Reserve Bank of India’s former governor Dr Duvvuri Subbarao recently visited Nepal. Siromani Dhungana and Hom Nath Gaire of the New Business Age caught up with him and discussed a range of issues, including inflation, banking sector, role of central banks among others. Along with that, he shared his efforts in restarting India's growth engine, in fighting persistent inflation during his tenure and underlined the need of meticulously formulating monetary policies to avert crisis in the banking sector. Excerpt:

 

Could you please shed some light on the concept of Banking Boring? How is it relevant in the present context?   

Noted economist and Nobel Laureate Paul Krugman’s thes is that the way to reform banking is to make it boring once again, is an influential idea that has generated a vigorous debate. He opined that the way to prevent another crisis is to make the banking boring. His simple idea was based on negative correlation between banking supremacy and economic activities. However, he was not the only economist to speak about making banking boring. 

 

Krugman actually divided the global economy period into three phases in terms of regulation and deregulation of the banking industry. The first phase, according to him was before the Great Depression of 1930s, the second phase, was after the world War-II, up until the 1980s and the third phase started since the financial liberalization and interest rate deregulation of the1980s.

 

The banking sector flourished and was the lucrative choice of intelligent people during the first phase. However, during the second phase the entire banking sector faced problems and tight regulation. This was the era of pragmatic regulation and as a result of that entire banking business turned to be a boring one. The third phase began in the 1980s marked with gradual liberalization and deregulation. Banks enjoyed freedom to operate as they wanted and once again, the banking sector became lucrative. 

 

In the post global financial crisis, the latest one, debate started on whether the banks caused that crisis and if the ultimate solution to it is to make banking boring.

 

How do you analyse the post crisis banking reform, especially related to developing countries like India and Nepal? 

There are five major questions about banking reform, which are interesting to analyse. First, what were the problems with the banking system that caused the crisis? Second, is making banking boring an appropriate remedy for banking industry problems? Third, what are the lessons from the crisis for the global banking sector? Fourth, is the post crisis reform moving in the direction of making banking boring? The last, why is banking going to be not boring but, in fact, exciting and challenging in poor and developing countries like India and Nepal? These all questions should be meticulously analysed to understand the prospects and challenges of banking reform from the perspectives of individual countries. 

 

Did the banking sector cause the latest financial crisis? If so, what were the problems within the banking system that caused the crisis?

Definitely, banking complexity was one of the causes of global financial crisis. Especially sub-prime mortgage financing of US banking system was the principle cause. Five major maladies led the crisis in banking system. 

 

The first malady was ideological shift towards loosening regulation. The second was globalization of banks. Banks expanded their services across national boundaries and consequently risk management became complex. Banks were unable to assess the real risk of banking sector across national boundaries. Similarly, the third ill was proliferation of the shadow-banking sector. The shadow-banking sector, even in advanced economies, affected the formal banking sector adversely. The transactions of non-bank financial institutions actually transferred risk to the formal banking sector. Another problem with the banking system was too big, too complex, and too imperative to fail institutions. Because of tight regulation and globalization coupled with shadow banking, the entire banking sector became very sophisticated. Finally, it was the incentive and compensation structure of the banking sector that triggered the crisis. Therefore, we can attribute the perverse incentive structures for banks and bankers as a problem. The incentive structure should be such that the management of banks should not be worried about their career in the long term. 

 

So, is making banking boring an appropriate remedy for the problems within the banking business?

My opinion is no. Narrow banking and boring banking sound quite romantic now. However, it is not an appropriate response in advanced economies, much less in developing countries like India and Nepal. Narrow or boring banking is a term coined during 1950s and 1960s and the situation was entirely different back then. Banks were not globalized as they are now. Hence, making banking boring is not an appropriate measure for banking reforms. You cannot say the whole problem is due to large banks. Second, it is not fair to blame failure of economy on banking sector. There are so many other problems too. It is not appropriate solution especially in emerging economies like ours. 

 

What are the lessons from the financial crisis for the banking sector?

There are some lessons from global financial crisis for the banking sector. First, financial stability is more important than we realize. Financial stability should be for the sake of economic growth and development initiatives. Second, price stability and macroeconomic stability do not guarantee financial stability. The central bank’s focus only on price stability and macroeconomic stability cannot ensure financial stability. Another interesting fact is that no country is an island today.  Rather all are interconnected to each other by one or another means of finance. Similarly, another lesson we learn from the global financial crisis is that the financial markets are not self-correcting.

 

We all know that one of the fundamental aspects is matching between demand and supply. If there is too much supply of any product, the price sharply goes down. The global financial market also operates in the same way. It is difficult to detect, in real time, pressures building up in financial systems. A collection of rational financial institutions does not necessarily result in a rational financial system. 

 

What can be the way out banking is not to be made boring? 

The way out is making banking responsible but not boring. Instead of making banking boring, the focus of the regulations must be on the shadow banking sector. Non-banking financial sector should also be regulated. One of the reasons for the banking crisis in advanced economies was unregulated non-banking financial sector. So, we need standardization and more transparency not only in the banking system but also in non-banking financial sectors. For this, we should have an effective regulatory architecture. 

 

What is your idea in promoting financial inclusion in developing countries like India and Nepal?

The banking system should adopt the principle of financial inclusion. There should be efficiency improvement and infrastructure financing. Further, banks should have risk management approach to avert crisis. Inclusive financial system increases access to banking system-- bank accounts and other banking products to more people. All bankers, the regulator and other stakeholders should be keeping a question in their mind and that is: why banking should be inclusive? The answer is clear, it creates more opportunities and space of expanding our services. 

 

Banking sector has many challenges and it should be considered that banking is not only about opportunities but also about obligation. Banks and bankers in developing countries have a historic challenge and opportunity of contributing to poverty reduction. Banking is going to be exciting, challenging and opportunity fulfilling, but making banking boring cannot be the way ahead for this.