Raghuram Rajan: Sustainable growth in the financial sector - 2015 C K
Prahalad Lecture
Speech by Dr Raghuram Rajan, Governor of the Reserve Bank of India, at the 4th D K
Prahalad Memorial Lecture, Mumbai, 18 September 2015.
* * *
Coimbatore Krishnarao Prahalad was born in Tamil Nadu. One of nine children, he obtained
an undergraduate degree in physics from the University of Madras and went on to a diploma
at IIM, Ahmedabad as a member of the first graduating batch. He followed that with a DBA
from Harvard Business School in 1975. Prahalad started his academic career at the
University of Michigan in 1977, and in 1990, he and Gary Hamel co-authored an article in the
Harvard Business Review titled, "The Core Competence of the Corporation." In this influential
article, building on the work of Edith Penrose who first stressed the importance of the unique
capabilities of a firm, Prahalad and Hamel encouraged corporate executives to "identify,
cultivate, and exploit the core competencies that make growth possible."
In their 1994 book, Competing for the Future, Prahalad and Hamel analyzed how established
market leaders like IBM tend to lose ground to innovative upstarts like Apple - IBM failed to
see the future of the personal computer because it was too focused on maintaining its
leadership in the mainframe business. Perhaps most important to India, Prahalad's 2005
book, The Fortune at the Bottom of the Pyramid: Eradicating Poverty Through Profits,
explored how businesses might pursue sustainable growth while catering to the poorest of
the poor. Indeed, much as the term "core competence", the term "the bottom of the pyramid"
has entered the common lexicon. He received many awards and honors during his life time,
but perhaps the greatest honor is the continuing influence of his work.
I met C.K. Prahalad when I was at the University of Chicago. Despite his enormous
reputation and the exalted circles he moved in, he was always down to earth, and immensely
insightful. He cared deeply about India, and gave freely of his time and money to make a
difference here. Many of you have attended the seminars he organized to improve Indian
business practice. He believed we Indians could be second to none; some of the
businessmen here have taken his message to heart and delivered. He and I never got a
chance to do research together, but we did write a joint letter to the then Prime Minister in
2009, together with Abhijit Banerjee, advocating, among other steps, accelerated efforts to
bring out a unique ID in India. Perhaps, therefore, we all had a small role in the Prime
Minister setting up the Unique ID Authority, headed by Nandan Nilekani.
As an aside, given how far Nandan's UIDAI has taken us towards a universal unique identity
for India, it would be sad if its use were severely restricted. Other countries like the United
States have used unique IDs, such as social security numbers, without serious allegations of
violations of privacy. Learning from worldwide experience, we need to see how we can
satisfy the concerns of the Supreme Court without undermining the value of the unique ID.
The unique ID can enable a variety of economically valuable activities that particularly benefit
the bottom of the pyramid. For instance, not only can UIDs expand the access of the poor
and young to credit as they borrow against the collateral of their future good name, it will also
allow the regulator to detect and curb over-lending to individuals by asking lenders to report
the IDs of borrowers to credit bureaus. Today, unscrupulous lenders can avoid current
regulations against over-lending by simply misreporting the borrower's name or address.
Similarly, the Government has used UIDs to weed out duplicate beneficiaries for various
welfare schemes, allowing better targeting of scarce funds to the very poor. I think C.K.
would want us to find a way to move forward with UIDs. I do believe, as C.K. did, that India
can be far more successful and influential than it is today. What do we need to do to
succeed? How can we compete effectively against the best? Do we need to identify our core
competencies as a nation? Rather than attempt to speak from the perspective of business,
let me speak from the vantage point of a central banker.
Let me also quickly offer my standard disclaimer: For any hints on what we will do in the
upcoming policy statement, please read the guidance in our last policy statement. I quote:
"Significant uncertainty will be resolved in the coming months, including the likely persistence
of recent inflationary pressures, the full monsoon outturn, as well as possible Federal
Reserve actions. As the Reserve Bank awaits greater transmission of its front-loaded past
actions, it will monitor developments for emerging room for more accommodation." Nothing I
say in what follows is meant to offer further guidance, and please don't read veiled meaning
where none is intended.
If we look around the world today, it does not present a pretty picture. Industrial countries are
still struggling, with a few exceptions, to grow. Our fellow BRICS all have deep problems.
Indeed, India appears to be an island of relative calm in an ocean of turmoil. What is different
and how can we be assured that it will continue?
A lesson from Brazil?
Perhaps Brazil offers a salutary lesson. Only a few years ago, the world was applauding the
country's thriving democracy, its robust economic growth, and the enormous strides it was
making in reducing inequality. It grew at 7.6 percent in 2010, and had discovered huge oil
reserves which the then President Lula likened to "winning a lottery ticket". Yet the country is
expected to shrink by 3 percent this year, and its debt just got downgraded to junk. What
went wrong?
