Bank consolidation

There is a revival of talk about bank consolidation. The chairman of SBI, Mr O P Bhatt, wants Indian banks to grow bigger. Mr Bhatt has been quoted as saying: “The size of Indian banks is not good enough, we need to consolidate....Even SBI is not large enough to serve Indian corporates”. Mr Bhatt thinks there should be at least two to three banks bigger than SBI and half a dozen banks the size of SBI in the country.

I have been sceptical about bank consolidation in India for quite some time. I reiterated my doubts in my recent ET column, Beware of bank consolidation. Earlier, my concern was about the HRD issues: did management of Indian public sector banks (PSBs) have it in them to manage mergers? Making a success of mergers has been a challenge to top management even in advanced economies where there is freedom of hire and fire. In India, where this is difficult and so is closure of branches, I would reckon that mergers would stretch top management for several years. It would prove a major distraction from other tasks that need urgent attention.

Now, after the recent financial crisis, I have an additional concern: the systemic risk posed by largeness. Better, on balance, to have a number of small banks competing with each other instead of having a few 'systemically large' institutions- except where banks are so small as to lose out on scale economies. The larger the bank, the greater the difficulty in managing it. Moreover, consolidation can work to the detriment of the customer. Lastly, you have to make out a case for merger, saying: look, I have made the most out of my present size, I need to get larger in order to sustain earnings growth.

I doubt that many PSBs can make this case. They have failed to get the most out of their existing size. As for SBI itself, it is large as it is. It doesn't have to get larger by gobbling up its subsidiaries, many of which have done better than SBI.

Incidentally, I read in one paper that SBI's proposed merger with State Bank of India has been held up by the finance ministry because of concerns about the malign effects of consolidation.

Small banks, manageable banks

I wrote earlier that we needed banks that idiots could manage and this meant that banks should not become too large or complex. The Economist carries a profile of a successful East European bank wherein the banker talks about the virtues of being small. The bank is Erste Bank,Austria's second biggest. Its CEO says banks should stay small because they can't attract the best talent, only mediocre people.

People who want to make a lot of money fast go to work in investment banks, but people who work in commercial banks are pretty average people," says Mr Treichl in an office so understated that it almost seems calculatedly so...."We should not think we can invent something brilliant. If we could we would be working somewhere else,"he says of the exotic credit derivatives that spread risk, like a contagion, through the financial system.

The banker also points to the difficulties in managing large banks, sprawled across several countries.

If you run something like Citi how the hell do you know what's going on in Poland if you only go there every three years?" he asks. "This is very much a people business. I need to touch and smell and feel what's going on."

Very true. But I would question the presumption that because investment banks attract brighter people, they can afford greater risks. If this were true, then Lehman, Bear and others would not have gone under. The problem is two fold. First, firms that are beyond the capability of even the brightest to manage because of their sheer size. Then, the problems of excess leverage, which create incentives to take excess risk that even the brightest are not immune to. Greed is not something that bright people are free from.

Should IITs and IIMs become universities?

Yes, says the recent Yash Pal committee on higher education. I say: no. The IITs and IIMs have serious work to do in their respective fields, engineering and management, and cannot afford to fritter away energies in diversifying into unrelated fields. More on this in my ET column, IITs and IIMs:Yash Pal is wrong.

The Yash Pal committee also takes too benign a view of governance at IITs and IIMs. On the hierarchy of governance, the committee places universities, IITs and IIMs in an ascending hierarchy. Now, it's true that IITs and IIMs have done a better job than universities. But that doesn't mean they have no governance issues. The IITs and IIMs have become high quality teaching institutions, thanks, in large measure, to generous financial support from government and the benefits of exclusivity in a highly uncompetitive Indian market for higher education.

I argue in my column that, to progress further, they need substantial improvements in governance and accountability. The composition and performance of their boards is one area that cries out for reform. The Bhargava committee noted that the IIM boards tended to reduce their roles to one of providing routine administrative approvals.

The most important function of a board is to lay down performance objectives for top management and to measure performance against objectives. How many IIT and IIM boards can claim to have done this? Somewhere along the line, many have forgotten that boards don't exist in order to approve canteen contracts.

