. This provided a means for laundering money.

The total currency in circulation, according to the RBI’s annual report, is about Rs 2 lakh crore short of the pre-demonetisation period. This is partly due to the increase in focus on printing of lower denomination currency notes. Initially, the RBI had focused on printing the Rs 2,000 notes to rapidly remonetise the economy. In addition, there could be some reluctance to hold cash. The replacement of cash transactions by digital transactions, the slowdown in small-scale industry, in the rural economy, construction and other informal segments of the economy could also lead to somewhat lower demand for cash. However, it is less probable that the cash of black money holders has not been withdrawn because they are unlikely to leave that in the bank accounts of the money launderers for long. It might have partly been settled for bitcoins, gold, or similar assets that are difficult to trace.

There is no doubt that those with holdings of unaccounted cash lost some of their wealth in the process of laundering it. To some extent, taxes were paid on it in the process of legitimising it. But in addition to that, illicit wealth was redistributed from black money holders to money launderers. Whether the money launderer was a company owner, a bank employee or a Jan Dhan account holder, there was now a need breed of criminals with wealth obtained from illegal means. The total reduction in black money was therefore much smaller than what might have been envisaged.

International evidence suggests that few countries address the problem of black money by demonetising their currencies. If the problem is large-scale crime, corruption, bribery, bureaucrat-politician nexus, rent seeking, tax evasion etc. the answer lies in reforming the criminal justice system, law and order, administrative reforms, bringing transparency in the functioning of the state and rationalisation and simplification of the tax system. In this context, the GST will be a far more effective mechanism to bring down tax evasion in indirect taxes considering the greater incentive for compliance that its design holds.

The real rationale for new notes by the RBI is a rather innocuous paragraph hidden away in its Annual Report. It says: "As a standard international practice, the design and security features of banknotes are reviewed periodically. In line with this practice, a new series (Mahatma Gandhi New Series) of banknotes in new design, dimensions and denominations, highlighting the cultural heritage and scientific achievements of the country, was introduced during the year. As part of this process, banknotes in the denominations of 500 and 2000 were introduced on November 8, 2016. New design notes in other denominations are due for phased introduction." (Section VIII.15, RBI Annual Report 2016-17).

The best way of achieving this objective would have been to slowly replace old notes with new ones, giving the public adequate time to exchange and deposit old notes, as is also "standard international practice". The outcome would have been the same. The pain would have been much lower.

This episode in India's policy-making highlights an essential tenet of policy-making — the need for a cost benefit analysis. For any objective that is to be achieved, we need to examine various policy options and analyse their costs and efficacy. For an economy on the path of reform, with many more reforms still to come, long-term sustainable impact can be achieved only when we strengthen the policy-making process as well.