Why #RBIvsGovt is a viral storm in a tea cup

livemint, 1st November 2018

The Reserve Bank of India (RBI) remains one of the most unreformed central banks in the world. The present rift with the government over India's liquidity crisis could be a turning point

New Delhi: Central bank deputy governor Viral Acharya's speech on the issues between the Reserve Bank of India (RBI) and the government has brought the rift between the two into public domain more visibly than perhaps ever before. One reason for the fissures seems to be that in the board meeting of the RBI there was a debate on some items listed on the agenda. There are reported to be differences of opinion between the independent directors and the management of the RBI on these items.

At first blush this seems rather strange because it is the job of the board of a regulator to discuss regulations. Regulations require board approvals. That such approvals should be given after a detailed cost benefit analysis of each regulation is to be expected. It should be quite normal, for example, to discuss what impact these regulations would have for the health of the banks and the economy, for small and big firms, for consumers and other stakeholders. It should be equally normal to have differences in opinion on such complex issues.

Why then did a discussion in the board turn into such a public storm? It seems that in the normal course of affairs the RBI board did not hold discussions on agenda items and merely approved what the management brought to it. Regulations were made by the Central Committee of the Board (CCB) to which the board had delegated all its functions. This meant that CCB could take decisions on any of the matters that the board should have deliberated upon. It resulted in a subset of the board, with largely RBI management, getting practically all the powers of the board.

This is unlike most boards which delegate specific functions to sub-committees of the board. The board would rarely question the decisions of the CCB. A normal healthy tension that should exist between the management and the board did not exist. A question arising from Acharya's speech is whether a discussion by board members in the RBI board constitutes interference in the job of the RBI and reduces its independence?

For its part, until now, the government did not pay adequate attention to the functioning of the RBI board. A healthy functioning board with discussions and debates on important issues and a more accountable RBI should have been the norm. Debates in board meetings should not have kicked off storms.

The government's overall commitment to financial sector reform was also weak when it rolled back bills like the Public Debt Management Agency (PDMA) and Financial Resolution and Deposit Insurance (FRDI).

In 2015, when new guidelines for regulation making processes by regulatory boards were accepted by all members of the Financial Stability and Development Council, these were not followed by some regulators. But there was no serious follow up by government. Now, at this stage, after publicly airing differences between the management and other board members, if the government uses Section 7 of The Reserve Bank of India Act, 1934, to give directions to the RBI on regulations, it is not a step towards improving the functioning of RBI governance. It would be a step backward in the reform process.

A matter of reserves

Another question in the speech is that of RBI reserves and its transfer to government. Acharya’s speech begins with how a transfer of excess reserves from a central bank to government can be catastrophic, as was in the case of Argentina. The RBI Act requires RBI to create a Reserve Fund of ?5 crore. In addition, RBI board can make regulations governing the manner and form in which the balance-sheet of the Bank shall be drawn up. But this requires the previous sanction of the central government.

In the past under Section 47 of the RBI Act, the RBI board created discretionary operational reserves and revaluation accounts to account for fluctuations on its assets side and unforeseeable expenses. For the year ending June 2018, RBI’s reserves, at Rs. 9.63 trillion, constituted 28% of its total assets (See box for details). This is higher than almost all central banks in the world.

A central bank is not a normal bank. It is not a commercial bank—so it bears negligible credit risk. As a consequence, there is no clear framework, as there is for commercial banks, on the reserves or equity capital required to be held by a central bank. It is not correct to use the Basel framework to compute the equity capital required in a central bank. In fact, as former chief economist of the IMF, Prof Olivier Blanchard, has emphasised, it's perfectly feasible for a central bank to run on negative equity capital. A central bank could have negative values of Rs.equity capital' and this does not induce any stress.

The reserves with RBI have been created by the RBI board. However, these funds were not created with the prior permission of the central government, as required by the law. Further, the RBI board has not made rules about how much should go into each reserve. In its 2015 Annual Report it said that it would come up with a framework for equity capital, but has not done that so far. As noted before, the present RBI Act requires only one Reserve Fund of ?5 crore.

