#55 An Autopsy By Patel; A Whodunit by Kaul
Two books on the story of Indian banking's systemic risks
This newsletter is really a public policy thought-letter. While excellent newsletters on specific themes within public policy already exist, this thought-letter is about frameworks, mental models, and key ideas that will hopefully help you think about any public policy problem in imaginative ways. It seeks to answer just one question: how do I think about a particular public policy problem/solution?
Welcome to the mid-week edition in which we write essays on a public policy theme. The usual public policy review comes out on weekends.
Over the past week, I read two books with similar themes and narrative arcs about the state of the Indian banking system. Urjit Patel’s ‘Overdraft: Saving The Indian Saver’ and Vivek Kaul’s ‘Bad Money: Inside the NPA Mess and How It Threatens The Indian Banking System’ are like long-lost twins who share the same gene pool but grew up to be different people. One is the local sheriff, a man of the law while the other is Robinhood, a man of the masses, revelling in knocking down the corrupt and powerful (excuse my usage of ‘man’ here). The truths they uncover aren’t new to those who follow the sector. But there is merit in taking a multi-decade big picture view on how we got here. The many failures of our policymaking and the structural faultlines they have created in the economy become easier to see with this perspective.
The Trilemma
At the heart of both the books is a trilemma of objectives of our financial system. A country can only achieve any two of them at a time:
An independent banking regulator
A banking sector dominated by government-owned and controlled banks
Fiscal prudence represented by having a low debt to GDP target and sticking to it
In India, the dominance of the banking sector by public sector banks is an article of faith. Government ownership of banks creates bad incentives in three ways. First, the banks are saddled with credit or loan targets as short-cut measures to stimulate growth in the economy and job creation. This leads to downstream problems of indiscriminate lending, aggressive underwriting and political interference in loan decisions to industries. Secondly, there is the incentive for political parties to announce loan waivers (especially in farm sector) with limited concerns about the impact on the bank balance sheets, the deterioration of credit culture and the crowding out of other borrowers as the government continues to finance its deficit by additional borrowing and pushing up the interest rates. Thirdly, there is no real desire to improve regulations on the risks on balance sheets and a quicker resolution of insolvency. The incentives are aligned for the lender, borrower and the regulator to ‘evergreen’ loans and kick the can down the road instead of facing a reckoning.
The Hammer And The Dance
Kaul’s book is what lazy reviewers often call a ‘rollicking ride’ through the challenges of managing this trilemma. Kaul often mentions his love for crime fiction as a genre in his social media posts and Bad Money does read like a whodunit. There are flamboyant characters in the book who become poster boys for NPAs while lurking at the bottom, hidden from the world are the big fishes whose crimes are more egregious. Kaul turns over every rock dotting the financial landscape and delights in the grime and worms that he unearths under them. There are clues strewn all over and he sifts through them in a relentless effort to find the truth. What Kaul finds is a curious case. There are over a dozen wounds of varying depth on the body. There isn’t a single perpetrator as Kaul discovers. This is Murder On The Orient Express all over again.
Patel’s book is quite the opposite. He is interested in the issues of policies and reforms that matter to the country’s destiny. He is not interested, as he puts it, in ‘passing matters’. He takes this dictum to his heart. There’s a rarely a mention of a single bank or person by name. There’s no Arun Jaitley or Raghuram Rajan in the book and banks are referred to indirectly. Patel is interested in identifying the root causes of the NPA crisis which he lays at the door of the principal-agent problem of the government owning banks and dominating the sector.
The government is a player, intermediary, shareholder and the regulator. He more than once compares the private banks favourably with their public sector counterparts and attributes better governance, tighter regulation and the markets to their superior performance. Once he’s established this and the events leading up to 2014, he’s interested in placing his version of the efforts made by Rajan and him in confronting the reality of the stress in the banking system. Their plan was to bring discipline in disclosures and resolution of stressed or insolvent assets in a time-bound manner.