I would add: there are limits to the effectiveness of board monitoring. We have seen this in the corporate world and must not expect anything different from academic board. The difference is that companies are subject to the discipline of the market place in a way in which academic institutions are not- certainly not, institutions of higher education in India.

America has a reasonably competitive market for higher education.Yet, it has state universities of high quality. In India, the government cannot afford to withdraw from public institutions until a more competitive market has evolved. For the same reason, board monitoring at the IITs and IIMs will not suffice. There must be periodic, external audits commissioned by an Appointments Committee for Higher Education that I propose.

The Bhargava committee provided an overview of the functioning of the IIMs. The government must now ask for detailed, institute-specific audits for the older IIMs and IITs. These audits must be based on extensive interactions with all stakeholders, not written documents provided by the institutions. There are private schools in the west that have subjected themselves to such an audit on their own. One b-school I know has benefited enormously from external audit is Toronto's Rotman School of Business which has moved up in the international rankings quite a bit over the years.

Do we need mega banks?

I had a post earlier on the problems posed by large banks and I proposed then that we may need to impose a regulatory cap on bank size.

I find that this proposal is being mooted by some very illustrious names and indeed is gaining some momentum- although I doubt that large banks, with their political clout, will allow the proposal to fructify. In an article in ET, Joseph Stiglitz writes:

We need to break up the too-big-to-fail banks; there is no evidence that these behemoths deliver societal benefits that are commensurate with the costs they have imposed on others. And, if we don’t break them up, then we have to severely limit what they do. They can’t be allowed to do what they did in the past — gamble at others’ expenses.

Much the same is echoed by Henry Kaufmann, a much respected figure on Wall Street. In his book reviewed in the latest Economist, Kaufmann is quoted as warning against the dangers of consolidation forced on the financial sector in the wake of the crisis and the problems posed by large banks:

Driving the weak into the arms of the strong may have been expedient, but it swelled the oligopoly of financial conglomerates deemed too big to fail.

Mr Kaufman draws a convincing link between this consolidation and greater market vulnerability. He sees two possible roads to reformation: dismantling the monsters or curbing their riskier activities to the point that they become public utilities, too safe, rather than too big, to fail.

So, if you can't limit the size of banks through regulatory fiat, then you have to limit the nature of their activities. My own view is that the former is,perhaps, the lesser evil. But, a former deputy governor of the Bank of England, John Gieve, quoted in FT, thinks the latter is preferable:

Sir John (Gieve) doubts that policymakers can set an optimum size for financial services, but suggests the industry could be subject to the sort of economic regulation applied to other utilities, such as telecommunications.

Green shoots, what green shoots?

Hopes of a quick recovery in the world economy are overblown. Emerging markets may bounce back but the advanced economies are mired in problems, especially the US. Nouriel Roubini thinks the chances of a double-dip recession are rising. He gives several reasons for this, including the damage to the US financial system and the failure to revive it. He also thinks the rise in oil prices, driven by excess liquidity, may well stymie a quick recovery.

The Obama administration has ducked the banking challenge, I argue in EPW. Not only is there no quick solution to the present crisis, I am increasingly sceptical about long-term proposals for reform after seeing the US treasury proposals. We have a serious problem of government capture by the financial system in the US. The proposals do not tackle the too big to fail problem, they do are not tough enough on bank compensation and it is unlikely that rules for bank capital will be stringent enough, as and when they emerge in the US. We probably need another serious crisis for banking reform to take place.

Meanwhile, China has circulated draft proposals for increasing bank capital to 12%. We in India should do likewise. We have a golden opportunity to create an even stronger, more competitive banking system in the near five years as the international banks struggle to get out of the present mess.

Let's put a cap on the size of banks

Large, complex financial institutions are lethal to the financial system. They can fail and when they do, they wreak havoc on the economy.That's why they have to be rescued- as we have seen in the present crisis. We also saw what happens when they are not rescued, as in the case of Lehman Brothers when confidence in the system evaporated.

I do not believe that the present two-pronged approach, which consists of a regime for winding down such institutions in the event of failure and higher capital requirements, will suffice. You have to tackle the root cause of the problem, the bigness of the bank itself. I cannot see how any CEO can manage risks in institutions with over a trillion dollars or so in assets. Ask any bank CEO with, say, $10 bn in assets and he will tell you he is fully stretched.