The board should discuss if it wishes to achieve compliance with the law and what should be done with the remaining reserves. In principle, this money should have been paid to government in the years the profit was generated as is done elsewhere by most central banks. Today the discussion must involve the pros and cons of transferring it to government or holding it back. If it is transferred, then the inflationary or other effects must be discussed. If it is held back or more is to be accumulated, then the board should put in place a framework and set of rules about each of the funds.

Protecting the fort

A third issue raised by Acharya is that governments have a short term view while central banks have a longer term view. But is this always true? Let us look at the case of RBI reform. Based on difficulties in the financial sector, a reading of India's archaic laws and learning lessons from the global financial crisis, the Financial Sector Legislative Reforms Commission (FSLRC) highlighted the need for reform. In its report submitted in 2013, it recommended changes in India's financial sector laws to provide the rapidly growing Indian economy a new financial regulatory architecture.

The Commission based its work on a number of RBI and government committee reports which had recommended changes, but it was the first to propose legal changes in the form of the Indian Financial Code. It sought to modernize governance and make regulators more independent as well as more accountable. For example, it proposed to do away with the government’s power to give directions, while it sought to make boards of regulators more accountable and transparent with agenda and minutes of board meetings to be public, and with boards having the responsibility of approving all regulations after due process.

The government's attempts at reform following the FSLRC report over the last 5 years have, in general, been opposed by the RBI. The exception, also mentioned in Acharya’s speech, was FSLRC’s proposal for making RBI an inflation targeting central bank. Media reported RBI as opposing the larger number of external members proposed by FSLRC, as it would undermine its independence. The government compromised. Even when three external and three internal members were to constitute the committee, the new law gave the RBI governor a casting vote. This tilted the balance in favour of RBI.

On other reform, including governance reform, reform of the regulation making process, appeals on RBI orders, etc RBI consistently opposed reforms. Then RBI governor Raghuram Rajan's speech titled, Financial Sector Legislative Reforms Committee Report (FSLRC) - what to do and when? famously argued "If it ain't broke, don't fix it".

It seems that as the economy grew rapidly, RBI’s capacity to evolve and reform did not keep pace. RBI failed to recognize that if we wait to fix things when they get broken, then the short term solutions that need to be provided are rarely optimal. Long term reform can only be undertaken when there is no crisis. If the board members are discussing short term solutions to the credit crunch for small firms, the RBI management cannot absolve itself of the responsibility for the situation coming to this point. There is little doubt that the proposal to let weak banks lend more is a risky one, but there is also little doubt that poor supervision by RBI management failed to arrest the slide early on.

Lending blame game

Why is India’s banking sector not lending to small companies? RBI has been an important stumbling block in the attempt to develop deep and liquid bond markets. It has kept a stronghold over the government bond market, which is an integral part of the bond market, by allowing limited participation in its market infrastructure—the exchange (NDS-OM) and the depository (SGL). While most major central banks in the world stopped trying to manage government debt after being given an inflation target, RBI protected its turf and forced the government to withdraw the bill that proposed to reform the bond market. This created a financial system in which large firms with better ratings and collateral accessed the banking sector at the cost of small firms.

At the same time, even though RBI was independent and free to give out commercial bank licences, it only gave out two bank licences in more than a decade. This failed to create a competitive environment where banks were competing to give loans to small firms. For its part, no government over the last 15 years addressed the issue of the lack of competition in the banking sector either.

The DG's speech is peppered with the usual fear mongering and buzz words RBI often uses whenever there is an attempt at RBI reform-"hyper-inflation", "full-blown crisis", "asset-price crashes", "financial crisis", "sudden-stops", "collapse", "unchecked financial fragility" and so on. Needless to say, many a country has undertaken central bank reforms without leading to a crisis. In India, fear mongering has often resulted in governments backing off on the question of reform. As a consequence RBI remains one of the most unreformed central banks in the world.

The present rift is a turning point. If the government uses this opportunity to improve governance, initiate changes in laws and regulations that strengthen India’s financial regulatory architecture, it would be a move in the right direction. If it merely asserts its powers by giving directions or imposing its will by other means, it could well turn into a catastrophe as predicted by Acharya.

