Duvvuri Subbarao: Should banking be made boring? - an Indian
perspective
Keynote address by Mr Duvvuri Subbarao, Governor of the Reserve Bank of India, at the
International Finance and Banking Conference on "Banking - Crisis and Beyond", organised
by the Indian Merchants' Chamber, Mumbai, 25 November 2009.
* * *
I. Introduction
First of all, my grateful thanks to the Indian Merchants' Chamber and the Institute of
Chartered Accountants of India for inviting me to be the Chief Guest at this year's
International Finance and Banking Conference. The theme of this conference, "Banking -
Crisis and Beyond" is relevant and timely. The global financial system has been engulfed in
possibly the deepest crisis of our time shaking our world view of the financial sector to its
roots. As attention both around the world and here in India shifts from managing the crisis to
managing the recovery, the importance of consolidating the lessons of the crisis and
reflecting them in our forward plans can hardly be overemphasized. Being at this conference
and sharing some thoughts and ideas with you is therefore an opportunity to which I attach a
lot of value.
II. Calls for making banking boring
2. Banks have been at the heart of the global financial crisis and bankers are widely seen
as being responsible for the crisis. Quite understandably, there is a deluge of ideas and
suggestions on reforming banks, banking and bankers. One of the more influential ideas, one
that has generated a vigorous debate, has been the thesis put forward by the noted
economist and Nobel Laureate Paul Krugman that the way to reform banking is to once
again make it boring.
3. 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, paid well and attracted intellectual talent, 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.
4. 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 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.
5. The boring banking thesis found an echo in other influential voices. In a speech last
month that attracted wide notice, Mervyn King, Governor of the Bank of England addressed
the moral hazard issue: why were banks willing to take risks that proved so damaging to
themselves and the rest of the economy? The problem, according to Governor King, was that
financial institutions became too important to be allowed to fail. His solution: restrict banking
to its traditional "utility" function - performing basic retail financial intermediation of deposit
taking and lending, and providing payment and settlement services; and hive off the riskier
financial services such as proprietary trading into a separate entity. In what has come quickly
to be known as the "utility and casino" model, the "utility" will be heavily regulated and will
enjoy implicit government guarantee while the "casino" will be left to the discipline of market
forces.
6. Closer home, another equally influential voice - Dr. Y.V. Reddy, former Governor of the
Reserve Bank of India - weighed in on the issue. In his Guhan Memorial Lecture last month,
Dr. Reddy called for "back to basics" in banking and urged that banks must curb the
tendency towards further financialization of deposits they mobilize and must focus instead on
lending to real sectors of the economy, particularly agriculture and the small and medium
industries, that have limited ability to tap the capital markets.
7. Although neither Governor King nor former Governor Reddy mentioned "boring
banking", in a sense both of them were calling for what can stylistically be interpreted as
boring banking.
8. Krugman's thesis of "boring banking" is interesting, but also debatable. It raises several
important questions. What were the ills of the banking system that caused the crisis? Is
making banking "boring" a necessary and sufficient cure to those ills? How do the several
proposals on the table at the international level for reforming banking measure up to the test
of making banking boring? And, how relevant is the "boring banking" perspective in India? I
want to use the platform of this conference that you have so kindly provided me to address
these questions.
III. Ills of the banking system that caused the crisis
9. Let me turn first to the ills of the banking system that caused the crisis. I will not go into
an extensive analysis of the causes. I will attempt something much more limited - just give a
brief synopsis to provide a backdrop for the "boring banking" discussion.
Glass-Steagall Act, financial innovation and risk transmission
10. Many believe that the genesis of the crisis can be traced to the repeal in the United
States in 1999 of the Glass-Steagall Act which mandated the separation of commercial and
investment banking to protect depositors from the hazards of risky investment and
speculation. The repeal opened up opportunities for commercial banks, investment banks,
securities companies and insurance companies to consolidate, setting off a wave of
innovation. Complex financial products were created by slicing and dicing, structuring and
hedging, originating and distributing, all under the belief that real value could be created by
sheer financial engineering. The system was characterized by opacity and dissipation of
information with no one having a full picture of the extent of risk, how it was getting
transmitted across the system and where it resided.
Globalization of financial institutions and services
11. A very striking feature of the financial crisis was its global scope with no country
escaping unscathed. This should not surprise us. The progressive globalisation of financial
institutions and services over the last two decades has led to a complex web of
interconnected markets, institutions, services and products. Institutions transcended borders;
markets became accessible in real time and financial services were available from
everywhere. In short financial markets and institutions declared "death of distance" and
"conquest of location". And when the crisis came, it showed that globalization meant that no
country can really be an island.
