• PAGE ONE
• INDEX
• HOME

`Vested interests blocking sound financial system'

Dinesh Narayanan

MUMBAI, Dec. 14

IN a paper, `Banks, short-term debt, and financial crises: Theory, policy implications and applications', Prof. Raghuram Rajan, Joseph L. Gidwitz Professor of Finance, University of Chicago and Fischer Black Visiting Professor, MIT, Sloan School of Manag ement, says: ``A banking system can be made absolutely safe only by doing away with the business of banking.''

In a conversation with Business Line, Prof. Rajan explains what that cryptic remark means, besides touching upon other issues surrounding financial systems.

Reproduced here are excerpts from the interview:

How are financial systems around the world recreating themselves, especially in the context of shifting development paradigms?

I would like to phrase the answer to present a slightly broader perspective. There are some questions I have been trying to find answers to such as how are financial systems developing, which way are they developing, and even in developed countries why d o financial systems not cater to the specific needs of the country, wholesale as well as retail. Why, for example, in Germany they did not have a stock market till recently? Why India does not have an adequate system for recovery of credit? Part of my wo rk has been to try answer this question.

The answer I have come up against, time and again, upon analysing countries in depth is that it is not because they are incapable, but there are strong interests that do not want a good financial system to develop. One could argue that there are forces i n this country that do not want an efficient credit system to be in place because that may restrict certain kinds of people from getting credit.

In other countries, there are occasions when the industrialists, once they got where they are after being financed initially, don't really want to face a lot of competition, they don't want a lot of entry. One of the problem with arm's-length financial m arkets, capital as well as debt markets, is that financiers lend to whoever is creditworthy. And, as a result, a lot of competition comes in when you have a vibrant stock market. You find that barriers are still erected and one of the barriers to new ent ry is an underdeveloped financial system.

If you correlate entry restrictions in these nations with the extent to which financial markets have developed there, you see a straight line, a strong correlation. The point, therefore, is that financial under-development is a way of restricting entry.

What has been happening in recent times is that the incentive to keep out domestic entry has been diminishing because there is a greater threat, which is the foreign market. And once you are open to foreign entry it becomes apparent that it is less of an incentive to keep out domestic financial markets. And so you see this explosion in domestic financial markets across countries.

Doesn't such opening up trigger the herd instinct to chase lucrative sectors for financing?

There is certainly some herd instinct on the part of domestic financial institutions. For example, when domestic banks in many countries, find dis-intermediation weaning away their best clients, they lend to stuff which is clearly visible and does not re quire much thought, real estate, for example. When Japan opened up you saw a herding into real estate. The same in Scandinavia.

In India, I think the herding is in securities, instead of lending, because that seems to be the safest thing to do. But eventually, a realisation dawns that such herding is not actually a very safe source for profits. It could be pretty dangerous and de trimental. That is when a financial system actually develops. You start moving out of these easy lending areas into developing ability to assess, evaluate and offer credit to riskier clients.

Talking about risk, aren't risk management tools being increasingly used for leveraging and profit maximisation rather than managing risk?

Yes. that is definitely a concern that tools of risk management are often misused. I think the problem is that the institution that has a risk management programme in place either puts multiple objectives into the programme -- you are supposed to manage risk but you are also supposed to manage profits -- and that is a strict no-no because the guys who manage risk will say ``we are getting compensated for making profits so let's make profits more and manage risk less''. That puts the institution at great risk because it is very easy to take big risk in pursuit of profit.

To that extent it is a problem. But that is more of an aberration. My prescription is, make your risk management function just that -- managing risk. And be specific about what risk you want to manage, thoroughly understand what you are doing and keep it under total control. Don't make profits with your risk management tool and don't tell it to make profits because that is a sure way of losing out to speculation.

In one of your papers you have stated: ``A banking system can be made absolutely safe only by doing away with the business of banking.'' Could you elaborate?

An analogy would probably make the point clear. Many people have written and spoken about the South Asian countries loading up on short-term debt and that it was a bad thing. And some of the international financial institutions were talking about banning short-term debt...putting some sand in the wheels of short-term debt. One should realise short-term debt does not come out of the blue. What I'm trying to say is that short-term finance is used to finance very illiquid or high-risk projects because nobo dy is going to lend long-term against those kind of projects.

Countries that have exhausted their long-term debt raising capacity go for short-term loans. So you see a build-up of short-term debt preceding a crisis. It is not because short-term debt is causing the crisis. It is because there is a loss of confidence in the country and, therefore, there is a build-up of short-term debt. If you prohibit that country from borrowing short-term, it would go bust sooner -- as soon as it runs out of long-term capacity.

A classic example is Korea. In 1980, South Korea had a financial crisis, but it hadn't borrowed too much short-term and so it survived that crisis by borrowing huge amounts short-term. It could not replicate it in 1997 because it had already borrowed a h uge amount short-term.

Similar is the case with banks. Banks can do the function they are supposed to do -- funding illiquid credits precisely because they can borrow short-term.

There have been some arguments about converting financial institutions into narrow institutions because if you want to finance demand deposits you can only hold very liquid securities. And if you want to finance long-term liabilities, only then can you h old these illiquid securities. The argument is that sometimes that mismatch is necessary to ``perform the function of performing''.

You have also talked about restricting banks from entering certain areas. Could you explain which are those?

This whole issue of universal banking, that is a subject of debate in India at the moment, raises the question how does it make sense to club different aspects of banking. One of the concerns is that far too little is made of the fact that many conglomer ates, and a universal bank is a conglomerate, find very few synergies. The dis-synergies or the costs associated with clubbing several businesses together are often much higher than the benefits.

And in the process of universal banking we keep saying one-stop-shop and all that but we don't pause to think whether people want such a one-stop-shop. And, more than that, is the cost of creating that one-stop-shop worth the benefits?

What are your views on free flow of capital?

What we learnt in the past few years is that there is a problem in allowing free flow of capital when your internal systems are inadequate -- you don't have good bankruptcy laws, good disclosure norms, good corporate governance etc.

The problem then, with having investors come in leave at will, is that if there is any sign of trouble, investors are not able to identify where the trouble is and, as a result, they flee before they are left holding the bag and the country is left in th e lurch. If you do not have a transparent and well-defined system of managing everything properly, allowing capital flows to come in is dangerous. You have to first fix the internal systems.

That said, you have to also recognise that the internal system does not fix itself unless there is competition. The domestic banking system is not going to change unless there is an avenue for domestic companies to raise money elsewhere. So we have a chi cken and egg problem here. The internal system would not get fixed if external finance does not come in and you cannot allow external finance without getting the system fixed. I don't know how this policy dilemma can be sorted out but probably some model could be worked out.

Would you favour some restriction on capital movement such as the Tobin tax?

I think that's a bad idea. You're just putting friction in the way of people leaving. And you don't want to put friction, because when push comes to shove, something of a Chile happens. In the crisis of 1998, Chile removed all the capital controls. It ab olished the Tobin tax to attract capital because investors were not coming in due to the level of the tax. I think it is far better to have a healthy financial system. The systems of East Asia were not healthy, they were not transparent. It is a problem of governance rather than the problem of foreign investors.