It's broke, fix it

Indian Express, 21st September 2018

The IL&FS trouble exposes the weakness in financial regulatory architecture. Reforms are called for

A large infrastructure finance company, Infrastructure Leasing and Financial Services (IL&FS), is in trouble. Some of its subsidiaries defaulted on their debt. As a consequence, it was sharply downgraded recently. We do not really know the system-wide implications of an IL&FS default. If tax-payer money is used to save IL&FS, it would be another drain on the Union Budget, already burdened by mismanagement and regulatory failures in the banking sector.

This situation need not have arisen had we put in place institutions that monitor and regulate systemic risks such as a systemic-risk regulator and a resolution corporation. There were attempts at many levels to put such laws and institutions in place. Laws were proposed, Budget announcements made and task forces created. Turf wars, and the misplaced view that India was saved from the crisis and therefore needs no reform managed to scuttle the proposed reform. A famous financial regulator's stance on the proposed reforms was "If it ain't broke, don't fix it!"

The most important lesson from the bankruptcy of Lehman Brothers was that the failure of one company can create a risk to the financial system as a whole. Such "systemic risk" needs to be monitored. If a firm is large, it is considered "too big too fail". Even if it is not too big, but so deeply integrated with the business of other firms in the financial sector, it may be "too networked to fail". In either case, such firms and their real-time networks need to be monitored. To understand how to respond to trouble in such a firm, the regulator must at all times know who will get hit if this firm fails, by how much, and what will be the consequences of such a failure. At all times there needs to be a full picture of their assets and liabilities. These firms can be put under enhanced supervision.

To ensure financial stability, this job needs to be given to an agency with powers to monitor risk-cutting across sectors. In this instance, IL&FS is a non-bank financial company regulated by the RBI. But the RBI does not have all the information required to understand risk to other financial firms arising from its debt of Rs one lakh crore. It may know about bank loans to the conglomerate. But pension funds, provident funds, mutual funds and insurance companies hold the debt of IL&FS subsidiaries. Since the RBI does not regulate them, it will not have the full picture.

A similar situation arose post-Lehman when AIG, an insurance company, witnessed distress. No one knew who would not be paid if AIG defaulted. This led to the understanding that today's financial markets do not lend themselves to only sectoral regulation. The ripple effects of financial shocks can be felt across sectors and all those need to be known before we decide how to handle a possible default.

The Financial Sector Legislative Reform Commission, when submitting its report in 2012, drawing upon lessons from the crisis, and analysing the present legal framework in Indian financial regulation, had recommended legislative and architectural reforms. This included a body that would monitor systemic risk. The Financial Data and Management Centre would have the legal powers to collect all regulatory data along with sectoral regulators. The 2016-17 Budget announced the setting up of such a data centre and consequently a draft bill was proposed. However, turf issues of financial regulators ensured that this important initiative did not see the light of day. Unfortunately, if there is trouble, these regulators will go scot-free while the government will have to bear the consequences.

Another equally important lesson from the global financial crisis was that in such times financial firms, both bank and non-bank, need to have an orderly mechanism for their resolution so that they can be sold as living firms with minimum cost to the economy and the taxpayer.

The proposed resolution corporation, to be set up through the Financial Resolution and Deposit Insurance Act, would have been watching the company, examined whether it is systemically important, asked it to prepare a living will if needed, and then stepped in before the firm defaulted. So today, if reforms based on lessons from the global financial crisis had been allowed, there would be an orderly mechanism for a resolution of a financial firm. The push back from various quarters opposing the FRDI bill led the bill to be withdrawn. Today the options are limited. The firm can be forced sold. But to whom? LIC, which is already buying up all the carcasses in the financial sector? Or IL&FS can be taken through IBC. This would mean its subsidiary firms that are non-financial firms could be sold one by one through the bankruptcy process. None of these are easy or fast solutions.

In the absence of a good legal framework to resolve a complex financial firm, a temporary solution involving a crack team and a war room to address the problem might be the best option. Hopefully, it will be able to manage the situation without paying a big cost. The IL&FS trouble exposes the weakness in India’s financial regulatory architecture. This episode should increase the urgency with which the required reforms are brought back on the table.

