Duvvuri Subbarao: Financial regulation for growth, equity and stability in
the post-crisis world
Inaugural address by Dr Duvvuri Subbarao, Governor of the Reserve Bank of India, at the
First Centre for Advanced Financial Research and Learning (CAFRAL)-Bank for International
Settlements (BIS) international conference on "Financial sector regulation for growth, equity
and stability in the post-crisis world", Mumbai, 15 November 2011.
* * *
Let me start by telling you about the motivation for the conference theme.
Failure of regulation, by wide agreement, was one of the main causes of the 2008 global
financial crisis. It is unsurprising therefore that reforming regulation has come centre stage
post-crisis. The progress in regulatory reforms over the last two years has been impressive,
but the agenda ahead remains formidable. Regulation will bring in benefits by way of
financial stability, but it also imposes costs. There are some ball park numbers for what the
Basel III package might entail in terms of growth, but there has been no rigorous thinking on
what the whole gamut of regulatory reforms currently on the agenda might mean for growth,
equity and stability in terms of costs and benefits over time and in different regions of the
world. Thinking through these vital and complex issues is the main motivation for the theme
of this conference - Financial Sector Regulation - Equity, Stability and Growth in the
Postcrisis World.
There was another strong motivation for the choice of the conference theme. The crisis, as
we all know, was brewed in the advanced economies, and much of the post-crisis reforms
are accordingly driven by the need to fix what went wrong there. The reform proposals were
discussed at international forums like the FSB and the BCBS. What has struck me though is
that the agenda and the deliberations have been dominated by advanced economy
concerns. As emerging economies, we have had a seat at the table in these international
forums, but we haven't been able to engage meaningfully in the debate as we have not
related to the issues. The stability of the advanced economy financial sectors is, of course,
important to us. After all we live in a globalizing world, and what happens anywhere has
impact everywhere. What concerns us, though, is that these global standards are going to be
applied uniformly but their implications for EMEs will be different given the different stages of
our financial sector development and our varied macroeconomic circumstances. We hope
that this conference will provide a forum for generating an emerging economy perspective on
issues of growth, equity and stability in the context of the post-crisis thinking on financial
sector regulation.
I have great pleasure in welcoming all the delegates to this first CAFRAL-BIS international
conference. You have travelled from around the country and across the world to be present
here, and we value your participation in this conference. I would like to acknowledge, in
particular, the presence here of Mr. Jaime Caruana, General Manager of BIS and the co-host
of this conference, Mr. Andrew Sheng, Ms. Stephanie Griffith Jones and Mr. John Lipsky, all
three eminent thought leaders, who will be chairing the various sessions, and my
predecessor at the Reserve Bank, Dr. Y.V. Reddy who, during his term in office, earned a
formidable reputation as a zealous guardian of financial stability.
I struggled to determine what I should say in this inaugural address. One option would be to
attempt a comprehensive overview of all the issues that might come up in the subject
sessions. Such double guessing would clearly be presumptuous on my part given the depth
and breadth of experience you bring to this forum. I will attempt something less ambitious.
What I will do is raise five questions straddling the three dimensions of the conference theme
- growth, equity and stability in the context of financial regulation - and sketch out an answer
to each of them in the hope that we will get more informed answers by the end of the
conference. I will fall back on the Indian experience, which I know best, to illustrate some of
what I say. I believe our experience will be relevant and applicable across a broad swathe of
emerging and developing economies.
Question 1: If financial sector development is good, is more of it better?
Development experience evidences a strong correlation between financial sector
development and economic growth, with the causation possibly running both ways.
Economic growth generates demand for financial services and spurs financial sector
development. In the reverse direction, the more developed the financial sector, the better it is
able to allocate resources and thereby promote economic development.
In India, we have experienced causation in both directions. We embarked on wide ranging
economic reforms following a balance of payment crisis in 1991. Very soon we realized that
the growth impulses generated by the liberalizing regime could not be sustained unless we
also undertook financial sector reforms. That is an illustration of growth triggering financial
sector development. For an example of the causation in the reverse direction, we have to
look no further than India's remarkable growth acceleration in the period 2003-08 when we
clocked growth of 9+per cent. Many factors have been cited as being responsible for this -
higher savings rates, improved productivity, growing entrepreneurism and external sector
stability. But one of the unacknowledged drivers of that growth acceleration has been the
impressive improvement in the quality and quantum of financial intermediation in India,
evidencing how financial sector can spur growth.
