The Legacy: Raghuram Rajan is leaving the battlefield just when he was getting the better of his rivals

India’s debonair central banker, Raghuram Rajan, leaves behind many broken hearts and disappointed souls. Chronicles of his legacy will list many achievements, but will also note that he left the battlefield just when he was getting the better of his rivals; what’s surprising is that the commander-in-chief agreed to his pre-mature withdrawal even though the general’s strategies could be seen bearing fruit.

Equally perplexing will be the choice of his replacement.

Both the government and Rajan personally have been advocates of an alternative global financial architecture. He has also been proposing for a while that it was time for a new Bretton Woods mechanism. And Rajan had taken the battle to the enemy camp. At the April 2016 spring meetings of the International Monetary Fund and the World Bank, Rajan observed how deeply multilateral financial institutions were in thrall of western economic orthodoxies. He even wryly remarked how ideas from emerging economies were dismissed as “crankiness.”

He was prescient about the trans-Atlantic financial crisis. He took on former US Federal Reserve chairman Ben Bernanke when US domestic monetary policy spilled over into the global economy and led to severe volatility in emerging markets. He is unlikely to have fond memories of the period: he had to douse this particular fire soon after his appointment in Sept. 2013.

So, here is question number one: Will his successor have the same zeal about promoting an alternative global financial architecture that is sensitive to emerging economy needs and is not partisan about any particular economic ideology?

Rajan also quits before another crusade could be brought to its logical end. He’s been battening down the hatches that allowed a cosy nexus between large corporate borrowers, bankers, politicians, and bureaucrats, to bleed public sector banks through questionable debt write-offs. Rajan had taken a large broom to bank balance sheets and forced them to take drastic action against defaulters.

Many large—and over-stretched—corporate borrowers have been carping about Rajan’s reluctance to reduce interest rates, which, when lowered, would have certainly helped moderate their interest burden. These same corporates also turned into quack economists on the matter of interest rates: in their collective view, only lower interest rates could bring back high rates of economic growth. This view is oblivious to the fact that the low interest rates in the US, or negative rates in Europe and Japan, have failed to promote any economic growth.

Time for question number two: Will Rajan’s successor have the stomach (or benign sanction from the government) to continue with the clean-up act? Or to hold rates steady when required?

So, what does Rajan’s legacy look like? Apart from the well-documented success in fending off volatility from the US Fed’s tapering in 2013, his tenure will be remembered for three systemic changes he fostered.

One will be the differentiated banking landscape that he designed and left behind. As RBI governor, he grandfathered the emergence of a new breed of universal, small, and payments banks. He was in the process of adding two more categories—custodian banks and wholesale (or long-term) financing banks—to the mix. We will now have to wait and see if his successor has the same enthusiasm for a differentiated banking model.

These new categories come in addition to existing myriad forms of cooperative banks, regional rural banks, local area banks, public sector scheduled commercial banks, State Bank of India group of scheduled commercial banks, old-generation private sector banks, new-generation private sector banks, and foreign banks.

Restive signs mark the payments banks space—three companies which received in-principle approval to launch payments banks (Cholamandalam, Tech Mahindra, and Dilip Shanghvi of Sun Pharma) returned their licences stating that the project was not economically feasible. Undeniably, and in true RBI style, the initial architecture is anti-profit and has flaws in it.

The second marquee item is his strict action against non-performing assets (NPAs) that continue to impair bank balance-sheets. This was viewed as his struggle to end Indian-style crony capitalism: large volumes of loans remain unpaid every year and yet defaulting borrowers manage to get fresh loans unfailingly with some help from politicians, bureaucrats, and complicit bankers.

The staggering amount of NPAs is a direct drain on taxpayers, since loss to state-owned bank balance sheets must be compensated with fresh equity infusion by the largest shareholder—government— every year.

Finally, the outgoing governor will be remembered for installing a new monetary policy framework, which uses inflation-targeting as its driving philosophy. It also includes a monetary policy committee comprising three government representatives and three central bankers, with the RBI governor getting the casting vote. This new structure overhauls the old belief that the economy’s fiscal (the government) and monetary policy (central bank) sides should remain out of each other’s hair.

While the government has been uncomfortable with Rajan’s public comments about governance and broader political economy trends—saying that central bankers should not interfere with the fiscal side—it has not shown the same restraint when trying to influence monetary policy.

It will have to be seen how future central bankers and monetary historians view Rajan’s acquiescence to large government presence in monetary policy making.

The article first appeared in www.qz.com/india and can also be read here.

Don't Bank On It

Decoding Raghuram Rajan's antipathy towards industrial conglomerates.

