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Banking reforms

Banking reforms

Context

Bold move by government

The government has decided to spend big money to clean up the banks it ownsThis is despite the obvious risks of moral hazard that bank bailouts across the world have inevitably faced

What happened in the recent past?

Three important policy documents laid the groundwork for banking reforms since the 1991 reforms

The report of the first Narasimham committee set up in 1991The report of the second Narasimham committee set up in 1998The report of the Raghuram Rajan committee that was released in 2009

Changes that have happened over the years

Indian banks now have to meet international capital adequacy standardsA smaller portion of their deposits has to be handed over to fund the fiscal deficitInterest rates are determined by the marketBranch expansion policies are more liberalNew private sector banks offer competition to the public sectors banks

1. Banking policy issues that the government needs to deal with

The need for public sector bank autonomyIndia needs to now shift the needle from autonomy towards privatizationBanking is the only important sector of the economy in which the private sector is dwarfed by the public sectorThe share of public sector companies has fallen sharply in most sectors such as airlines

2. India should move towards a three-tier banking structure

The first Narasimham committee had said that India should move towards a three-tier banking structureFour large lenders were to be developed as global banks, 10 banks were to become nationwide universal banks and local banks would concentrate on specific regionsThe ongoing debates about bank consolidation and differentiated licensing require a framework rather than the current ad hoc statements

3. The weakest banks cannot be shut down at once

This move could cause a disruptionThere is a strong case to convert at least some of them into narrow banks that use all their deposit money to buy government bondsThey could in effect become large payments banks rather than the more traditional financial intermediaries

4. India needs to move towards a new financial structure

In this system, large companies get mostly funded by the bond markets while smaller firms depend more heavily on banks for their financeThe problem is that the corporate bond market is still illiquid, with most bonds held to maturity by a narrow set of investors

Lessons of the global financing crisis

No country has figured out how to maintain financial stabilityCredit booms have inevitably left bad loans in their wakeBank-led financial systems such as Japan have been in troubleSo have financial systems such as the US where the bond markets are more important

What do unstable financial systems lead to?

Unstable financial systems hurt economic growth and job creation in the long runThe fiscal costs of bailouts can also be staggering

What should be the next step?

The next step should be a clear roadmap for future financial policy before India stumbles into its next banking messThe Indian political leadership needs to get a sense of what financial structure it desires—and then get experts to advise it on how to achieve it that goal.

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