Paradoxical as it may seem, Brazil tried to grow too fast. The 7.6 percent growth came on
the back of substantial stimulus after the global financial crisis. In an attempt to keep growth
high, the New York Times says the central bank was pressed to reduce interest rates,
fuelling a credit spree that overburdened customers are now struggling to repay.1 Further,
Brazil's government funded development bank hugely increased subsidized loans to
corporations. Certain industries were favored with tax breaks while price controls were
imposed on gasoline and electricity, causing huge losses in public sector firms. Petrobras,
the national oil company, which was supposed to make enormous investments in oil drilling,
instead became embroiled in a corruption scandal. Even as government pensions burned an
ever larger hole, budget deficits expanded, and the political consensus to narrow them has
become elusive.
Towards sustainable growth
While the Brazilian authorities are working hard to rectify the situation, let us not ignore the
lessons their experience suggests. Growth has to be obtained in the right way. It is possible
to grow too fast with substantial stimulus, as we did in 2010 and 2011, only to pay the price
in higher inflation, higher deficits, and lower growth in 2013 and 2014. Of course, India is not
in the same situation today. But with the world being an inhospitable place, we have to work
hard to strengthen our current recovery and put it on a more sustainable footing. And while
monetary policy will accommodate to the extent there is room, we will expand sustainable
growth potential only by continuing to implement reforms the government and regulators
have announced. These are intended to strengthen the environment for doing business and
to expand access to financing, and these will then in turn allow our companies to find and
exploit their core competencies.
For the RBI, the key tasks are to keep inflation low not just today but well into the future so
that we get moderate nominal interest rates that satisfy not just the vocal borrowers but also
the silent savers. We also need to clean up the banking system of distressed assets so that it
is in a position to fund growth again. While we understand the difficulties industry has and will
work as hard as we can on improving the environment, India must resist special interest
pleas for targeted stimulus, additional tax breaks and protections, directed credit,
subventions and subsidies, all of which have historically rendered industry uncompetitive,
government over-extended, and the country incapable of regaining its rightful position
amongst nations.
Belief
What will be critical in success, as the Prime Minister said earlier this month while meeting
industrialists and bankers, is that business has to believe in the tremendous possibilities and
opportunities the nation has, and be willing to take the investment risks that will generate
returns. No country succeeds without believing in itself - I do not mean the unwarranted
belief that we are intrinsically better than everyone else but the confidence that given our
population, our demographics, our massive infrastructure investment opportunities, and the
wide range of capabilities in our people, the arc of history is turning towards us. While Indian
business has been hurt by public authorities' acts of omission and commission in the past, it
has to look forward. And I have no doubt that as business presses people in positions of
public responsibility to make the changes needed to ease doing business, we will respond.
What specifically are we doing on the environment in the financial sector and what more do
we need to do? Let me turn to that, dwelling specifically on the need to foster competition
and innovation, on creating an environment hospitable to those who do not belong to the
club, on improving the structures we have to deal with distress, and on strengthening human
capital in the financial system.
Fostering competition and Innovation
In order to get sustained growth, we need more competition, especially from new entrants
who are in a better position to reach hitherto excluded parts of our economy. After a decade
of no new entry, we will see two new private banks this year, and a large number of payment
banks and small finance banks next year. Licensing is likely to go on tap.
Incumbents have expressed fears about unfair competition. Competition is only unfair if it is
not on the same playing field. In fact, new entrants have no privileges that incumbents do not
already enjoy. We hope, though, that the new entrants will find innovative ways of giving
customers better services at lower prices, thus shaking up and changing the banking sector
for the better.
Regulators are naturally a conservative lot. It is good we are that way else there would be no
speed breakers in the economy to slow its propensity to get into trouble. But we also should
not stand in the way of innovation. There is a Chinese saying: "Cross the river by feeling the
stones". We have tried to follow that path of experimentation and incremental liberalization.
So, for example, as increasingly innovative new services want their customers to have the
ability to make payments quickly, we have allowed small value card payments without
twofactor authentication. As we and financial institutions gain experience, and as new
technologies ensuring security emerge, we can liberalize further. More generally, our
philosophy is to allow innovation in institutions, instruments and practices so long as they do
not present a clear and present danger. Once we understand them better, and they grow to a
material size, we can do a deeper analysis on how they should be regulated.
Similarly, we have been allowing more and more participation in derivative markets by what
are typically known as speculators - those without an underlying risk they are hedging.
Speculators are much maligned in India and often confused with market manipulators. The
two are different. Speculators take positions in an instrument and thus take risks, much as an
investor in a stock takes risk. They typically take the necessary other side to hedgers.