Reimagining financial reforms in India, 10 years after Great Recession

livemint, 17th September 2018

Ten years after the 2008 financial crisis, more, not less, financial sector reform is urgently needed in India

Until Lehman Brothers filed for bankruptcy on 15 September 2008, home loans going bad in some pockets of the US seemed like a small problem for the world. It was a local issue unlikely to cause a problem even for the US economy. If a bank gave a loan to a household who could not pay it back, it was going to be a problem for the individual household, not even particularly for the bank. It was assumed that the bank would be able to absorb small losses.

Banking regulators did not worry too much even if a bank had a lot of such loans on their books. Governments did not look to see if a large number of banks had a lot of such loans on their books. No one really worried that non-bank financial institutions were also buying up some of these mortgage backed securities.

Consumer protection

With the bankruptcy of Lehman Brothers and the unfolding of the Global Financial Crisis (GFC), it came to be understood that mis-selling of financial products to consumers can create risks to the entire financial system. By banks giving loans for nearly the entire value of the house being purchased, assuming that when house prices rise, the loan could be repaid, they created a risk. When lots of banks gave lots of such loans, they created a risk for the banking sector. And, when they created derivative products of these loans that were bought and sold to many other financial institutions, both in the US and globally, they created risks for the global financial system.

The entire edifice was based on the assumption that house prices could not fall. Once house prices started falling, home loans started going bad. Foreclosure under the US law, or simply handing over the keys of the mortgaged house to the bank and walking away was the most rational step for borrowers to take. As banks’ books started going bad and they sold their sub-prime loans to other parts of the financial system, the problem became widespread.

Among the biggest lessons from the GFC for financial regulation was that consumer protection must lie at the heart of financial sector regulation. Consumer protection goes beyond the concept of consumer complaint and redress. It is about not being allowed to sell loans that the consumer may not be able to pay back. The consumer may not even understand what is being sold to her. It is the job of the adviser to advise the consumer so that she is not sold such a product. It is not enough to get consumers to sign off on small print disclosure statements that they do not read.

A financial product, unlike a cup of coffee, is not something we consume when we pay for it. What we receive by buying a financial product is a promise by a financial firm to pay us sometime in the future. In bank deposits, it is a promise to pay back the principle and the interest in the future. In insurance, it is about the promise to pay under certain states of nature. In pensions, it is a promise to invest your money well and pay you the principle and returns when you retire. Under annuity, it is a promise to pay you regularly in return for your one-time payment, or purchase of the annuity.

Now, what happens if this promise is not fulfilled by the firm? First, there may be sheer fraud. Second, the firm may go bankrupt. Third, the entire financial system may collapse. The job of regulation is to minimize the risk of all of these. Note, it has to minimize the risk, not completely eliminate it. So it has to allow firms to sell financial products, not ban them, and still find ways to protect consumer’s interests.

Often only the financial firm understands how the money it has raised from its customers is being invested. It may put it in very risky assets in the hope of getting high returns. Managers who get paid bonuses based on high returns may choose risky assets. The regulators job is to reduce the risk of failure of the firm, of the system as a whole, and of the obligation for the taxpayer to pay for such failure. Given the complexity of finance, the way a financial adviser often gets a commission to sell a financial product, be it a loan or an insurance policy, or a savings product, there is ample scope for mis-selling.

Systemic Risk

Post Lehman, it was understood that when mis-selling is done on a large scale, it can lead to the risk of failure of financial institutions and the financial system as a whole. The regulation of institutions, or micro-prudential regulation, which was the old job of regulators, and looked at whether a bank was taking on too many risks and could fail, was not adequate. There had to be a systemic view of the financial system as a whole.

Systemic risk could arise from two sources. If too many banks had the same kind of risks, say the risk of failing if house prices fell, the system as a whole could have a crisis. Even if only some banks failed, but were “too big to fail”, so big that they could pull down the financial system as a whole, then there would be a crisis.

Before GFC, the boundaries of financial regulation were more limited. Subsequently, it was understood that a Bear Sterns was “too networked to fail”, but since it was not a bank, it was not similarly regulated. AIG, an insurance company and not a bank, had assets and liabilities that no one even knew about because it was not regulated under a resolution framework. So far hedge funds had been left more or less to themselves as their investors were rich and well educated and did not need to be “protected” as the poor did.

