April 22, 2015

Here are two recommendations to Raghuram Rajan on how to get India’s banks to become functional banks

Sir, I refer to David Keohane’s and James Crabtree’s “India’s central bank struggles to ensure lenders pass on interest rate cuts” April 22.

There are references to a “broken down process of monetary transmission through which the wishes of the central bank are transmitted to the real economy”, and to “a banking system frozen by high rates of bad loans”.

The following is what I would advice Raghuram Rajan to do, if he really wanted banks to become functional financing efficiently the real economy.

First, get rid of stupid Basel bank regulations that, with their different equity requirements based on credit risks, so distort the allocation of bank credit. These introduce a regulatory risk-aversion that has no place anywhere, but much less in a developing country, since risk-taking is the oxygen of any development. In its place put for instance an 8 percent equity requirement on all bank assets, and throw out forever, the portfolio invariant credit-risk equity requirements. Of course that could create a big need for fresh bank equity, and so…

Second, in order to take away the dead weight caused by the bad loans, and to help to fill any new bank equity needs, the central banks should proceed like Chile did during its financial crisis. Namely capitalizing all the banks by purchasing their non-performing loans, against the commitment by the banks to repurchase these assets from the central bank with their retained earnings, before any substantial dividend payments to their shareholders could be made.

You would then have well capitalized banks, ready to give credit on non distorted terms to for instance “risky” SMEs and entrepreneurs, and simultaneously been made so much safer that, presumably, they would have to pay less interest rates to depositors, and in the medium or long terms less dividends to shareholders. Not bad for a couple of hours work eh?