I elaborate on this in my ET column, Banks that can be run by idiots. I propose a ceiling a bank size- say, 5-10% of GDP. For a large economy, we should be closer to the lower end of the range; a smaller economy could be at the higher end. In addition, regulators should keep in mind some absolute size limit beyond which financial institutions become impossible to manage. In the process, we will also have less concentration and more competition.

In defence of economists

Morale in the economics profession is rather low, given the panning that economists have received in the wake of the sub-prime crisis. People have asked: how come economists did not provide warnings or don't seem to have solutions? (although some did warn and many have proposed solutions). The Economist ran a cover story in July about all that went wrong with the economics profession.

Robert Lucas responds to the criticism about why models failed to predict the depth of the downturn:

The Economist’s briefing also cited as an example of macroeconomic failure the “reassuring” simulations that Frederic Mishkin, then a governor of the Federal Reserve, presented in the summer of 2007. The charge is that the Fed’s FRB/US forecasting model failed to predict the events of September 2008. Yet the simulations were not presented as assurance that no crisis would occur, but as a forecast of what could be expected conditional on a crisis not occurring.

Until the Lehman failure the recession was pretty typical of the modest downturns of the post-war period. There was a recession under way, led by the decline in housing construction. Mr Mishkin’s forecast was a reasonable estimate of what would have followed if the housing decline had continued to be the only or the main factor involved in the economic downturn. After the Lehman bankruptcy, too, models very like the one Mr Mishkin had used, combined with new information, gave what turned out to be very accurate estimates of the private-spending reductions that ensued over the next two quarters. When Ben Bernanke, the chairman of the Fed, warned Hank Paulson, the then treasury secretary, of the economic danger facing America immediately after Lehman’s failure, he knew what he was talking about.

Lucas is right, of course. Models do incorporate policy responses. Few economists would have thought that the US government would let a big bank fail. Such a failure would not have been part of the model. The decision to let Lehman was an inexplicable blunder- and it is doubtful that the crisis would have been as severe if that had not been allowed to happen.

Lucas also points out that the policy response to the crisis, based on whatever economics has taught us about crises in the past, has been pretty effective at least ensuring that there is no repeat of the Great Depression:

The recession is now under control and no responsible forecasters see anything remotely like the 1929-33 contraction in America on the horizon. This outcome did not have to happen, but it did.

Crisis won't upset US dominance

That's the title of my last ET column. Several commentators have predicted the eclipse and decline of the US consequent to the crisis just as gloomier commentators have forecast the demise of capitalism. They are both wrong. Capitalism will reinvent itself, with fresh rules for the financial sector, and the US will retain its pre-eminent position.

One reason, as historian Niall Ferguson points out, is that when the US has a serious recession, its principal economic rivals suffer sharper setbacks to growth, so the US ends up the winner. Another is that the dollar does not have a serious competitor- does anyone seriously believe that the world's central banks will hoard their reserves in remnimbi?

America's economic dominance is to some extent derived from and supported by its military and political dominance. The US can, if it is really pushed, exert pressure on its oil producing allies to rein in oil prices. It can get economies with surpluses to park these in US treasuries. It has a major say in the creation of rules for the world economy through institutions such as the IMF, World Bank and WTO.

There are two areas in which the US is far ahead of the rest of the world: military power and higher education. Its lead in these areas will serve to ensure its pre-eminence in the world economy for as far as we can see now.

Status of IIMA

An important judgement related to IIMA is due on August 25- and it seems to have escaped the notice of much of the media. The only detailed report I have seen appeared in DNA.

The Gujarat High Court, the paper reports, will rule on "Whether the legal status of IIM-A (Indian Institute of Management, Ahmedabad) is of an autonomous institution, a State or an instrumentality of State..". If IIMA is a state institution, then article 226 of the constitution would become applicable whereby a high court can entertain a writ petition against the state or any state institution.

The issue has arisen in the context of a case filed by a dismissed IT manager of IIMA. The employee stated that "despite having performed her duties satisfactorily, she was illegally dismissed by the present director in complete violation of the principle of natural justice.".

