Rule of law and competition in banking
Economic Times, 9 January 2014
RBI's process for the entry of new banks is inconsistent with the rule of law. We urgently need to transform competition in banking, but we should never lose sight of the objective of becoming a liberal democracy. There are numerous possibilities for improving competition in banking and upholding the rule of law.
What is the meaning of the rule of law? The law should be known to all in advance. Given the facts of a case, it should be possible to arrive at a reasonable prediction for what the outcome would be. Reasoned orders must be published, explaining the facts and the arguments that led to an adverse outcome. Aggrieved parties should be able to ask for judicial review of the order.
The process of bank licensing at RBI violates all these precepts. There is no regulation defining entry into banking. A sophisticated person cannot anticipate which of the 26 applicants will be greenlighted. In the past, reasoned orders were not published, and there was no judicial review.
RBI's bank licensing thus violates the rule of law. It is the rule of men. I have the highest regard for the men and women manning the process, past and present. But the process militates against the construction of liberal democracy, and is ultimately incompatible with the Constitution of India.
One argument in favour of such clubby processes is that they work well. The Indian experience does not support this proposition. Roughly half of the banks that came through this process, from 1993 onwards, have run into trouble. The application of such processes with stock exchanges and commodity futures exchanges have given us bad outcomes.
Some good men like to say: Let me be a dictator, and I will give you a good outcome. The trouble with the rule of men is that in the future, we will most surely be ruled by bad men. When we depart from the rule of law, the attraction of arbitrary power generates incentives for bad men to devote resources into capturing these positions.
We need a strong State and not a strongman. We need a machinery of impersonal checks and balances, with dispersion of power, which yields good outcomes when government is populated by ordinary folk. Sad is the land that needs heroes -- in bank licensing and RBI as much as in the Jan Lok Pal.
There are huge problems with competition in Indian banking. What is the way forward? Roughly half of new private banks have gone bad: this demonstrates that the everyday machinery of regulation and supervision of banks works badly. Indeed, weak technical capabilities at RBI are fueling the ambitions of the wrong kinds of players. We should build technically sound regulation and supervision.
The draft Indian Financial Code (drafted by FSLRC) shows how to do banking regulation properly: by clarifying the objectives of regulation, establishing sound foundations for the rule of law in regulatory governance, and strengthening accountability. These improvements will enable the entry of new private banks for three reasons. First, some dubious players will get deterred by the prospect of dealing with a technically sound RBI.
Second, sound entry processes can be grounded in the Indian Financial Code, drawing on our experiences about what kinds of banks work well. Entry regulations could be drafted, that avoid family domination and entrepreneurs, attract professionally managed banks with dispersed shareholding, wall off related party transactions, and test technical capabilities. Once new banks are in the play, their behaviour will be constrained by competent regulation, thus giving better outcomes.
Third, competition in banking is much, much more than the entry of new private banks. There are myriad aspects where RBI has setup anti-competitive provisions. It is hard for existing banks to start branches. It is hard for foreign banks to play. It is hard for mobile phone and Internet-based companies to compete in payments. It is hard for money market mutual funds to compete in deposit accounts. It is hard for non-banks to do currency trading. It is hard for market-based mechanisms such as corporate bonds and securitisation to exist. A stagnant banking system did not come about by accident: it has been carefully constructed. Our job is to dismantle all these anti-competitive mechanisms.
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