Finally, India is on its way to hosting a differentiated set of banks, each of which will perform a set of pre-determined functions. Central bank Reserve Bank of India (RBI) granted in-principle approval on September 16 to 10 entities for launching a "small bank". In August, it approved 11 institutions for activating "payments banks". In 2014, RBI had granted approval to two private sector organisations for launching "universal banks".

These "in-principle" approvals will be converted into licences after 18 months from grant of approval once the regulator is satisfied that the institution has met all conditions.

So far, so good. But a few issues need clarity.

One, different bank categories already exist in the system — cooperative banks (there are five kinds under this head), local area banks and regional rural banks. Add to that the universal banks which can broadly be slotted under four heads, according to ownership — State Bank of India and its associate banks, public sector banks, old generation private banks, new generation private banks and, finally, foreign banks. So, while competition is good, is it still unclear how the new banks will make any dent.

Let me explain.

Let's start with the payments banks. According to RBI's guidelines, these banks can only accept deposits, provide remittance services, issue ATM/debit cards (not credit cards), act as a business correspondent of another universal bank, distribute third-party investment products (another company's mutual fund, insurance or pension fund products), among other things. But there's one big difference: payments banks cannot lend. On top of which, they have to invest 75 per cent of their deposits in government securities or treasury bills with a maximum maturity of one year, and the balance 25 per cent in fixed deposits or current account of another scheduled commercial bank.

This brings us to the second point: The pathway to a respectable rate of return for payments banks seems ridden with multiple potholes. As per the guidelines, payments banks have four key areas of business opportunity, all of which yield fee-based incomes: fee from remittances, fee from transaction services (such as debit cards), fees from sale of third party investment products, fees for providing business correspondent services.

But given the capital cost, the network roll-out expenses and the cost of managing operational risks, this revenue source might not be enough to provide adequate returns. Or, the volumes that will be required to generate adequate returns might be difficult to achieve. Plus, given the demographic profile of a payments bank's core constituency, ticket sizes are likely to be small and perhaps misaligned with acquisition costs. This is despite use of technology solutions to lower costs.

On top of this, the payments bank will have some genuine dilemmas. One, how does it price deposits? If it's lower than universal banks, it could raise issues of discrimination. Also, if it has to make a spread from investing in gilts, then deposit rates have to be lower than the sovereign yield rates. Will anybody bite at these rates? It will, therefore, have to rely on high-yield fees, such as those paid on sale of insurance or pension products. Some kind of regulatory framework might be necessary here, given the scope for mis-selling.

The telecom operators, though, may have a slight edge. They might be in a position to leverage their network and customer base for remittances and other related services. This not only lowers their acquisition costs immediately but also obviates the need for brick-and-mortar network substantially.

That might explain why Aditya Birla Nuvo (Idea Telecom), Reliance Industries Ltd (Jio), Airtel M Commerce Services Ltd and Vodafone m-pesa Ltd have got an approval for launching payments banks. The other interesting candidate is individual Vijay Shekhar Sharma, who started popular mobile wallet company Paytm. Aditya Birla Nuvo is the holding company for the AV Birla Group's financial and telecom services. Reliance, on the other hand, has tied up with India's largest bank State Bank of India, apart from launching its nation-wide 4G telecom network Jio.

Many large corporates had earlier expressed a desire to obtain universal banking licences, but were quietly discouraged by RBI. Many large business houses owned banks pre-nationalisation and, for some of them, obtaining a banking licence is like re-acquiring a business that was snatched away. But, the payments bank guidelines do not spell out a clear migration path to universal banking.

On the other hand, the guidelines for small banks do have a clear transition route, which includes a five-year track record as a small bank. But, here's the rub: the guidelines also say, "…proposals from large public sector entities and industrial and business houses, including from NBFCs promoted by them, will not be entertained."

So, this is the third leg of RBI's bank licensing process: keeping corporates out of banking, specifically the lending business, through an elaborate route.

RBI allows small banks to migrate to universal banks, but precludes industry houses from applying for small banks. It lets corporates apply for payments banks, but locks the door leading to universal banking. Even among payment bank applicants, companies or industrial groups which did not have a clear advantage in payments banking — such as Kalpataru Corporation or Videocon d2h Ltd — were not considered.

In its press release announcing names of successful applicants for small banks, RBI stated: "…the Reserve Bank intends to use the learning from this licensing round to appropriately revise the Guidelines and move to giving licences more regularly, that is, virtually 'on tap'." It's still unclear whether on-tap licensing is only for small banks or will be extended to universal banks also, and whether there will be some thawing in RBI's antipathy towards industrial conglomerates.

We might have to first wait for the NPA tide to ebb before RBI warms up to the idea of banks launched by industrial houses.

Originally published in Outlook magazine (http://www.outlookindia.com/article/dont-bank-on-it/295433#comments) under column "Man About Mumbai"