Without speculators, there would be little depth in most markets and prices would be
distorted. The market manipulator moves thin markets in a preferred direction so as to make
a quick profit, in contrast to the speculator who simply takes a side she thinks will make
money. In the securities we regulate, we intend to encourage broader participation while
discouraging manipulation.
More generally, we would like to improve regulation by focusing on what is absolutely
necessary to create a sound business environment - focusing on enabling regulation rather
than paternalistic regulation - while increasing enforcement of what is on the books. We will
trust but we will also verify. To this end we are streamlining all our regulations by the end of
the year into new Master Documents which will be placed on the Internet and updated on a
real time basis, so that any regulated entity can know quickly the gamut of what is required
when undertaking an action.
Including outsiders
As India grows, financial sector participants will grow beyond the insiders who typically
dominate economic activity in the early stages of growth in every country. Outsiders and new
entrants will want access, arm's length contracts that they can trust, and a dispute settlement
system that is transparent and predictable.
Start first with access. We need to bring more of the hitherto excluded to participate in the
financial system. The Prime Minister's Jan Dhan Yojana has created accounts for much of
the excluded population. Government has taken the next step of attaching a variety of
financial services such as accident and life insurance to these accounts, and sending Direct
Benefits such as scholarships, pensions, and subsidies to these accounts. We also have to
ease access to bank accounts through Business Correspondents, payment banks, and
pointof-sales machines so that they are used frequently. Easy payments, access to cash-in and
cash-out facilities, and widespread availability of safe savings instruments have to be our
next objectives in the financial inclusion of households.
We also need to ease lending to small producers, whether they are farmers, Self Help
Groups, or businesses. For this, we need to improve the structure and working of credit
information bureaus, collateral registries, and debt recovery tribunals - ironically, credit flows
easily only when the lender is persuaded that he will get his money back, so easier access to
credit necessitates harsher consequences of default. Perhaps the most important source of
collateral value is land. We need better digital mapping and clean records of land ownership
across the country so that land can be used more effectively as collateral.
Newcomers and outsiders rely, not on relationships to get things done, but on arm's length
auctions and contracts, enforced quickly by an impartial bureaucracy and judiciary. The
clean-up that is taking place in methods of allocating resources like mines and spectrum, and
the attempts to improve the speed of bureaucratic and judicial decision making are all much
needed to increase participation, though much more has to be done over time. Any reforms
have to be institutionalized, so that they outlive the reformer's passing.
Finally, newcomers and outsiders need protection against unfair practices. As one example
of what we are doing, RBI has developed a Charter of Consumer Rights following public
consultation. Bank boards have been asked to put in place frameworks that ensure those
rights are protected. After those frameworks have been in operation for some time, RBI will
take a view on best practices, and regulation, if any is needed. In the meantime, field visits
by RBI, to check mis-selling as well as the proper functioning of bank infrastructure such as
branches and ATMs, will be expanded.
Resolution of distress
Failure is inevitable in a free enterprise system. An effective resolution system is needed to
preserve residual enterprise value after financial failure. Two critical elements are the speed
of resolution and the predictability of how losses are shared amongst contracts. For instance,
few outsiders will want to lend if they believe they will be subordinated to promoter interests
in bad times. So we need a speedy bankruptcy code to resolve distress while maintaining the
priority structure of claims, and I am glad the Finance Ministry intends to bring one in soon.
The bankruptcy code will give creditors more ability to resolve distress, and help strengthen
the corporate bond market, which is so essential to infrastructure financing.
In the meantime, we have to find ways to deal with the distress in the banking system.
Regulatory forbearance, where RBI softens its rules on classifying bad loans, only makes it
easy for banks to "extend and pretend". It is not a solution. Since no other stake-holder -
such as the promoter, tariff authorities, tax authorities, etc. - contributes to resolution, the
real project limps along, becoming increasingly unviable. Meanwhile, analysts grow
increasingly suspicious of bank balance sheets and the growing volume of "restructured"
assets. Also, some large promoters take advantage of banker fears about assets turning
non-performing to extract unwarranted concessions, without any sacrifice in the value of their
stake. Regulatory forbearance therefore ensures that problems grow until the size of the
provisioning required to deal with the problem properly becomes alarmingly large - which
then prompts calls for yet more forbearance.
Forbearance is also a disservice to the bank's owners (which may include the Government)
who, instead of being faced with a small problem early and being given the opportunity to
apply corrective action, are faced with large problems suddenly when they cannot be pushed
into the future any more.