Claims and counter-claims regarding the status of IIMA were made by the concerned counsels:

The IIM-A counsel, Nandish Chudgar, countered the argument by stating that the petition was not maintainable as the institute was an autonomous institution - it did not fall under the status of 'State' and 'an instrumentality of State' under Article 12 of the constitution, as held by a division bench of the Gujarat high court in 2002 in a case against IIM-A.

In his counter reply, Sinha argued that the decision of the division bench of the Gujarat high court, which is relied upon by the IIM-A's advocate, was mainly based upon the decision of the Supreme Court in the case of Chander Mohan Khanna vs. National Council of Educational Research and Training in 1991. However, by a subsequent judgment of a division bench of the supreme court, in the case of Pradeep Kumar Biswas vs. Indian Institute of Chemical Biology in 2002, has specifically held that the decision in Chander Mohan Khanna does not lay down the correct law.

IIMA has thus far scrupulously adhered to norms applicable to public institutions in matters such as SC/ST quotas, OBC quotas, the Pay Commission awards and the RTI Act. It is also subject to CAG audit.

Goldman Sachs under fire

Goldman Sachs has been, at some point at least, a much admired firm. But it has come under heavy fire in recent months, as reputations in banking and investment banking have tumbled following the sub-prime crisis. The firm's stellar second quarter performance has done nothing to diminish the criticism. If anything, talk of record bonuses has infuriated people even more- the talk is that average pay at Goldman this year could touch a million dollars.

I wrote about this phenomenon in my ET column, Goldmine Sachs is an illusion. On the face of it, Goldman's performance looks impressive. It has increased return on equity while reducing its leverage by half and reducing its dependence on proprietary trading. But, then, Goldman today is a bank fully backed by the Fed. Its borrowing costs are surely lower than what they would be if it did not have an implicit central bank guarantee.

In return for the guarantee, the central bank is entitled to lay down capital requirements and other regulations for Goldman. Goldman's tier I ratio of around 13% is way above the Fed's requirement of 6%. But that is only because the regulatory requirements are far too low and are yet to be revised upwards. Capital requirements for banks will rise, even more so for banks with trading operations and for systemically important banks such as Goldman. The key question is what sort of return on equity Goldman can show after higher regulatory requirements kick in.

I argue that abnormal returns on equity such as the one Goldman showed this quarter (23%) arise not just from inadequate capital requirements but also from other market imperfections. There are others who argue that Goldman was close to imploding like Lehman and was saved only by its alumni ensconced in the corridors of power in the US. They cite the bail-out of AIG and the form it took- cash payments to counter-parties of AIG- as proof.

There's been a huge outpouring of venom towards Goldman. The most recent one is in New York magazine. The earlier celebrated diatribe appeared in Rolling Stone magazine.

Meanwhile, FT reports that Goldman's reputation has been tarnished by recent events.

In a survey of 17,000 Americans, Brand Asset Consulting found that Goldman’s stature – as measured by several gauges of brand strength – had suffered in 2008 and 2009.

“Goldman Sachs still has that Gordon Gekko look to it among the general public,” said Anne Rivers, who oversaw the survey, referring to the villain of the 1987 film Wall Street.

ICICI plan for credit card defaulters

ICICI Bank is never far from controversy, is it? A couple of weeks ago, it made waves when it sent a legal notice to the HR head of rival HDFC Bank for allegedly saying in an interview that she didn't want the ICICI culture to seep into her bank.

Now, ET carries a story about ICICI Bank's plans to recover dues from credit card defaulters by getting employers to deduct specified sums from employees' salaries and remit these to the bank. Apparently, ICICI Bank is inserting a clause into its agreements with credit holders permitting such deductions.

As you can see from the ET website, the move has provoked a storm of outrage and even some downright abusive comments. As one reader has pointed out, such a clause may not be legally enforceable and would certainly require a tripartite agreement involving the employer. Moroever, it's doubtful that the regulator and government will permit such a clause. The move has the potential to create embarassment similar to that caused by ICICI Bank's strong arm tactics to recover housing loans.

For bankers, caution in lending has to be the watchword. Toughness in recovery won't work in this country- it will only create hostility all round. Sympathies are always tilted towards the borrower as they are towards the tenant.