But now it was understood that hedge funds had big positions that could impact the financial system as a whole. If the system as a whole could collapse due to the activities of some firms and if taxpayer money had to be used, then these boundaries needed to be expanded beyond the hitherto regulated entities to those who had so far been unregulated. New tools of regulation: macro-prudential tools were created. New powers were given to regulators. They were now to look for where was the risk being concentrated. Bigger financial institutions saw greater scrutiny.

The post-GFC period saw a major re-haul of the financial sector laws and regulatory architecture. The Dodd-Frank Act in the US, a new regulatory architecture in the UK in the form of “twin-peaks model’’ towards furthering prudential regulation and conduct regulation of market participants are some examples. South Africa has been the most recent addition to the list of countries that have overhauled their financial sector regulation in the aftermath of the global financial crisis.

By then financial regulators in Britain, Australia and many other countries had already moved away from sectoral models of regulation—such as separate banking regulators, insurance regulators, pensions regulator and so on—to regulators who looked at the different businesses and arms of a financial company that could involve banking, insurance, derivatives etc. These now also started setting up systemic risk regulators, or macro-prudential regulators, and gave them new powers. In some cases these were placed inside central banks such as the Financial Policy Committee in the UK, and in some cases in a council of regulators such as in Australia.

In the US, the Treasury had to put in billions of dollars of taxpayer money to bail out some of the biggest banks which could not be allowed to fail. Small banks were allowed to fail as the FDIC (the Federal Deposit Insurance Corp.) undertook an orderly resolution process. After the crisis more than 30 countries enacted laws for bankruptcy for financial firms and set up resolution corporations.

Lessons for India

The Indian financial system was much less developed compared to the sophisticated ones that witnessed the crisis. It was at the other end of the spectrum, where instead of worrying about sophisticated derivatives products being traded, most derivative products have restrictions, or are banned, and the bulk of the population has no access to bank loans. The Reserve Bank of India, in some speeches after the crisis, claimed that the world should learn lessons from Indian regulators because we weathered the crisis well and were protected because of our policies.

However, beyond the rhetoric, there were few takers for banning financial products and services in the manner that Indian financial sector regulators had done. While the IMF advocated that only permanent capital controls like those in India and China could protect countries from capital surges and capital flight, countries that did impose controls after the GFC imposed only temporary controls.

One lesson from the crisis was that each regulator looking at risks in her sector was unable to see risks arising across the financial sector as a whole. To address the issue of financial stability the government of India created a non-statutory council of regulators, the Financial Stability and Development Council (FSDC). This body was expected to review the system as a whole.

However, no new macro-prudential tools were created and the body was not given any legal power. For example, it decided that regulation making by financial sector regulators must follow a better and more formal regulation making process that involved board decisions about regulations, the need for them to be clearly outlined, taking feedback from stakeholders, responding to the feedback. This process was outlined in a manual, a handbook for regulation making. But not all regulators changed their ways. The FSDC lacked legal powers.

A number of expert committee reports that looked into the problems being faced by Indian finance recommended changes in regulations and the regulatory architecture. However, these could not be implemented under the present legislative framework. For example, to create a framework for bankruptcy of firms required the Indian Bankruptcy Code to be enacted. Similarly, to enable changes in the way financial regulations are made, the Financial Sector Legislative Reforms Commission (FSLRC), set up by the Government of India, proposed the Indian Financial Code-a blueprint of a comprehensive law to create a reformed financial regulatory framework.

Though the Indian Financial Code was not tabled in Parliament as a single piece of legislation, many elements of the law were implemented. These included the merger of the commodities regulator (Forwards Market Commission) with the securities market regulator (Sebi), the shift of regulation of non-debt capital flows from RBI to the Ministry of Finance and the setting up of an inflation targeting regime and a Monetary Policy Committee of the RBI.

