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Tuesday, Jul 27, 2004

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Treading the beaten path

N.S. Vageesh
Suresh Krishnamurthy

Chennai , July 26

DR Y.V. REDDY can be accused of prescience.

Look at the speech "Reviving confidence in the Indian economy" given by him at the first Dr S. Radhakrishnan Memorial Lecture sponsored by University Grants Commission and organised by the University of Hyderabad, at Hyderabad on September 5, 2001. "In regard to private sector banks including cooperatives, vulnerability of some of them is no longer an impossible contingency... . In case it is assessed by the regulator that a bank is insolvent... the logical requirement would be liquidation unless a serious contagion resulting in systemic risk is anticipated. A prompt liquidation operation, whenever warranted by these considerations would ensure two aspects. First, retail or small depositors up to Rs 1 lakh would be able to recover their deposits quickly (perhaps in matter of days) and secondly, depositors with over Rs 1 lakh deposits would need to book losses. In India, very often, in case of such banks, for a variety of reasons, a softer approach is taken and, sometimes, legal hurdles are faced. It is possible to argue that this soft approach has resulted in a typical situation of moral hazard when the management tends to become inefficient and depositors do not exercise adequate prudence."

Having clearly enunciated the principle to be followed in the case of insolvent banks, Dr Reddy has now chosen to follow the beaten path of announcing a moratorium followed by a merger with another public sector bank. This move protects depositors who have invested more than Rs 1 lakh too. As Dr Reddy admits, moral hazard is a live possibility in such situations. What incentive is there for good governance, when bank managements know the regulator will bail them out? And why would depositors exercise any caution, when they know the RBI holds their interests paramount. Should RBI focus so much on their safety sometimes to the detriment of shareholders?

Ask Dr S. Narayan, Former Finance Secretary and former Economic Advisor to the Prime Minister, and he says, "Given the kind of constraints in our banking system, I would agree with what the RBI has done in this particular issue. Depositors interests have to be protected first, especially in this case, given the track record of the promoters."

Dr Subir Gokarn, Chief Economist, CRISIL, however, says that there is clearly a moral hazard issue in this case although he says that he is not aware of the background and motivations in this particular issue. He adds that as a statement of principle, any deposit amount in excess of Rs 1 lakh should not be protected. According to Dr Gokarn, bailouts have to be avoided as far as possible and the present move does go against such a principle.

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Treading the beaten path

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