Patel’s prose is dense. This is a surprise. One would think the first RBI Governor who spent half his career working in the private sector would write to clarify. I guess it is a ploy to deliver the message to those who matter while keeping it ambiguous enough to not rake unnecessary controversies. Yet reading important and insightful passages, like the one below, written in this style convinces me it is a missed opportunity to make public policy analysis more accessible. Here’s Patel explaining in great detail the moral hazard of the government using the banks to stimulate growth in the economy through what he refers to as ‘banking sector-fiscalisation’:
“In this scenario, the normal mechanisms that mitigate moral hazard in agency situations are greatly weakened. First, public ownership reduces the (risk-adjusted profit-maximizing) incentive for requiring optimal pure risk capital from borrowers – both the absolute levels and the effectiveness of co-financing decline. The use of intermediaries by the government as quasi-fiscal instruments, with diversion of financing for non-commercial purposes, reinforces the decline in the quality of assets.
Secondly, the absence of effective and time-bound bankruptcy procedures force intermediaries to roll over existing sub-standard debt or convert them into equity, thereby continually building up the riskiness of their asset portfolio and further diluting the (already weakened) notional leverage norms. Beyond a point the practice, in effect, morphs into a fraud in some instances, which comes to light years later.
Thirdly, a virtual certainty of sustained bailouts by the government replaces a policy of ‘constructive ambiguity’ with one of ‘destructive unambiguity’.
Fourthly, there is a higher regulatory forbearance for bank closure, given their public sector ownership. The resulting political economy of financial intermediation with the aforementioned characteristics leads to aggravated moral hazard (AMH). Inevitably, at some point, self-correcting processes – even the modest ones – stall. One can reasonably hypothesize that non-performing-asset–induced (financial) shocks have amplified the structural weakness in the Indian economy, with concomitant lengthy growth repercussions.”
The 9R Framework
Patel spends a better part of his book discussing the 9R framework that RBI put in place to address the various market failures in the banking system. The first four Rs – Recognise the Reality, Record, Report and Recovery – are about putting in place the right systems. A Central Repository of Information on Large Credits (CRILC) that enabled the RBI and the banks to view the stress of a large account across banks and reduce information asymmetry was a start. The Asset Quality Review (AQR) process started in 2015 made it difficult for the banks to under-report NPAs. Similarly, other steps were taken to expedite recovery through what Patel calls the ‘alphabet soup’ of measures (JLF, SDR, S4A etc). Patel then moves on to other steps taken between 2015-17 to address the fifth to eighth R (Resolution, Reinforcement, Recapitalisation and Reset).
The chapter on ‘Reset’ is where he discusses the landmark IBC bill and the Feb 12, 2018 regulations released by the RBI that prescribed a compulsory recognition of problem assets and initiating restructuring failing which the insolvency proceedings would start. News reports during that time suggested finance ministry wasn’t consulted on this circular. Patel explains in great detail how this circular brought the rules in line with both the letter and spirit of the IBC 2016. For Patel, this was the most critical reform that was introduced to correct the course on stressed assets and to respect enforcement of contracts in the financial system. In a way, this was the culmination of everything he had worked on since 2014: a time-bound process that made no exceptions and aligned the incentives of everyone to disclose, recognise and resolve a stressed account.
The Great Scuttle
In the next chapter, Patel sheds his reticence to describe in detail how the Feb 2018 circular was scuttled and became the reason for the schism between the regulator and the ministry. The chapter titled in a quite un-Patel like fashion – The Empire Strikes Back – reads like pages from Kaul’s book have been transplanted here. Patel writes:
“The disposition with respect to the IBC or, more generally, in the conviction in the pathway, perceptibly changed – conceivably on defensible grounds – in mid-2018. Instead of buttressing and future-proofing the gains thus far, an atmosphere to go easy on the pedal ensued. A case of our old failing of a premature pronouncement of victory, perhaps?
Until then, for the most part, the finance minister and I were on the same page, with frequent conversations on enhancing the landmark legislation’s operational efficiency; we sought feedback on changes to preserve the principles that formed the bedrock of the IBC; which tweaks were likely to work; and where resource improvements could help; etc.”