Given the historical experience, it is tempting to believe that if financial sector development
aids growth, more of it must be better. I am afraid that will be misleading. We must look for a
more nuanced response, especially in the light of the lessons of the crisis.
In the world that existed before the crisis - a benign global environment of easy liquidity,
stable growth and low inflation - the financial sector kept delivering profits, and everyone
became enticed by a misleading euphoria that profits would keep rolling in forever. Herb
Stein, an economist, pointed out the truism that "if something cannot go on forever, it will
eventually stop". But no one paid attention. The financial sector just kept growing out of
alignment with the real world.
It will be useful to put some numbers on how, across rich countries, this misalignment kept
on increasing. Take the case of the United States. Over the last 50 years, the share of value
added from manufacturing in GDP shrank by more than half from around 25 per cent to
12 per cent while the share of financial sector more than doubled from 3.7 per cent to 8.4 per
cent. The same trend is reflected in profits too. Over the last 50 years, the share of
manufacturing sector profits in total profits declined by more than two thirds from 49 per cent
to 15 per cent while the share of profits of the financial sector more than doubled from 17 per
cent to 35 per cent. The large share of the financial sector in profits, when its share of activity
was so much lower, tells a compelling story about the misalignment of the real and financial
sectors.
The world view before the crisis clearly was that the growth of the financial sector, in and of
itself, was desirable, indeed that real growth can be got by sheer financial engineering. Our
faith in the financial sector grew to such an extent that before the crisis, we believed that for
every real sector problem, no matter how complex, there is a financial sector solution. The
crisis has made us wiser. We now know that for every real sector problem, no matter how
complex, there is a financial sector solution, which is wrong. In the pre-crisis euphoria of
financial alchemy, we forgot that the goal of all development effort is the growth of the real
economy, and that the financial sector is useful only to the extent it helps deliver stronger
and more secure long term growth.
How does financial sector regulation come into all this? It comes in because the financial
sectors of emerging economies are still under development. How should they respond to the
lessons of the crisis, particularly in reshaping their regulations? Is a larger financial sector
necessarily better for growth? For equity? Is there such a thing as a "socially optimal" size for
the financial sector? What are the weights to be attached to growth and stability in the
objective function of regulation? Are the weights stable over time, or if they should vary, on
what basis? As we seek answers to this long list of questions, the basic tenet that must guide
our thinking is that it is the real sector that must drive the financial sector, not the other way
round.
Question 2: Financial sector regulation, yes, but at what cost?
Even as efficient financial intermediation is necessary for economic growth, the financial
sector cannot be allowed an unfettered rein; it needs to be regulated so as to keep the
system stable. This we knew even before the crisis. What we have learnt after the crisis is
that the quantum and quality of regulation matters much more than we thought.
In the years before the crisis - indeed even before the Great Moderation - a consensus was
building around the view that if the burden of regulation is reduced, the financial sector will
deliver more growth. That consensus has nearly dissolved. We now know that financial
markets do not always self-correct, that signs of instability are difficult to detect in real time,
and that the costs of instability can be huge. Global income, trade and industrial production
fell more sharply in the first twelve months of the Great Recession of 2008/09 than in the first
twelve months of the Great Depression of the 1930s. Three years on, the crisis is still with
us; it has just shifted geography. And there is still enormous uncertainty about when we
might see its end and with what final tally of costs in terms of lost output and foregone
welfare.
So, the emphasis of post-crisis regulatory reforms on making the financial system stable is
understandable. But a relevant question is, where do we strike the balance between growth
and stability? In other words, how much growth are we willing to sacrifice in order to buy
insurance against financial instability?
For illustrative purposes, let us take the Basel III package. A BIS study estimates that a one
percentage point increase in the target ratio of tangible common equity (TCE) to
riskweighted assets (RWA) phased in over a nine year period reduces output by close to 0.2 per
cent. It is argued though that as the financial system makes the required adjustment, these
costs will dissipate and then reverse after the adjustment period, and the growth path will
revert to its original trajectory. A BCBS study estimates that there will be net positive benefits
out of Basel III because of the reduced probability of a crisis and reduced volatility in output
in response to a shock. An IIF study, however, estimates a higher sacrifice ratio - that the G3
(US, Euro Area and Japan) will lose 0.3 percentage points from their annual growth rates
over the full ten-year period 2011-2020.