Proliferation of quasi banks beyond regulatory purview
12. As the pace of globalisation and financial innovation gained momentum, and
encouraged by an extended period of monetary accommodation, banks entered into areas of
activity that had earlier been the preserve of non-bank institutions. Banks looked for, and
exploited, opportunities to shift profitable but risky businesses to entities outside the
regulatory purview. To economize on capital requirements, banks developed new structured
products to distribute the credit risk, they also found new special purpose entities and
vehicles to handle them. The structured investment vehicles quickly spawned a vast "shadow
banking" network that operated and thrived outside the perimeter of bank regulation. With
few regulatory restrictions and no coordinated oversight, they were able to take on risks that
they did not fully comprehend. And when the Minsky moment arrived turning the financial
mania into panic, the risks reverted to the parent banks causing financial turmoil and
economic down turn.
The moral hazard of "too big, too important to fail" institutions
13. The lure of profits encouraged financial institutions to expand, transcending borders
and business segments, to exploit economies of scale and scope. And this was facilitated by
the implicit faith of the authorities in "light touch" regulation. Consequently, what we ended up
with was large financial conglomerates with footprints across the system. These institutions
knew that their failure would result in a systemic collapse, and that they would therefore be
rescued at public cost. This acted as a perverse incentive for them to take on risks that we
now know were imprudent if not reckless. The moral hazard of "too big to fail" is therefore
reckoned as one of the prime causes of the crisis.
Compensation and perverse incentives
14. Finally, the asymmetric compensation structures in many financial institutions
encouraged risky behaviour. The variable components of compensations were anchored to
short-term profits, were one sided (high in good times and at worst zero in bad times) and
had little or no risk adjustment. This myopic attitude towards long term risk provided perverse
incentives to bank managements to maximise their current compensations at the cost of
shareholders, and to maximise leverage without regard to the tail risks to the institution.
IV. Is "boring" banking a necessary and sufficient solution?
15. The ills of the banking system listed above raise two follow-on questions. Is making
banking boring in the sense that Krugman indicated a necessary and sufficient solution to
curing those ills and preventing their recurrence? And what will be the cost of making boring?
Both questions cause much confusion, the first because it has too many answers and the
second because it has too few. Abstracting from these answers, I will argue that it is neither
possible nor desirable to make banking boring.
16. 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.
17. 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? Let us say a large investment bank, a casino if you will, fails. Because of the
inevitable interconnectedness, that will cause a break down of trust not just in that particular
bank but in the entire financial sector. So utilities cannot expect to insulate themselves
against the risks being taken by the casinos. Third, the co-existence of utilities and casinos
can also 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?
18. There have of course been problems in the way banking evolved around the world -
problems that were at the heart of the crisis. But clearly the answer is not to adopt Luddite
solutions that take us back decades. The solution is to look ahead to what we need. We
need to build institutions that go beyond narrow banking and provide the whole gamut of
financial services to meet the needs of customers, markets and economies. We need to build
on the innovations of the last few decades but in doing so build in also correctives based on
the lessons of experience. We need to build a safe and enterprising banking sector that
supports growth while preserving financial stability. We need to nurture financial markets and
institutions within clearly defined and effectively supervised boundaries. Doing all of this is
the basic thrust of the international reform agenda currently under discussion to which I now
turn.
V. International reform initiatives - will they make banking boring?
19. The reform initiatives in the wake of the crisis are intended to rein in the "irrational
exuberance" of the banking sector, keep it safe and healthy, and make banking an aid for
growth and macroeconomic stability. What is relevant to our discussion here is that none of
these measures is aimed at making banking boring; on the contrary, several of them will
likely make banking more challenging and thereby spur innovation of a more value adding
and sustainable variety. In order to enable an appreciation of this, let me provide a brief
synopsis of the various initiatives under discussion from the macro and micro perspectives.
The macro perspective
20. One clear lesson of the crisis is that regulation and supervision at the institution level is
necessary, but not sufficient. Even if each institution is healthy and safe on a stand-alone
basis, systemic risk can build up because of procyclical, herd behaviour - what economists
call the fallacy of composition. It is therefore necessary to supplement micro-prudential
regulation with macro prudential oversight.
21. At a macro level, to address procyclicality and contain leverage, three important
initiatives are underway: (i) development of capital buffers that banks would be required to
maintain to counter cyclical effects; (ii) requirement for institutions to set provisions on a
dynamic basis, i.e. building up buffers in good times to be drawn down in bad times; and (iii)
developing a metric to contain excessive leverage in banks to supplement the risk based
capital ratio.