RBI ended the forbearance accorded to restructured loans. Henceforth, restructured loans
will be classified as non-performing loans. However, RBI has made it easier to recognize and
deal with distressed projects. In other words, while ending forbearance, we have introduced
flexibility for those who recognize and deal with stressed assets early - the early warning
database of large loans, the Joint Lenders' Forum, the Strategic Debt Restructuring process,
the 5/25 mechanism, and so on should all be seen as RBI's way of giving banks the flexibility
to deal with the stressed asset problem in the absence of a functioning bankruptcy code,
even while bringing more urgency and discipline to dealing with the problem.
Naturally, some criticise our easing the way for restructuring. One gentleman accosted me
the other day and asked why, when he was paying his debt regularly, his competitor who had
siphoned money out of the firm through over-invoicing was getting his debt written down
because it was unpayable. The reality is that firms have got into trouble for a variety of
reasons, only one of which is over-invoicing. Wherever possible, of course, promoters should
share fully in the costs of restructuring. But the restructuring process is not meant to deal
with criminality. Siphoning money out of a business is a crime against lenders and investors,
and should be dealt with as such by the investigative authorities. However, the original sin of
over-invoicing should not be a reason to keep idle a spanking new plant and to let its workers
go.
Developing human capital
The country needs many more finance professionals with specific skills for the enormous
financing needs that lie ahead. Today, for example, too many of our project decisions are
made by banks listening to the same set of consultants, which means that too few
independent views get embedded in the evaluation decision. Ironically, the same consultants
who advised on the project initiation are also called in when the project goes bad. Banks
need to have these skills in-house so they are not forced to follow the herd. This problem is
most apparent in public sector banks, though private banks are not immune.
The quick way is for our public sector banks to recruit the needed talent in the short run from
the market. While the challenges of making a mark in the public sector may attract some to
the top public sector bank positions, for subordinate positions it may be essential to pay a
market wage. That cost will be small when set against the enormous national benefit of
banks making better decisions.
Of course, the bulk of public sector promotions will continue to come from in-house talent.
Also, poaching talent from other banks is a zero sum game for the system. Therefore, our
banks will have to develop skills in-house by training staff - not so much in soft skills such as
leadership but hard skills such as risk management capabilities.
In our development role, the RBI has to help strengthen the human capital in the financial
system. Some of our teaching units such as the College of Agriculture and Banking and the
Staff College have been training bankers in important areas such as agricultural lending and
MSME lending. Increasingly, our Center for Advanced Financial Research and Learning
(CAFRAL) will provide courses in state of the art financial techniques such as project
evaluation, structuring and resolution of distress as well as risk management. Banks may
want to pool resources to set up other such facilities, or press CAFRAL to expand its
offerings.
Conclusion
These are some of the ways I think we can position the financial system towards sustainable
growth. Before I end, let me try to answer one last question. In the same way as firms have
core competencies, do countries have core competencies?
Perhaps they do. But it is very hard for public authorities to determine what they are in the
face of massive lobbying and disinformation from interested parties. If we say we want to
focus on national core competencies, every industry will be out to show why it thoroughly fits
the bill - in the same way as every industry today wants to tell us why they especially
deserve special tax benefits or interest subventions. Remember, the License Permit Raj
persisted precisely because some industries were favoured over others in the so-called
national interest. So even if nations have core competencies, it will be very hard to determine
what they are, and very easy to succumb to vested interests in supporting the wrong ones.
Better to focus on creating an enabling environment, and let the core competencies emerge
from the fillip given by the environment - much as the IT sector emerged as a result of the
investment the country made in technical education, but without specific encouragement by
the government.
Let me conclude. CK Prahalad believed Indian business was capable of scaling world
heights and so do I. But there are no easy paths to the top. Jugaad or "working around"
difficulties by hook or by crook is a thoroughly Indian way of coping but it is predicated on a
difficult or impossible business environment. And it encourages an attitude of short cuts and
evasions, none of which help final product quality or sustainable economic growth. While we
should respect the entrepreneurial abilities of our business people in difficult environments, it
is better for us to change the environment for the better. That is indeed what we are trying to
do.
All this requires patience. The current difficulties of emerging markets stem from a
complicated set of reasons, but an important one is impatience to regain growth by
overemphasizing old and ineffective methods of stimulus. Brazil may have overspent, China
may have overinvested. The world is a difficult place. Let us recognize we are doing quite
well in comparison - indeed, many industries in difficulty have a problem because exports
are low or imports are very competitive, and not because domestic demand is inordinately
weak. We cannot compensate entirely for what is happening across our borders, else we will
risk acquiring the problems our fellow emerging markets have. We have to have the
discipline to stick to our strategy of building the necessary institutions and creating a new
path of sustainable growth where Jugaad is no longer needed. For this, we need the
understanding and cooperation of business, not impatience and pressure for quick
impossible fixes. Only then can we realize our true potential as a nation. Thank you.