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'When an institution believes its knowledge and capability is superior to everyone, it behaves like a frog in the well.'
'And this is precisely the cause for the mess,' says J N Gupta.
Illustration: Dominic Xavier/Rediff.com
For most Indians, the Reserve Bank of India until a few years ago stood for prudence, success, and responsibility.
It was an institution that Indians were proud of.
Its policies and strong regulation insulated India from the 2008 financial crisis.
The way it managed balance of payments and currency rates was certainly fit to be used as case studies in leading management institutes.
However, of late, unfortunately, the RBI does not instil the same confidence.
The sheen from the RBI's unquestionable reputation has worn off.
A series of events in the last couple of years tell a story of colossal failure of the institution -- unable to change with the times and living off its 84-year legacy.
For the first time, the RBI's name was dragged into a chargesheet filed by the Serious Frauds Investigation Office in cases related to IL&FS.
The Supreme Court of India struck down its circular and also threatened it with contempt.
Not only that, questions are being raised all around on various regulatory and supervisory failures of the RBI.
The case of the Punjab and Maharashtra Co-operative Bank has added to its woes.
Clearly, these are testing times for an institution, which has 84 years of nearly unblemished track record.
While diehard supporters of the institution would brush aside present criticism, the fact is that such overconfidence that the RBI can do no wrong or fail in its duties is the cause behind its recent failures.
When an institution believes that its knowledge and capability is superior to everyone, that it is omniscient, it behaves like a frog in the well.
And this is precisely the cause for the mess.
Unlike other regulators, it doesn't believe in consultation with stakeholders, disclosures and transparency. It doesn't like to be questioned.
Regulated entities have no option but to say 'yes sir'.
The RBI's success in managing monetary policy as well as exchange rates is in contrast to its failure in regulating and supervising banks and other financial institutions, including NBFCs and co-operative banks, where it has failed miserably.
The RBI may pin the blame on a host of reasons for all the mess, but can't give itself a clean chit.
It seems that the RBI can't see any wrong within itself and, therefore, it fails to see wrong elsewhere as well.
Failures results in irreparable damage.
Post-mortem is good only to fix responsibility and avoid future problems.
The NPA mess
The monster of NPA, threatened the entire banking sector, derailed the economy and caused widespread losses to investors.
Thankfully, depositors did not suffer, courtesy the government's support to public sector banks as no government can ever survive sitting over a bank failure.
The question is: Did the monster grew overnight? If not, why the RBI did not stem the problem in the initial stage itself?
The reason is simple: Although the RBI has many laws and procedures and tons and tons of reporting requirement, unfortunately, data without adequate processing is of no use.
The banks may have had commercial reasons or motivation to hide the NPA problem or carry out imprudent lending, but what stopped the RBI in nipping the problem in the bud?
How companies were supported by banks with unmanageable debt-equity ratios and weak financials?
The conclusion is that there was weak supervision and lack of effective tools to supervise.
Assets liability mismatch
While the present crisis in the NBFC sector can be partly attributed to management issues, the bigger villain is asset liability management (ALM) profile mismatch.
One needs to travel back three decades, when most of the projects financed by banks and NBFCs had payback period of 7-10 years at the most.
Banks and lending institutions were mostly allowed to lend for a maximum seven years, with initial grace period and some leeway.
Correspondingly, banks could raise deposits for up to 10 years.
Thus, there was scope as well as discipline to manage ALM.
However, no economy can be standing still. Over a period of time, profile of projects and players changed.
It was no longer a monopoly of the government to own and operate infrastructure projects and project life cycle leapfrogged from 7 to 10 years to 15 to 50 years.
With no corresponding major change in supply side maturity profile, with no scope to manage ALM, discipline was confined to dictionary and banking prudence was no more in fashion.
When the RBI did not raise red flags on ALM profile, the maturity profile of liability side became shorter and shorter.
Lenders managed liquidity by frequent roll-overs.
Loan arrangers were a new class of intermediaries, who managed ALM by mastering the art of roll-over, so much so that long-term infra projects were financed by even three- to six-month commercial paper.
The NBFC industry was in great motion and believed in the first part of Newton's First Law of Motion, which states, 'An object continues to be under the state of uniform motion'. This was a potential time bomb and any trigger in the form of a credit event, would have forced roll-over opportunities to shrink.
The IL&FS case had a contagion effect across the NBFC sector, bringing in play the second part of Newton's first law, 'unless an external force acts on it'.
The problem became acute as most of the lenders were mutual funds and insurance companies, which had to follow numerous prudential investment norms to protect the interest of investors.
Cash credit
India has been following a cash credit-based system of lending. The beauty (or the ugly part) of cash credit system is that, although technically payable on demand, the loan never gets paid back and it keeps increasing.
It is a golden pot which keeps on flowing and continues to meet both personal and business needs of borrowers.
It is an ideal system to hide and prolong detection of any problem, unless the supervision is very strong.
Given the compulsions and culture, banks had no incentive to change -- in this competitive world who wants to lose business?
While the world moved away from cash credit-based financing to cash flow-based financing, Indian banks continued with its archaic system.
Cash credit system was acceptable when the economy was mainly brick-and-mortar.
With businesses becoming global, things really became difficult.
The RBI failed to transform the system in time.
J N Gupta is the founder and managing director of Stakeholders Empowerment Services.