22. A somewhat original idea proposed by Prof. Raghuram Rajan, currently under
discussion, is to require institutions to maintain "contingent capital" to tide over systemic
crisis or idiosyncratic problems. This proposal will potentially require banks to issue long-term
debt instruments that would automatically covert to equity under specific triggers. This
contingent arrangement will accordingly enable banks coming under stress to quickly buffer
their capital without imposing any cost on tax payers. All this will not, of course, be costless.
The challenge is to design the contingent capital provisions in a way that optimally manages
the trade off between higher cost and lower moral hazard.
23. An important proposal aimed at mitigating systemic risk is to impose a systemic risk
capital surcharge on institutions that pose a higher risk to the system because of their size,
complexity or interconnectedness. There is increasing support for such a measure. In fact,
Lord Turner, Chairman of the UK Financial Services Authority, went further and argued that
should such a capital charge prove insufficient, there should be no hesitation in levying a tax
on specific financial transactions. The Turner proposal is based on the premise that
regulation should ensure that the financial sector remains within its "socially useful" size.
24. Large, interconnected and complex institutions will be subject to additional regulatory
obligations in other dimensions as well. Importantly, such institutions will be required to
institute more sophisticated risk management systems, have robust contingency plans and
put in place "living wills" that can steer the course of their orderly exit should problems in
these institutions become unmanageable. The Basel Committee on Banking Supervision
(BCBS) is working on resolution mechanisms for cross border financial institutions with an
aim to containing risk.
25. There is a proposal to move OTC derivatives to central counterparties and charge
differentiated capital for OTC derivatives that are cleared on a bilateral basis. This will
contain systemic risk to some extent.
26. Another lacuna that came into sharp focus during the crisis is that while financial
activity is increasingly getting international, regulation remains fiercely national. The growing
cross border nature of banking and banking services underscores the need for a coordinated
oversight of banking entities, particularly of large and complex institutions. In an ideal world,
we would have global regulation; because we are in a less than ideal world, we are having to
settle for a "global framework" that will mandate minimum consistency across jurisdictions in
regulatory principles that would apply to similar markets, institutions, activities and products.
27. Finally, the emergence of a large shadow banking system, typically with higher than
average leverage, has underscored the need for their regulation and the importance of
mandating disclosure and reporting requirements. This is coming in the form of expanding
the perimeter of regulation to those institutions that are "near banks" which are currently
unregulated or under-regulated.
The micro perspective
28. Let me now turn to the micro perspective which focuses on ensuring the safety and
soundness of individual institutions.
29. First, to ensure that bank exposures are adequately and sufficiently covered by capital,
various enhancements to the Basel II capital framework have been finalised. These
specifically relate to higher capital requirements for trading book to minimize the opportunity
for regulatory arbitrage between the trading and banking books. There are also proposals on
the table for improving the quality of capital to ensure that regulatory capital is comprised
largely of elements having a true loss absorbing capacity in a going concern scenario.
30. Second, recognising that solvency of banks can be threatened by illiquidity as much as
by inadequate capital, work is currently under way to develop a global standard for liquidity
risk regulation of cross-border banks, and strengthening information sharing on liquidity risk
among home and host country supervisors.
31. Other initiatives under way include promoting compensation structures that reflect the
underlying risks taken over a longer term horizon and enhanced oversight of credit rating
agencies, particularly where ratings are being used for aligning bank risk to regulatory capital
requirements.
32. Collectively, the measures initiated both at the macro and micro levels to reform the
financial sector aim to impart a balanced perspective to banking. The intention is to ensure
that the stability of the system is preserved, the integrity of core banking is not violated, retail
customers' savings and deposits are not jeopardized and that the costs of riskier business
products and practices are internalized to prevent, or at any rate minimize, externalities.
VI. Boring banking - an Indian perspective
33. Let me now turn to Indian banking. The decade of the 80s and 90s and the first decade
of this century saw several financial crises around the world, many of them centred in banks.
These crises were sometimes country specific, often regional, and in the case of the current
crisis, global in scope. And in each case, the banking sector became a drag on the real
economy, jeopardized public finances and hurt economic growth. What is noteworthy though
is that even as other countries and other regions went through banking upheavals, Indian
banking remained safe. This is a reflection, in part of our cautious and prudent regulation,
and in part of the relatively lower globalization of our banking sector.
34. All this does not mean that the lessons of the crisis are irrelevant for us. Going forward,
our banking sector too will acquire an increasingly international character - Indian banks will
increase their presence abroad while foreign banks will have larger presence in India. The
task for the Indian banks is to learn to compete abroad and to set the terms of competition at
home. It is imperative therefore for Indian banks to learn from the successes and failures
around the world, study international best practices and adapt them to the Indian conditions.
