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A blog on financial markets and their regulation
In the quarter century since economic reforms, India has created a reasonably well functioning equity market, but has failed to create a well functioning banking system. We began the reforms process with a broken banking system, and have come full circle to a broken banking system once again. And no, the mess is not confined to just the public sector banks.
I am reminded of Albert Einstein’s apocryphal remark that insanity consists in doing the same thing over and over again and expecting different results. That leads to the question: what can we do differently. I can think of several things:
We can leverage the equity market to improve the functioning of the bond market. More than a decade ago, I wrote:
“Let me end with a provocative question. Having invented banks first, humanity found it necessary to invent CDOs because they are far more efficient and transparent ways of bundling and trading credit risk. Had we invented CDOs first, would we have ever found it necessary to invent banks?”
For a short time in 2007, when the CDOs had started failing, but the bank failures had not yet begun, I did experience some degree of doubt about this statement. But now I am convinced that banks are simply badly designed CDOs. The global banking regulators seem to agree – much of the post crisis banking reforms (for example, contingent capital, total loss absorbing capital and funeral plans) are simply adapting the best design features of CDOs to banks. The question is why should we make banks more like CDOs when we can simply have real CDOs. In India, the lower tranches of the CDO could trade in our well functioning equity markets, because they offer equity like returns for equity like risks. The senior most tranche would be very much like bank deposits except that they would be backed by much more capital (supporting tranches).
We could encourage the growth of non bank finance companies. Prior to the Global Financial Crisis, GE Capital was perhaps the sixth largest US financial institution by total assets. Even during the crisis, GE Capital perhaps fared better than the banks – it had only a liquidity problem and not a solvency problem. India too could try and create large non deposit taking non bank finance companies (NBFC) with large equity capital. Again NBFCs find it hard to compete against banks with their TBTF bailout subsidies. Neutralizing or rationing these subsidies is one way to let NBFCs grow larger.
I think the time has come to seriously think out of the box to make India less dependent on its non performing banks.