We then get a first-hand account from Patel about canards spread about how MSMEs would suffer, the demands from various sectors how they were different and couldn’t be painted with the same brush of the IBC and the noise in the media. Patel drops discretion in favour of candour here:
“Sowing disorder by confusing issues is a tried-and-trusted, distressingly often successful routine by which stakeholders, official and private, plant the seeds of policy/regulation reversal in India; this has been the case for as long as I can remember. It does not help that few policymakers have the patience to sift the wheat from the chaff, appreciate intricacies and focus on final outcomes. The prospect of a transparent, time-bound process on autopilot for recovering debt was unsettling.”
The din increases over time and the petitioners reach the Supreme Court. There’s a telling line in the book:
“Lawyers who had agreed to represent the RBI in the Supreme Court (SC) dropped out at the eleventh hour, literally the night before the hearing. The SC granted a stay and postponed hearings more than once, in effect, until the following year. In April 2019, the SC pronounced the regulation to be illegal.”
This to me reads like a writing prompt for Vivek Kaul’s next book. Patel is perplexed. As he writes:
“It is difficult to fully understand, at least for those of us who are not lawyers, that a transparent rule is untenable, but discretion on a case-by-case approach is kosher.”
Patel writes about further dilution of the regulations which take them away from IBC’s spirit that has happened in the time since he has left RBI including the ability of lenders to bypass IBC. The upshot is that IBC which was considered a landmark reform and an important element of our improvement in ‘ease of business ranking’ has been compromised.
Lessons Everywhere
Both books are an important addition to our understanding of the stress that’s systemic to our financial system. Kaul is a curious observer who looks at the wider economy with an open eye and investigates the linkages without getting caught up in the hype. He is borderline cynical in his approach but in his defence, you can’t help being one if you see what he shows you. Patel’s book is an insider’s view on the structural issues hurting the system, the steps he, Rajan and Viral Acharya took to address them and how the ‘empire’ struck back at them.
Patel takes a comprehensive view of the problem – marshalling data and facts, principles from various papers and economic theories to explain the issues of government ownership of banks, the incentives of public sector employees in these banks and the expediency of the political parties to use credit as a means of public welfare. He brings in Gary Becker’s famous Crime and Punishment experiments to explain the behaviour of borrowers and loan officers in public sector banks. There’s a delightful conceptual framework he builds based on this that helps our understanding of what kind of a vigilance system would be most effective in a public sector institution.
Let The Debate Begin
While reading Patel, I came across the current CEC’s lament about the banking system last week. We seem to have internalised the idea of banks being the pump-primer for our growth. As the CEC said:
“Large part of the current slowdown is because of problems in the banking sector. NPAs, risk aversions and decline in corporate lending had an impact on investment which led to slowing of growth which in turn led to drop in consumption. This again led to lower investment,”
Well, the more things change, the more they remain the same.
Patel’s book plays safe in sticking to conceptual issues and solutions. Yet, there were two points he emphasises in the book which I thought will elicit reactions in India. The first was the Feb 2018 circular which led to his departure and his views on how the system worked then. Predictably, S.C. Garg, who was then the secretary, economic affairs, has already responded to the observations in the book. The Deputy Governor of the time, Viral Acharya, who also has a book released last week, has waded into this debate. The other point was Patel’s view of the regulator being blindsided and slow to respond prior to 2014. I expect the former governors of RBI to have a view on this. This debate has just started.
I would recommend both the books to readers of this newsletter. Kaul’s is a whodunit, Patel’s is an autopsy. Read them as genre pieces. You won’t be disappointed.
HomeWork
Reading and listening recommendations on public policy matters
[Interview] An old interview of Gary Becker on his paper “Crime and Punishment: An Economic Approach” in the Chicago Maroon.
[Article] An analysis of what the SC’s setting aside of RBI’s Feb 12, 2018 circular means by Shreya Nandi and Gireesh Prasad in the Mint.
[Article] Andy Mukherjee writing in the Business Standard on IBC
[Interview] Viral Acharya’s interview on NPAs and IBC in The Hindustan Times
If you like the kind of things this newsletter talks about, consider taking up the Takshashila Institution’s Graduate Certificate in Public Policy (GCPP) course. It’s fully online and meant for working professionals. Applications for the August 2020 cohort are now open. For more details, check here.