Just as banking around the world is not going to revert to being boring, neither will Indian
banking get boring.
35. In fact, I will go further and argue that boring banking is an oxymoron in the Indian
case. Here my intent is to argue not so much from the perspective of a banking model -
narrow or full service - but from the perspective of the challenges that Indian banks will have
to meet. Meeting these challenges is going to demand lateral thinking, entrepreneurship and
management calibre - all a far cry from anything like boring. In order to illustrate this, I will list
and explain what in my view are four big challenges that Indian banks will need to address.
First challenge: financial inclusion
36. Despite its impressive progress, commercial banking in India has not penetrated
sufficiently to serve the large mass of rural, illiterate and poor people in any meaningful way.
Rough estimates indicate that of the 600,000 habitation centres in the country, only about
30,000 centres are covered by commercial banks. Even this big picture, stark as it is, does
not fully convey the true extent of exclusion. Furthermore, even where 100 per cent financial
inclusion is claimed, oftentimes it is inclusion only in a nominal sense. Households have bank
accounts that remain dormant; few conduct any banking transactions and even fewer receive
any credit. What we should attempt is quality financial inclusion which aims not at chasing a
target but instead focuses on giving access to at least minimal financial services to the
currently excluded.
37. The Reserve Bank has taken several steps over the last few years to further financial
inclusion - encouraging "no frills" accounts to allow access to basic financial services,
initiating and then expanding the Business Correspondent (BC) model and the use of mobile
phones for extending banking outreach. More recently, we have expanded the categories of
entities that can be appointed as BCs and also allowed banks to charge a commission for
services rendered by BCs. There are of course formidable challenges to the BC model that
we need to address - high maintenance costs, small size of transactions, expanding
awareness, improving communication skills and techniques for dealing with semi-literate
people in local languages, enlisting the cooperation of the village administrations and
overcoming the constraints posed by lack of electricity and sometimes telecommunication
access.
38. What is clear though is that it is not possible to cover a country of a billion plus people,
spread over 600,000 habitations, covering vast distances, with poor infrastructure and
sometimes inhospitable terrain by traditional brick and mortar branches.
39. We need to think laterally, harness technology, adopt effective dissemination practices
and reach out to all the people across the country to provide at least minimal banking
services. Financial inclusion is especially valuable as it will at once promote both growth and
equity. I can hardly overemphasize how big a challenge financial inclusion is for banks, for
the banking regulator and for the government. Working to meet this challenge can hardly be
a boring proposition.
Second challenge: financing infrastructure
40. Distinct from other large emerging market economies which are typically demand
constrained, India has been, and will remain in the foreseeable future, a supply constrained
economy. The biggest supply constraint is of infrastructure - physical, social and urban. It is
widely recognized that poor and inadequate infrastructure is adding to production costs,
denting productivity of capital and eroding the competitiveness of our productive sectors.
41. The Eleventh Five Year Plan targets increase in infrastructure investment from around
5 per cent of GDP in 2006/07 to 9 per cent by 2011/12. This translates to cumulative
infrastructure investment over the Plan period of over Rs. 20 trillion (US$ 520 billion). Almost
one half of this investment is to be funded through debt, and as much as 43 per cent of this
total debt requirement (21 per cent of overall planned investment) is planned to be financed
by banks. We have to await the mid-term appraisal of the Eleventh Plan for an update of the
above numbers. Regardless of any revision the numbers may undergo, what is clear is that
the financing needs of our infrastructure are huge.
42. A big issue in bank financing of infrastructure is the asset-liability mismatch. While
infrastructure typically requires long term funding, the deposits of banks, their main source of
funds, are relatively short-term. The problem of asset-liability mismatch in long term financing
is not unique to India; banks elsewhere too face the same problem. But in advanced
economies, the long term finance space is filled by insurance companies and pension and
provident funds. If some of the pending legislation gets through, in India too we can expect
new sources of long-term financing to open up. But until that happens, the burden of
infrastructure financing will have to be met largely by the banks. In order to partly offset this
problem, the Reserve Bank has, since 2000, allowed banks to enter into take out financing
arrangements with other financial institutions.
43. To facilitate financing for infrastructure, the Reserve Bank has also relaxed the
exposure norms. To avoid concentration risk, banks are mandated to restrict their exposures
to a maximum of 15 per cent of the banks' capital funds in case of a single borrower and 40
per cent in case of a borrower group. These norms are relaxed in the case of financing for
infrastructure by up to 5 per cent in the case of a single borrower and 10 per cent in the case
of a borrower group.