Capital requirements for banks

How much additional capital do banks need? The Economist reports on the results of some stress tests:

Based on the estimates used in the American government’s stress tests, the 19 firms involved collectively need to hold minimum core capital of $313 billion. Between the start of the crisis in mid-2007 and the end of 2010, these firms are expected to eat up about $317 billion of capital (with gross losses of almost a trillion dollars offset by core earnings). On this basis, they would need to have entered the crisis with $630 billion to have avoided breaching the floor. That is equivalent to 8.1% of their current risk-weighted assets. The American and European systems actually had a core-capital ratio of nearer 6% at the end of 2007, according to the Bank of England. The Basel rules allowed core-capital ratios to go as low as 2%.

If anything this calculation is generous. Using Bloomberg’s higher estimates of the losses recorded so far, a peak core-capital ratio of nearer 10% would have been needed for the big American banks. And of course losses are not evenly distributed across the system. Citigroup would have needed a starting core-capital ratio in the mid-teens. Using a similar methodology, Switzerland’s UBS would have needed a pre-crisis ratio of about 12% to have avoided hitting the floor of 4% .

If we accept 8% as the core capital requirement and posit an equivalent requirement of tier II capital,we end up a minimum capital requirement of 16%. There will be further additions based on the size of the trading book and for large banks. One thing appears reasonably clear: in about two years from now, we can expect banks to be operating at a capital level of 15-20%. The current capital adequacy in the Indian banking system is 12-13%. Topping up capital to meet the new requirements will be quite a challenge considering that the government is committed to retaining 51% equity ownership.

Quotas and quality

Everytime, the subject of quotas for disadvantaged in education comes up, the refrain is that this will undermine 'quality' or 'excellence' in education. We will end up with engineers who can't design bridges properly and doctors who are no better than quacks. This argument was heard during the OBC quota debate.

I argued at the time that the cut-offs for OBCs- of, say, 98 percentile at the IIMs- would still mean that OBC students who got admission were in the top 2% of an applicant pool of over 200,000. This was very high quality considering that your chances of getting into a top B-school in the US are high if you are in the top 10-15% in an applicant pool of 10,000!

Well, we have the benefit now of having had a chance to see how OBC candidates have done. Outlook reports that they have done pretty well in several places:

Outlook accessed records from a few premier institutes—IIT Kanpur, IIM Ahmedabad and two Delhi-based colleges, Hindu and Lady Shri Ram—to gauge the performance of students. admitted through the OBC quota. And the good news is that all these students have fared rather well—a fact confirmed by teachers in
these institutions.

As with other institutes, IIT Kanpur too had implemented the nine per cent quota in the first phase in 2008. Of the total of 564 students admitted through the joint entrance examination, 63 were from the OBC reserved category. And if the average marks (on a grade point average) for first-year students in the general category in a coveted course like B Tech (Computer Sciences) was 7.92/10, the OBC students were not far behind at 7.2/10.......Things are equally encouraging at IIM Ahmedabad, which admitted 17 OBC students in the reserved category out of a total of 297 candidates . All have moved to the second year, and with mostly ‘A’s and ‘B’s.

So much for the concern about undermining quality through quotas. Let me add: if anything undermines quality, it is the capitation fee racket. And what is the neo-liberal answer to that? Let us have market-determined fees so that what happens underhand is legitimised. The argument is eerily similar to that made for legalising drugs. And the consequences of such legitimisation could be as malign.

One problem with legalising drugs is that it renders drug use respectable and that could stimulate demand further. With market-determined fees, your render the politics of exclusion legitimate. There is no pretence of being apologetic about cutting out a large chunk of the population from higher education.

Governance issues at Delhi Metro

Delhi Metro has had more than one big failure. Since its CEO, E Sreedharan, is something of a folk hero, the general response has been to shrug it off as a failure on the part of people down the hierarchy. I had a post on this subject the last time. Again, putting on my B-school prof hat, I would argue that management failures that occur repeatedly or are significant point to governance failures. Sunil Jain elaborates on this point very well in his column in BS in which he also asks for Sreedharan to step down:

... it (the CAG audit of Delhi Metro) points to the novel 50:50 management structure to mean that neither of the governments is in charge, so the company is pretty much run by the management, namely Sreedharan. The company’s board doesn’t even have the token independent director. There appears no standard proocedure for evaluating contracts and several changes have taken place in contracts after they have been won. The CAG talks of testing standards being watered down to meet deadline, of tests being conducted in non-accredited laboratories, of these being done without DMRC staffers being present, and so on. To top it all, DMRC hasn’t kept any records of test reports since it ‘would involve additional expenditure’!