Two more bills were tabled in Parliament and later withdrawn. The first aimed at developing a deep and liquid bond market in India. It was to enable setting up of a Public Debt Management Agency and unification of debt market with the securities market infrastructure and regulatory framework. The second aimed at created a legal framework for orderly resolution of failing financial firms, where there exists a vacuum in India today. The act was to enable the setting up of a resolution framework for financial firms and a Resolution Corporation. Today, without a framework for bankruptcy and orderly resolution for financial firms, India faces the risk that if a large private sector bank goes bankrupt, there is no legal way of dealing with it other than to force a public sector bank or insurance company like the Life Insurance Company to buy it out. This is a bad solution as it could weaken the firm buying the failing bank.

The Indian solution has been to treat the lesson from the crisis as going even more slowly on financial sector liberalization than it had in the past, rather than to allow financial sector products and services to be sold and to regulate them better. However, to serve the growing needs of the economy for debt, equity, payment systems, and innovations in financial products and services require that regulatory reform is undertaken with much greater speed.

The rupee is falling and India should let it

livemint, 10th September 2018

The Reserve Bank of India's stated policy is to reduce volatility, rather than target a specific level for the currency. Should the RBI intervene to strengthen the rupee?

The Indian rupee has been sliding against the US dollar in recent days as emerging markets come under pressure. That's made the currency one of Asia's worst performers, losing 12% this year. The rupee's latest moves have sparked a debate in India. The Reserve Bank of India's stated policy is to reduce volatility, rather than target a specific level for the currency. Should the RBI intervene to strengthen the rupee? If so, what precisely should it do and what would the impact be?

A number of factors are pressuring officials to act - not least among them, that the rupee has become both a badge of national pride and a tool of political brinkmanship. But so far the government and the RBI have been unruffled by the fear-mongering. They shouldn’t lose their nerve.

Some of the loudest complaints have come from companies fretting about the likely impact currency depreciation will have on corporate balance sheets. Those who bet RBI would step in when faced with depreciation pressure borrowed heavily in international markets. Yet India's currency-derivative markets, with many restrictions and limited liquidity, make hedging quite expensive, so these companies are now exposed.

Another pressure point is the price of oil, which quickly becomes a matter of unhappiness among the middle class. India imports about 80% of its petroleum needs, a factor only complicated by the country's exorbitant domestic taxes on fuel-almost 100% on petrol and 60% to 70% on diesel. This means that when the rupee depreciates, the exchange rate pass through to fuel prices and, as a result, the rest of the economy, is high.

The RBI does have a number of instruments it can use to support the currency. The most obvious is to intervene in foreign exchange markets by selling dollars: the central bank has more than $400 billion in reserves at its disposal. Alternatively, it could raise interest rates, a move justified by the currency weakness, higher oil prices and the latest above-target inflation data. Third, it could raise dollars by borrowing from non-resident Indians, which has become a go-to in times of currency stress.

The RBI has used these instruments in the past—and the results haven’t been pretty. The central bank moved to prevent rupee depreciation in May 2013, after then US Federal Reserve chairman Ben Bernanke’s taper talk. Intervention continued through September, as pressure continued to mount on emerging market currencies. The result? The rupee fared worse than all other emerging market currencies.

Every move-from tightening liquidity and raising interest rates to discussion of non-resident borrowing and restrictions on derivatives was interpreted as a panic reaction that only confirmed the rupee was under pressure. Foreigners felt it was better to take money out of India sooner rather than later, and the fall of the rupee became a self-fulfilling prophecy. Currency and derivatives markets, money and credit markets, and high costs of borrowing all hurt the economy in subsequent months.

In the years that followed, RBI continued to manage the rupee carefully. It mostly achieved this by reducing the size of the rupee-dollar derivatives market, which made its intervention more effective, and then buying rupees forward.

To some extent, the approach worked: currency volatility settled. While the real exchange rate of the rupee appreciated, the currency didn’t weaken in line with India’s higher inflation. Yet some could argue this merely set the stage for the current rout, which can be seen more as an overdue recalibration than a flash in the pan.

To be sure, there are some segments of the economy that gain from rupee depreciation. A weaker currency helps export growth, which has been weak in recent years. Companies-many of which are small and labour-intensive-have struggled with the transition to a goods and services tax, and several have had a hard time getting credit. A weaker rupee would also offset competition of cheap imports from countries like China, which could give domestic industries a much-needed boost.

