Since the global financial crisis unfolded, policymakers and politicians in India have claimed that prudential government regulation and oversight spared Indian banks the calamity that befell their Western counterparts. Academics such as Panagariya (2009), journalists and bankers alike have heaped gobs of praise on the regulations that former Reserve Bank of India (RBI) governor, Y. V. Reddy, upheld since 2003. One banker was so moved by Governor Reddy, he declared, “He saved us!” This, unfortunately, gives undue credit to regulators as prognosticators of and saviors from the crisis. We argue that India’s dodging of the largest financial blows resulted from a confluence of factors which are unique to India. In our opinion, it would be too sanguine to argue that divination by banking regulations or Governor Reddy’s foresight enabled Indian banks to largely escape the fallout from the global financial crisis. Rather, heavy regulation has come at a significant cost.
Upon independence in 1947, India adopted a socialist model to economic development with heavy government intervention backed by a regulatory framework that was consistent with the running of a closed economy. The overhang of insular economic policies, born of Fabian socialism, continues to impact significant parts of the Indian economy including banking. As every Indian knows, the nationalization of banks, a decades-old concept, was a centerpiece of Prime Minister Indira Gandhi’s Garibi Hatao (remove poverty) policy. Increasingly onerous banking regulations were put in place to promote rural banking and direct credit to the agriculture and small business sectors. These heavily regulated banking sector policies were consistent with India’s central planning model. When these regulations were put in place, remnants of which continue to haunt foreign investors today, the avoidance of a global financial crisis through contagion was the last thing on anyone’s mind.
Upon his appointment as Governor, Mr. Reddy inherited this slew of inward-looking regulations, a hangover from the socialist policies and devoted to keeping out foreign bank competition. His latitude in making sea changes in financial sector policies was severely limited due to two reasons. First, the RBI has never enjoyed the same degree of independence from political pressures as its US counterpart, the Federal Reserve Bank. By way of illustration, the Reserve Bank of India Act of 1934 stipulates that the central government has the power to supersede the RBI’s Central Board if, in its opinion, the RBI fails to carry out any of the orders the government prescribes. Second, for the past two decades, fundamental economic reform in India has been hamstrung by a series of shaky coalition governments with socialists and communists at the center. The relatively slower pace of economic reform in India (compared to say China) has more to do with the constricted policy latitude imposed by fractious coalition politics rather than the foresight of one man.
We therefore believe that the confluence of factors discussed above better explains Governor Reddy’s extreme caution toward exposing Indian banks to global forces than his foresight into bankers’ “sin” as Panagariya argues. Greed on the scale of Western banks was never an issue with Indian banking anyway. This is because Indian bank managers are largely public sector employees whose salary structures do not have the same scale of perverse incentives related to bank profits. Under the circumstances, it is a stretch of the imagination to argue that Governor Reddy successfully resisted government pressure to deregulate banks or that his foresight saved Indian banks.
Far from India’s saving grace, bank nationalization and government intervention in banking decisions have actually hindered Indian banks from competing globally, allowing inefficiencies to go unchecked. In fact, heavy government regulation of the banking system not only saddled banks with significant non-performing loans for quite some time, they stifled productivity for nearly two decades. There is no question that India’s inefficient financial system is in urgent need of reform.
Risks and rewards are part of banking and it is not possible to grow without experiencing gains and losses from calculated risk-taking. Prudential regulations must not only protect banks from the most harmful effects of the global financial crisis, they must enable banks to compete successfully in global markets. Today, the top three international banks in terms of market capitalization are Chinese. While they took some heavy blows, all three remain nearly ten times larger than the largest Indian bank, the State Bank of India. Hence, it is necessary to temper the satisfaction that government regulation of the banking sector together with the RBI’s foresight protected banks from the financial crisis.
The fact is there is no alternative to globalization and integration in this world. If India wants to be a player in global financial markets, its banks cannot simply wait on the sidelines to see whether other countries’ banks are succeeding or failing, timorously avoiding international competition. Growth in such an environment implies that insular banking policies be abandoned in favor of those that promote efficiency and prudent risk-taking. While we are all happy that Indian banks largely avoided the fallout of the global financial crisis, that does not mean that the Indian experience provides a “model” that can or should be replicated by other countries. The fact is the jury is still out on that question.
Khanna, Tarun and Yasheng Huang, Can India Overtake China? Foreign Policy Magazine, July-August, 2003.
Panagariya, Arvind, India’s Financial Secret Weapon, Foreign Policy Magazine, January 2009.
Reddy, Y.V., Financial Sector Regulation in India, Economic and Political Weekly, Vol. 45, No. 14, April 03-April 09, 2010.