This is a danger we need to be alive to all the time, namely, that an individual can become bigger than the system - and no individual is infallible. It is the system that must loom larger and the individual must always be subordinated to the system. That, after all, is the principle of democracy. Unfortunately, despite enormous evidence to the contrary, there continues to be a strong preference for the dictatorship model in a corporate setting on the ground that it delivers results. It is forgotten that the results are always in the short-term and they arise from storing up huge problems for the future.

CAG Audit of Delhi Metro

Delhi Metro's iconic CEO, E Sreedharan, tendered and withdrew his resignation in quick time following the recent collapse of a Delhi metro bridge. The CAG Audit of the Metro, tabled a year after it was submitted, is damning in its contents. Although the Audit was of Phase I and not the ongoing Phase II, the report suggests that some of the problems that have arisen at the Metro are the result of flaws in procedures.

A comptroller and Auditor General (CAG) audit report has found that the Delhi Metro Rail Corporation scaled down testing requirements in four contracts as these were falling behind schedule. ...

The report also says DMRC has not been put under direct control of any administrative ministry. “This model,” the report points out, “presents ambiguity relating to coordination and control by the executive government and the proper forum for legislative accountability.”

The bidding process was also found to have flaws: out of 13 “design and construct” contracts reviewed in seven cases, the estimates were revised or approved after the opening of financial bids, the CAG report says.

So, what does the Delhi government propose to do now? I am in no position to comment on the way the Metro is proceeding. But, as a B-school prof, I will say one thing: there is something terribly wrong with a situation where a 77-year old engineer is considered indispensable.

Privatising education

Two phrases to beware of in discussions on HRD policy are 'skill development' and 'public-private partnership'.

To understand why, just take a look at Latha Jishnu's article in BS. 'Skill development' can easily become a substitute for a proper education, going all the way up to a university degree and, worse, it can mean creation of skills with limited earning potential. As for 'public private partnership' or even 'private initiative' in education, it could well mean that the government abdicates its role in education in favour of profit-seeking ventures in education that will, by definition, be non-inclusive in character.

On 'skill development', Jishnu chronicles a recent Delhi initiative:

To ensure that such a lacuna should not reflect on its image as the capital of an economic superpower in the making, it launched the programme for skill development of domestic workers, a programme to turn out trained housemaids for the rich and the burgeoning middle class. And in this endeavour, it had impressive sponsors: the International Labour Organisation (ILO) no less, the Union Ministry of Labour and Employment and the Delhi government, all under the umbrella of the high-sounding National Skill Development Programme.

For the most part, domestic workers are poorly schooled or illiterate and their skill development consists of nothing more than a basic course in how to stay clean and speak well and learn to operate household gadgets. Part of the package is learning how to prepare an ‘urban meal’, serving food in a formal environment and handling domestic pets. All this would help in their ‘career progression’, we are told.

According to figures given by the government the demand for domestic servants is scheduled to grow six-fold to 600,000 in the next five years. That clearly is an underestimation. Even today, the average middle class home in the capital employs an average of 2.5 maids, apart from drivers and gardeners, according to another calculation. In coming years, the socialist republic of India would need, perhaps, two or three times that number of domestic helpers to serve its burgeoning middle class.

The focus on 'skill development' coincides perfectly with the state truncating its obligation to provide quality school education.

There clearly is a vested interest in keeping the system thus. The debate on reforming the system, too, is skewed and dishonest. Those who advocate market-based solutions to the lack of schooling in India refuse to acknowledge that the common school system prevalent in the US, UK and other developed Western countries was vital in nation-building and building egalitarian societies.