What are the implications of these numbers relating to growth sacrifice for EMEs? Let me
take the example of India. Admittedly, the capital to risk weighted asset ratio (CRAR) of our
banks, at the aggregate level, is above the Basel III requirement although a few individual
banks may fall short and have to raise capital. But capital adequacy today does not
necessarily mean capital adequacy going forward. As the economy grows, so too will the
credit demand requiring banks to expand their balance sheets, and in order to be able to do
so, they will have to augment their capital.
In a structurally transforming economy with rapid upward mobility, credit demand will expand
faster than GDP for several reasons. First, India will shift increasingly from services to
manufactures whose credit intensity is higher per unit of GDP. Second, we need to at least
double our investment in infrastructure which will place enormous demands on credit. Finally,
financial inclusion, which both the Government and the Reserve Bank are driving, will bring
millions of low income households into the formal financial system with almost all of them
needing credit. What all this means is that we are going to have to impose higher capital
requirements on banks as per Basel III at a time when credit demand is going to expand
rapidly. The concern is that this will raise the cost of credit and hence militate against growth.
A familiar issue in monetary policy is an inflexion point beyond which there is no trade-off
between growth and price stability. Is there a similar inflexion point in the growth-financial
stability equation? If there is, how do we determine that point?
Question 3: Does regulation have a role in achieving equity?
That takes me to my third question: does regulation have a role in achieving equity?
The dichotomy between growth and equity is standard stuff of development economics. For a
long time, the orthodoxy was that if we took care of growth, equity followed automatically a la
a high tide raising all boats. Experience has taught us that reality is more complex. Received
wisdom today is that growth is a necessary, although not a sufficient, condition for equity. To
achieve equity, we need growth that is poverty sensitive - that is growth to which the poor
contribute and growth from which the poor benefit.
How does this standard question translate in the context of financial sector regulation? This
is a question that we in India struggle with. Should stability be the sole objective of our
regulation, with other instruments being deployed to achieve equity? Or should equity be a
variable in the objective function of regulation?
To seek answers, we must ask a variant of the above questions. Is the financial sector
inherently equity promoting, or at least equity neutral? Our experience in India has been that
left to itself, the financial sector does not have a pro-equity bias. Indeed, it is even possible to
argue that the financial sector does not necessarily reach out to the bottom of the pyramid.
Our response to counter this bias has been to use regulation to encourage socially optimal
business behaviour by financial institutions. Let me just list a few of our affirmative action
regulations. We have a directed credit scheme, called priority sector lending, whereby all
banks are required to ensure that at least 40 per cent of their credit goes to identified priority
sectors like agriculture and allied activities, micro, small and medium industries, low cost
housing and education1. We have a "Lead Bank" scheme under which there is a designated
commercial bank identified for each of the over 600 districts in the country with responsibility
for ensuring implementation of a district credit plan that contains indicative targets for flow of
credit to sectors of the economy that banks may neglect. We have largely deregulated
licencing of bank branches; banks are now free to open branches freely in population centres
of less than 100,000 - with two stipulations: first at least a quarter of the branches should be
located in unbanked villages with a maximum population of 10,000; and second, their
performance in financial penetration will be a criterion for giving banks branch licences in
metro and large urban centres.
By far our most high profile campaign in recent years has been our aggressive pursuit of
financial inclusion. Why is financial inclusion important? It is important because it is a
necessary condition for sustaining equitable growth. There are few, if any, instances of an
economy transiting from an agrarian system to a post-industrial modern society without
broad-based financial inclusion. As people having comfortable access to financial services,
we all know from personal experience that economic opportunity is strongly intertwined with
financial access. Such access is especially powerful for the poor as it provides them
opportunities to build savings, make investments and avail credit. Importantly, access to
financial services also helps the poor insure themselves against income shocks and equips
them to meet emergencies such as illness, death in the family or loss of employment.
Needless to add, financial inclusion protects the poor from the clutches of the usurious
money lenders.
The extent of financial exclusion is staggering. Out of the 600,000 habitations in India, less
than 30,000 have a commercial bank branch. Just about 40 per cent of the population across
the country have bank accounts, and this ratio is much lower in the north-east of the country.
The proportion of people having any kind of life insurance cover is as low as 10 per cent and
proportion having non-life insurance is an abysmally low 0.6 per cent.
