Our banks should strike a balance

The perspectives in respect of both central banking and commercial banking have been undergoing significant changes in the post-crisis world.

While no global consensus has been reached through the now influential G-20 forum, broad contours are evident, which can be captured in some sort of a crude and simplified framework.

Strangely, the Western world seems to be veering to India's tradition and practices, which have not undergone any significant or fundamental changes even after its reform of post-1990s.

The Western Framework

Let us first talk about the Western world. After the breakdown of the Bretton Woods system in the early 1970s, the West embarked upon financial liberalisation and deregulation, and the thinking on the role of central banks also underwent a parallel change.

In simple terms, the central banks became purist and commercial banks became more and more non-purist. This requires some elaboration.

We may interpret the purist central bank as one that pursues a single objective, uses a single instrument, and which enjoys operational independence in monetary policy formulation and implementation without, in particular, government's political influence.

Thus, pursuit of price stability as the single or primary objective, with inflation targeting, use of short-term interest rate as a single instrument combined with a committee approach to interest rate setting, came to be regarded as the golden rules for central banks to imbibe. Multilateral institutions, as part of their structural conditionality, incorporated these views strongly while advising country authorities, which were also accepted by many emerging markets as well.

The purist approach to central banking also resulted in the central banks being stripped of supervisory responsibilities by separating supervision from regulation, and the debt management function from monetary management function.

In parallel, the commercial banking operations were liberalised and deregulated. A purist commercial bank can be interpreted to mean a bank that accepts deposits and provides credit, particularly production credit, with prudent cash and liquidity management rules.

A purist commercial bank was not expected to enter into investment business, in particular in equities and real-estate markets, and was prevented from taking speculative positions.

Blurring of the line

The post-Bretton Woods paradigm after deregulation resulted in the blurring of distinction between commercial and investment banking. Supervisory powers over commercial banks became more off-site than on-site, and more macro than micro. This change can be interpreted to mean commercial banking transforming itself from purist into non-purist.

In the post-crisis world, there is a general tendency of reversal of the above trend. Central banks are turning non-purist: multiple objectives incorporating financial stability along with price stability are not shunned, regulation is ideally viewed as optimal if it is combined with supervision in the hands of the central bank, and questions are raised about the wisdom of debt management remaining separated from monetary management.

The central banks were forced to adopt multiple instruments such as the extraordinary and unconventional measures of quantity easing with government support. They do not seem to be as independent as they were prior to the crisis and Treasury's influence and overriding powers have become all-pervasive. In short, central banks are turning into non-purist from purist.

Indian Tradition

In contrast to the above developments in the West, the Indian situation has not radically changed over time, despite several reforms undertaken since the early 1990s.

Fundamentally, the central bank remains non-purist. It has multiple objectives, multiple instruments and does not enjoy operational autonomy of the kind required legally or by convention. The ‘financial stability' objective was added to its arsenal, well ahead of the global financial crisis.

The commercial banking system remains purist in the sense that the scope for commercial banks to extend their operations to speculative investment activities is very limited.

The main reason for this is that India followed a gradualist approach to imbibing Western reforms, particularly in the financial sector. ‘Reforms without disruptions' was the motto all along, though some could interpret this as some form of reform inertia or muddling through the reform process.

One main advantage of this approach has been that India was seen to escape through various crises — which afflicted several emerging markets earlier and the western world in the recent past — without serious damages.

The Way Forward

The way laid for the Western world is not yet clear. Overall, the Western world seems to be veering back to India's tradition — though it is very difficult to say at this stage whether the pendulum will swing again in the reverse direction, once the post-crisis recovery is complete.

As far as India is concerned, as in the past, it has to weigh and balance its approach and adapt practices that suit its environment without any dogmatic ideological stance.

It would seem in general that as India attempts to fall in line with G-20 commitments, it should ensure that enough flexibility is retained to follow policies that are conducive to achieving India's own developmental goals and priorities.

It would be in the fitness of things if the central bank gains more operational autonomy, and the commercial banking system is freed to some extent to enable it to raise additional capital that would be required and leverage its operations more flexibly for better integration with global markets.

(The author is Director, EPW Research Foundation. The views are personal. >blfeedback@thehindu.co.in )

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