All the solutions that are being suggested now, such as education vouchers that would allow the poor to send their children to a private school of their choice — one wonders at the choice that exists between non-functional government schools and profit-making private institutions that are just a notch above them — and the 25 per cent reservation in private schools for the poor are nothing but a deflection from the need to overhaul the grossly divisive and unequal system.

...In the intervening 45 years the gulf has only deepened. But if all of India went to the same kind of schools how would one get the endless flow of domestic helpers

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How do we reform Indian banking?

Pranab Mukherjee's budget disappointed reformists and it would have been particularly crushing for advocates of banking sector reform. Not even a token reference to the Raghuram Rajan committee report; on the contrary, Mukherjee jangled the nerves of commentators by hailing Indira Gandhi's nationalisation of banks.

Here again, reformers were being foolish if they expected 'big bang' moves- greater entry for foreign banks or dilution of government shareholding in public sector banks (PSBs) below 50%. No policy maker would like to stick his neck out on foreign banks in the wake of the financial crisis in which the biggest banks have been badly hit. And after Sonia Gandhi's stout defence of bank nationalisation a few months ago, no FM could even think of diluting social control of PSBs.

But, it's not as if banking sector reform only means things like the above. We need to find creative ways of encourage more domestic players without undermining domestic stability. Letting industrial houses into banking may not be advisable but we could tinker with private bank ownership norms so that lesser entrepreneurs can get in.

But, also, as I argue in my ET column, In banking, do what is doable, we have focus on improving governance and management at PSBs. Makes sense because the global economic reality and the domestic political reality together imply that PSBs will continue to dominate the Indian banking landscape in the foreseeable future.

Pranab Mukherjee's budget

The market tanked yesterday. I wasn't surprised at all and had forecast a correction in my ET column a fortnight ago, Market rally may prove deceptive.

I based my assessment on two things. One, the $ 5 bn plus FII inflows in the present financial year represented something of a correction to the huge outflow of $11 bn last year. We could not expect this sort of inflow to continue. Secondly, I, for one, have never bought the notion that the Congress or the present UPA is hugely reformist is orientation and that all that it needed to get into reform mode was shake off the Left. Sonia Gandhi retains the leftward leanings of the family and this is duly reflected in the Congress today.

So, I had a few quiet laughs when I saw the commentators and businessmen on TV shake their heads in sadness at the many missing items- fiscal consolidation or even a medium term plan for one, disinvestment, petroleum deregulation, impetus to FDI, labour market reforms, financial sector reform (the Raghuram Rajan report was not even mentioned in passing).

I must mention one distinguished exception to the nay-sayers: Surjit Bhalla, whom one would regard as ultra-reformist. I did a double take reading his piece in BS today. He hails this as the second most reformist budget ever presented after Yashwant Sinha's 1999 budget. I read his piece again thinking this was being said tongue- in- cheek. No, Bhalla is serious. Well, leaving aside the critics on TV, I doubt that that is a claim that even the FM or the Congress would make!

What do I make of the budget? Well, I am yet to put the numbers on a spread sheet and pore over them (which is what I do once the media frenzy dies down). I have just a couple of thoughts for now. One, the budget is true to the Congress manifesto and the broad indications given in the President's speech.

Two, the focus is on providing the maximum fiscal stimulus. This probably reflects the government's view that the 'green shoots' hypothesis is premature, that the global economy will take its own time recovering and that, therefore, the Indian economy's growth momentum is best sustained through as big a stimulus as possible. People fear that this will push up interest rates and crowd out private investment. But private demand for credit is weak, which is why there is huge liquidity out there in the markets, so this fear may prove misplaced.

Three, my guess is that the FM has left the possibility for greater disinvestment proceeds than budgeted and spectrum auction for later in the year. To do this now would detract from the stimulus. So, give the maximum stimulus now and once there are signs that growth is of the order of 7%, push ahead with disinvestment. If this hypothesis turns out to be right, the FM may well surprise us with the fiscal deficit number in his next budget- it could prove lower than 6.8%.

Now, this is not how economists and market analysts view matters. They would have liked some fiscal consolidation here and now and they probably reckon that economic recovery is happening anyway. Unlike most of the intelligentsia (which is not necessarily very intelligent), I have great respect for the instincts of politicians, so I would go along with the FM. If the FM's calculations prove right, it would be quite an achievement.