These statistics, distressing as they are, do not convey the true extent of financial exclusion.
Even where bank accounts are claimed to have been opened, verification has often shown
that the accounts are dormant. Few conduct any banking transactions and even fewer
receive any credit. Millions of households across the country are thereby denied the
opportunity to harness their earning capacity and entrepreneurial talent, and are condemned
to marginalization and poverty.
Over the last few years, the Reserve Bank has launched several initiatives to deepen
financial inclusion. Our goal is not just that poor households must have a bank account, but
that the account must be effectively used by them for savings, remittances and credit. Our
most ambitious initiative has been the "Business Correspondent" model or branchless
banking which, leveraging on technology, helps reach banking services to remote villages at
a low overhead cost.
In the context of this conference theme, the issue is the following. Financial inclusion is
equity promoting. Banks, however, may see this more as an obligation rather than as an
opportunity. Given that scenario, should we pursue financial inclusion through moral suasion
or issue a regulatory fiat? What combination of regulatory incentives and disincentives would
be optimal?
As I leave this topic, I must also add that using regulation, or political direction in a larger
sense, for achieving equity has not been a practice unique to emerging and developing
economies. It is quite common in rich societies as well. In his bestselling book, Fault Lines,
Raghuram Rajan persuasively argues that America's growing inequality and thin social
safety-nets created tremendous political pressure to encourage easy credit and keep job
creation robust, no matter the consequences to the long-term health of the financial system.
That is a thought we must ponder over.
Question 4: Should we make banking boring?
Post-crisis, there is a deluge of ideas and suggestions on reforming banks, banking and
bankers. Analysts with a historical perspective believe that the seeds of the 2008 crisis were
sown when the separation of banking from securities dealing was undone. What really
contributed to the disproportionate growth of the financial sector relative to the real sector
that I spoke about earlier was investment banking and securities dealing. It is the huge
leveraging by this segment that fuelled the crisis. Hence, as the noted economist and Nobel
laureate Paul Krugman has argued, the way to reform banking is to once again make it
boring. It is worth exploring this question as it has implications for growth, stability and equity.
Taking a long term historical view, Krugman argues that there is a negative correlation
between the "business model" of banking and economic stability. Whenever banking got
exciting and interesting, attracted intellectual talent and bankers were paid well, it got way
out of hand and jeopardized the stability of the real sector. Conversely, periods when
banking was dull and boring were also periods of economic progress.
To support his thesis, Krugman divides American banking over the past century into three
phases. The first phase is the period before 1930, before the Great Depression, when
banking was an exciting and expanding industry. Bankers were paid better than in other
sectors and therefore banking attracted talent, nurtured ingenuity and promoted innovation.
The second phase was the period following the Great Depression when banking was tightly
regulated, far less adventurous and decidedly less lucrative - in other words banking
became boring. Curiously, this period of boring banking coincided with a period of
spectacular progress. The third phase, beginning in the 1980s, saw the loosening of
regulation yielding space for innovation and expansion. Banking became, once again,
exciting and high paying. Much of the seeming success during this period, according to
Krugman, was an illusion; and the business model of banking of this period had actually
threatened the stability of the real sector. Krugman's surmise accordingly is that the bank
street should be kept dull in order to keep the main street safe.
Krugman's thesis of "boring banking" is interesting, but debatable. It raises two important
questions. Is making banking boring a necessary and sufficient solution to preventing the
excesses of the pre-crisis period? And what will be the cost of making banking boring? Both
questions cause much confusion, the first because it has too many answers and the second
because it has too few. The Dodd-Frank Act of the US is a response to the excesses of
investment banks. In Europe, the responses are somewhat different. Abstracting from the
specifics, I will argue that it is neither possible nor desirable to make banking boring.
The narrow banking of the 1950s and 1960s was presumably safe and boring. But that was
in a far simpler world when economies were largely national, competition was sparse,
pressure for innovation was low, and reward for it even lower. Bankers of the time, it is said,
worked on a 3 - 6 - 3 formula: pay depositors 3 per cent interest, lend money at 6 per cent
and head off to the golf course at 3 pm. From the 24/7/365 perspective of today, that may
appear romantic but is hardly practical.