The RBI and India's government, at present, are calm. This is a strong posture that must withstand the daily news, media pressure, lobbying and political taunting. In 2016, RBI had been given a new mandate to meet its inflation target and maintain growth. Defending the currency at all costs isn't part of the brief. This latest weakness will test its resolve.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

How Parliament can reform its ailing public sector banks

The Economic Times, 24th July 2018

India needs a strategy to get the government out of banking. Non-performing loans among state-owned banks -- a legacy of India’s socialist past which account for nearly 70 percent of deposits -- have crossed 5 percent of GDP. The central bank has restricted lending at 11 of them and forced one, IDBI Bank Ltd., to sell itself to the government-owned Life Insurance Corporation of India.

State banks have repeatedly been a burden on the exchequer and will almost certainly continue to be so. The great need is to increase the number and size of private banks, which have performed better than their public-sector counterparts. Unfortunately, the government just abandoned the one policy that would have eased such a transition.

Earlier this month, according to reports, the administration of Prime Minister Narendra Modi decided to withdraw the Financial Resolution and Deposit Insurance bill from parliament. The bill was meant to address the biggest hurdle in dealing with failing banks: There’s no way to sell them off.

The current legal framework only allows struggling banks to be merged or liquidated. While the banking regulator, the Reserve Bank of India, has in the past forced healthier banks to swallow up weaker ones, there are very few state banks strong enough now to take on such a burden. The only other option is to sell off each loan or asset one by one, which can take as long as 10 years.

With no other options, the government has been recapitalizing loss-making banks -- essentially pouring taxpayer money down the drain (including into Punjab National Bank, which lost nearly $2 billion in a corruption scandal). Selling off IDBI only puts the bank’s problems onto the balance sheet of LIC, one of India’s biggest insurance companies.The FRDI bill would have done two critical things. Most directly, it would have created a mechanism to sell a bank as a living entity to another bank. A Resolution Corporation, similar to the Federal Deposit Insurance Corporation in the U.S., would have been created to take over failing banks and either run them temporarily, sell them, infuse equity or, as a last resort, liquidate them.

Second, once such a framework was in place, the RBI would have had much greater flexibility to give out licenses for more private banks. The central bank has hesitated thus far to increase their number, despite repeatedly promising to do so, because there was no easy way to deal with the new banks if they ran into trouble. The FRDI bill would have made the prospect of creating new banks much less risky.

Politics doomed the bill. One clause gave the proposed Resolution Corporation the option of “bailing in” troubled banks -- using uninsured depositor money to infuse equity into the bank if a buyer couldn’t be found. The optics, at a time when many state banks look like they’re on the verge of failure, were terrible. Worse, most Indians didn’t realize that their deposits were only insured up to 100,000 rupees (less than $1,500). Pensioners worried they might be stripped of their life savings.These problems could easily have been fixed. The “bail in” clause could have been scrapped, and insurance limits raised. If the insurance were raised to $20,000, virtually all depositors would be covered.

Abandoning the bill entirely, by contrast, will have far-reaching effects. Unless India can find a way to shrink the state banking sector, it'll be hard if not impossible to revive lending and investment. Small enterprises in particular are desperate for bank finance.

The Modi government may be right that “big bang” reforms -- liberalizing land and labor markets, for instance -- are too politically difficult. But it’s done a good job thus far implementing smaller changes that can have a big impact, such as the Bankruptcy Code passed last year that does for companies what the FRDI bill would have done for banks. If India can't even manage these less-striking reforms, the chances of boosting growth into the double-digit range are remote.

And there's a scarier prospect as well. The share of deposits in private banks have increased in the last two years from a quarter to a third of the total. Under current conditions, it's not clear what the government and RBI would do if a big private bank failed. There are no public-sector banks healthy enough to buy out a big bank. There's no fiscal space to infuse equity, as public banks are already bleeding the government's coffers.

A high-profile liquidation could possibly trigger a contagion. Many countries set up resolution regimes after the global financial crisis, understanding the grave impact of a banking failure on the real economy. India may soon come to regret not doing so as well.