Ram Guha in Nehru Memorial controversy

Historian Ramachandra Guha finds himself in the midst of a controversy at the Nehru Memorial Museum and Library. I haven't seen this reported anywhere and got to know about it only through a debate in ET last week. In the debate, Ram Guha and scholars on his side and Madhu Kishwar and several others on the opposite side aired their views.

I reproduce portions of the two versions below. The question I have is: in matters such as this, is it possible at all establish the truth? How does one do it? You can't have a judicial probe into every single matter- and even then the findings will be questioned. I don't pretend to have solution. If anybody does, please let me know.

Kishwar and company write:

The Petitions Committee of the Lok Sabha had found serious irregularities in the fellowship selections process conducted in NMML in 2004-05 (one year before Prof Mukherjee joined). Mr Ramachandra Guha was a member of the fellowship selection committee and of the sub-committee which did the shortlisting.

Their role has been questioned by the Petitions Committee and by the fact-finding inquiry set up by Dr Karan Singh, the NMML Executive Council chairman. The standing committee of Parliament for the ministry of culture and the Central Vigilance Commission have also asked NMML to take action in the matter. It is following this that Dr Karan Singh suspended the deputy director, N Balakrishnan, pending an enquiry, on 1 May 2009.

It appears that Ramachandra Guha and some others involved as selectors or beneficiaries want to remove Prof Mukherjee to subvert the process of a fair inquiry because they are afraid of being implicated by it. To this end they even launched a campaign in early May 2009 to get Balakrishnan’s suspension revoked.

Guha and others write:

The ET report vilified a senior scholar while disregarding the wider issues raised by 57 signatories to the memorandum to the prime minister, who include such widely respected intellectuals as Rajmohan Gandhi, Sunil Khilnani, Sanjay Subrahmanyam, Sumit Sarkar, Nandini Sundar, Krishna Kumar, and Mushirul Hasan.

These scholars list four objective indicators of the decline of the NMML: (1) The once excellent publication programme has been discontinued; (2) The acquisition of rare manuscripts and oral histories is virtually at a standstill; (3) The once dedicated staff is totally demoralised; (4) The NMML has abandoned its principled non-partisanship by opening its doors to political use and misuse.

The fourth charge is perhaps the most grave. In past times, the NMML was open to all ideological currents. Its vast collections include the papers of Jawaharlal Nehru and Indira Gandhi, but also of such longstanding opponents of the Congress as Dr S P Mookerjee and E M S Namboodiripad.

Will more capital harm banks?

Regulators are determined to impose higher capital requirements for banks in the wake of the present crisis. The rationale to is to make sure that banks are less vulnerable in future than they have proved this time.

Takafumi Sato, commissioner of Japan's Financial Services Agency, questions this approach in an article in the FT:

Suppose stronger regulations make banks issue more equity. Then the capital market will expect greater profits in return, and bank management may be tempted to meet such profit pressure by taking more risks. Was this, however, not the cause of the catastrophe?

Also, bigger capital requirements may induce complex risk-taking. If bankers add simple risks, regulators will notice and request more capital. In order to satisfy both regulators’ demand for a high capital-to-risk ratio and investors’ demand for return on equity, bankers may want to take risks in a sophisticated manner, inventing exotic products and creating a darker shadow banking system.

So, Sato thinks there is moral hazard attaching to more bank capital rather than less. Sato's argument is flawed on several counts:

• With lower bank capital, equity holders today have less incentive to monitor managers.With higher capital, they will need to be more alert.
  
• Also, managers have greater incentive to take risks- payoffs to risky gambles are higher with lower capital and more debt.
• It's not as if investors' return expectations from banks are cast in stone and they will demand the same returns from banks as they have in the past even when bank capital goes up. Investors in banks will have reconcile themselves to lower returns, treating bank stock on the same par as, say, utilities. As they say, banking will become a more boring sector but a safer one.
  

Sato is on firmer ground when he writes:

Capital adequacy regulations are a cornerstone in our efforts towards financial stability. They, however, should be complemented by reliable valuation, good risk measurement and proper incentives.

On this, I agree. Higher capital should be accompanied by closer supervision and regulation. Isn't that what all the talk of regulatory reform is all about?