Dissecting Urjit Patel's Outburst - He Has A Point

Last week, the normally reticent governor of the Reserve Bank of India, Urjit R. Patel, lashed out against critics of the central bank in the wake of India's biggest banking fraud, demanding more regulatory powers that he said would level the playing field between the RBI's supervision of public and private sector banks.

His uncharacteristic outburst reveals his frustration with assigning accountability for weak corporate governance at India's state-run banks. It also reflects the fact that the existing enforcement mechanism in case of financial misconduct hasn't been a major deterrent to frauds. That said, given the policy objective of inclusive growth in a developing country like India, state ownership of banks isn't going away soon. The focus in the interim should be to find innovative solutions to improve corporate governance and enforcement, while considering RBI's demand for increased regulatory powers over state-run banks.

In his speech, Mr. Patel based his demand for greater supervisory powers on the premise that market discipline is "appreciably weaker" in state-backed banks compared with private banks. He put this down to a "perception" that while shareholders will punish an errant private bank, the government - the principal shareholder of public sector banks - isn't interested in fundamentally modifying its ownership structure.

There are problems with this premise. First, state-backed banks aren't 100% state-owned, they are listed companies and are hence subject to market discipline in terms of disclosures and audited financial reports. Depositors are also free to move between banks, should they perceive one bank to be riskier than the other. There is some merit in the argument that whereas private banks that are badly run would find it hard to raise capital, state-backed bank are able to receive capital from tax payers. And yet, it was Mr. Patel who said last year the recent recapitalization plan of state-backed banks would ensure greater market discipline. This is because the capital infusion would be contingent on performance.

While weaker market discipline at state-run banks is debatable, the problem of weak corporate governance, or self-discipline, isn't. It is this weakness that Mr. Patel hopes to overcome with tighter regulation. Specifically, Mr. Patel said the RBI as a regulator should be able to hold boards of state-backed banks accountable and replace nonperforming senior management and board members. He also expressed his frustration at the RBI's inability to force a merger of public sector banks, revoke their license or trigger a liquidation.

His comments were immediately countered by the government. Newspapers cited The Banking Regulation Act that showed the RBI did have the power to direct changes in management. Former Finance Minister Yashwant Sinha was quick to respond to Mr. Patel, saying ownership isn't an issue when it comes to disciplining errant bank officials, and the RBI and the government can and have worked together to sort out governance issues in the past.

A closer reading of the Act, however, shows that the ultimate power in matters of dispute does rest with the Ministry of Finance and it is common knowledge that that board appointments at public banks are political decisions - a factor that could reduce the quality of governance. The state's dual role as a player and referee can lead to a conflict of interest. So, Mr. Patel is right in drawing attention to governance issues at state-run banks.

But while increased regulatory powers for the RBI is certainly worth considering, it is also possible to improve corporate governance in state-backed banks in the interim. A study by Ang and Ding highlights how Singaporean government-linked companies have implemented international best practices in their corporate governance structures. In Australia, government-owned corporations have adopted several principles which are beneficial for corporate governance. These principles include efficiency in production and allocation of resources, management independence, and accountability for overall firm performance.

Also, while Mr. Patel wants increased regulatory powers the question that needs to be asked is whether the central bank has suitably exercised its existing powers? In the case of the fraudulent transactions at Punjab National Bank in the alleged Nirav Modi scam, the RBI had previously highlighted risks associated with not aligning the bank's electronic messaging system with their core banking system, but then didn't conduct a follow-up audit. It has only now served an ultimatum to banks to get this sorted by April 30. Similarly, it isn't clear why the RBI allowed Indian banks to use letters of understanding - a less secure form of credit guarantee than letters of credit. The RBI's rules regarding the issue of LCs clearly state that banks should be vigilant while making payment to the overseas suppliers on the basis of shipping documents. In the case of LoUs, funds raised for the payment of import bills weren't always being used for the purposes for which they were sought. It is only now that the RBI has banned LoUs.

The government is unlikely to dispense with its social banking objectives in the absence of suitable alternatives to inclusive growth. After all, India doesn't primarily live in its metropolises. What is needed is institutional innovations to resolve the government's conflict of interest as a player and a corporate governance regulator. A truly autonomous Bank Boards Bureau that insures best practices in corporate governance is one way forward. Another suggestion has been to let the RBI concentrate solely on monetary policy and leave the supervisory task to an independent body focused on the job. The subject has been the topic of much debate internationally, with the trend towards conglomeration and cross-sector competition the strongest argument in favour of a single supervisory agency.

(Indrani Dattagupta is a financial journalist and has previously worked for The Economic Times, Dow Jones Newswires and The Wall Street Journal.)

Disclaimer: The opinions expressed within this article are the personal opinions of the author. The facts and opinions appearing in the article do not reflect the views of NDTV and NDTV does not assume any responsibility or liability for the same.
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