The boring banking concept does not appear persuasive even going by more recent
evidence and on several counts. First, recall that during the crisis, we saw the failure of not
only complex and risky financial institutions like Lehman Brothers but also of traditional
banks like Northern Rock. What this demonstrates is that a business model distinction
cannot be drawn between a utility and a casino; and if it can, it does not coincide with the
distinction between what has to be safe and what need not be. Second, in an interconnected
financial sector, how can a "boring" bank realistically ring-fence itself from what is happening
all around given all the inter-connections? Third, will not the co-existence of utilities and
casinos open up arbitrage opportunities? During "tranquil" periods, financial institutions with
higher risk and reward business models will wean away deposits from narrow banks. But
when problems surface and stresses develop in the financial sector, the position will reverse
with the deposits flowing back into the so called "boring banks", triggering procyclicality.
Finally and most importantly, what will be the cost of boring banking in economic terms?
Does restraining banking to its core function just to keep it safe not mean forgoing
opportunities for growth and development?
What is the lesson from this discussion of "boring banking" for the EMEs where universal
banking is in early stages and trading of the kind witnessed in the North Atlantic systems is
nowhere comparable? It is important for the EMEs to draw the right lessons - markets may
not be self-correcting but they cannot be substituted by central planning and micro
management. Making markets competitive, open and transparent while putting in safeguards
to curb excessive trading can help EMEs to enable financial markets to play their rightful role
in efficient allocation of resources.
Question 5: Why is burden sharing across countries still off the reform agenda?
The last question I want to raise concerns cross-border equity, in particular the burden
sharing on account of the external spillovers of domestic regulatory policies. Why is
crossborder equity still off the agenda in any international meeting? I know I am asking that
question somewhat provocatively, but that is deliberate. Let me explain.
The crisis challenged many of our beliefs, and among the casualties is the decoupling
hypothesis. The decoupling hypothesis, which was intellectually fashionable before the crisis,
held that even if advanced economies went into a downturn, EMEs would not be affected
because of their improved macroeconomic management, robust external reserves and
healthy banking sectors. Yet the crisis affected all EMEs, admittedly to different extents,
discrediting the decoupling hypothesis.
The decoupling hypothesis was never persuasive given the forces of globalization. But the
forces of globalization are asymmetric. What happens in systemically important countries
affects EMEs more than the other way round. The regulatory policies that the advanced
economies pursue have knock-on impact on the growth and stability of EMEs. I need hardly
elaborate - capital flows engineered by the multi-speed recovery and the consequent
volatility in exchange rates, the spike in commodity prices triggered by their financialization,
the shortage of the reserve currency because of the flawed international monetary system
and the constant threat of protectionism.
As all these problems confronting EMEs are a consequence of the spillover of advanced
economy policies, should their solution remain the exclusive concern of EMEs? Isn't there a
case for sharing the burden of adjustment? How do we evolve a code of conduct for building
in cross-border equity concerns into financial regulation? I do hope these questions will figure
in our discussions over the next two days.
Conclusion
Let me now conclude. I have raised five questions straddling growth, equity and stability in
the context of the post-crisis approach to regulation:
(i) If financial sector development is good, is more of it better?
(ii) Financial sector regulation, yes, but at what cost?
(iii) Does financial regulation have a role in achieving equity?
(iv) Should we make banking boring?
(v) Why is burden sharing across countries still off the reform agenda?
I realize I have raised more questions than answers. For considered answers, I look to the
insights and intelligence of the delegates at this conference.
One last thought. Even as I have annotated my five questions from the perspective of
emerging economies, I realize that these concerns are not unique to them. We only have to
look around the world. What began with demonstrations in Madrid this spring has coalesced
into something on a much grander scale. The discontent has traversed from southern Europe
across the Atlantic and has inspired the "Occupy Wall Street" movement in New York's
Zuccotti Park and beyond. Despite its amorphous nature and its refusal to formulate a set of
demands, the protest campaign across the world is fired by a simple, but powerful idea - that
the elite cannot go on doing obscenely well even as the rest keep moving backwards. The
message from this collective rage is that growth itself can be destabilizing if it has no equity
dimension. That is a sobering thought.
Before I leave this platform, let me place on record my deep appreciation for the intellectual
and logistic effort that has gone into organizing this conference by the team at CAFRAL led
by Usha Thorat and the counterpart team at BIS led by Philip Turner. We owe them a great
deal.
I wish the deliberations over the next two days all success.