44. A number of recent measures and several in the pipeline should facilitate greater flow
of credit to the infrastructure sector. Let me recount a few important ones. First, interest rate
futures have been reintroduced recently and these should aid banks in managing their
interest risk more efficiently. Second, repos in corporate bonds are slated to start soon; we
expect to issue final guidelines by end-November 2009. Third, in the second quarter policy
review last month, we announced the introduction of plain vanilla OTC single-name credit
default swaps (CDS) for corporate bonds for resident entities. Fourth, a separate category of
NBFCs - infrastructure NBFCs - is being introduced. Fifth, banks will be permitted to build
up capital for "take-out" exposures in a phased manner. Finally, refinancing through the
special purpose vehicle, India Infrastructure Finance Company Ltd. (IIFCL), is expected to
leverage bank financing for Public Private Partnership (PPP) projects. These measures,
along with existing ones, can be expected to enhance banks' ability to fund infrastructure
projects.
45. Going forward, financing infrastructure is going to be a big challenge for the banking
sector. This huge and growing demand of infrastructure finance will have to be met even as
banks wrestle with expanding their traditional banking services. Apart from finding the
resources, banks will also need to hone their skills in appraisal and management of risks
inherent in infrastructure financing. This is a daunting challenge, and hardly fits the
description of a "boring" prospect.
Third challenge: risk management
46. Let me now turn to the third challenge - the challenge of risk management. In the years
ahead, two big forces will define the environment in which Indian banks will be called upon to
operate - a rapidly globalizing India and a fiercely competitive banking industry. This means
in the main that Indian banks will have to upgrade their risk management architectures. In
this regard, an important lesson thrown up by the crisis is that in addition to managing more
effectively the traditional risks such as credit risk, operational risk and market risk, banks also
need to manage some new risks that have proven to be significant such as reputation risk,
counterparty credit risk, liquidity risk, interest rate risk in the banking book and incremental
risks in the trading book. Expertise in risk management needs to be complemented by
strengthening stress testing techniques. Evidently this calls for substantially broadening and
sharpening the skill endowment at the institutional level. However, this cannot stop at getting
a new toolbox and learning how to use it; it has to extend to changing the mindset. Banks
need to develop a culture of risk management at the institutional level. What the crisis has
shown is that risk management cannot be done in silos; it demands a more integrated
approach with risks and their interconnections across the entire organization recognized and
managed synergistically.
47. Buffering the capital base of banks is obviously a standard and much needed response
to risk management. In this regard, countries around the world are in the process of
migrating to the Basel II capital standard. In its current form, the standard provides a menu of
approaches from simple to advanced to assess credit, market and operational risks and to
calibrate the capital requirement to the assessed risk. Importantly, the standard provides a
framework for assessing the new risks that I talked about earlier.
48. India is committed to adopting the international best practices though with the
sequencing and pacing determined by our domestic conditions. As of March 2009, all Indian
banks have migrated to the simpler approaches of the Basel II standard. The task on the way
forward is to graduate to more advanced approaches. Towards this end, in consultation with
banks, the Reserve Bank has now finalized a four-year time frame starting in April 2010 and
ending with March 2014. Moving to advanced approaches is both skill and technology
intensive. In the first instance, it will therefore necessarily have to be confined to the larger
banks. While the Reserve Bank will actively facilitate the transition of such larger banks to
advanced approaches, it is expected that the banks themselves will be proactive in preparing
themselves to meet the preconditions for the transition in view of the competitive advantages
it will offer.
49. All in all, going forward, risk management is going to involve pushing the frontiers of
knowledge and transforming that knowledge to practical policy. That can hardly fit the
description of boring.
Fourth challenge: further improvements in efficiency
50. Let me now turn to the fourth and final challenge on my list which is the challenge of
further improving the efficiency of banking. But before I look ahead, I need to look back a
little. The growth acceleration of the Indian economy during 2003-08 is attributable to a host
of factors. Some of these are tangible such as the deregulation of the industrial sector,
liberalization of external trade and external finance, reform of direct and indirect taxation and
elimination of controls on doing business. Some of the factors that contributed to growth are
intangible such as improved productivity, higher efficiency and growing entrepreneurism. We
often forget to add to this list the contribution made by the financial sector by way of larger
and better quality financial intermediation that raised the level of aggregate savings and
channelled them to investment. Just one statistic will evidence this - bank credit as a
proportion of GDP nearly doubled from 29 per cent in end-March 2000 to 56 per cent at
endMarch 2009. Even more notable, this rapid expansion of credit has been accompanied by a
significant improvement in asset quality which is now