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The Rediff Business Interview/ Professor R G Rajan

'Punish fraud, not poor business judgement. But India does the opposite'

Professor Raghuram C Rajan, Joseph L Gidwitz Professor of Finance at the Graduate School of Business, the University of Chicago, is also the director of the corporate finance programme of the US National Bureau of Economic Research. A Ph D in finance from the Massachusetts Institute of Technology and an alumnus of the Indian Institute of Management (Ahmedabad), Professor Rajan is on the editorial board of several financial journals and has won awards in the US for his papers on banking, credit, credit policies, liquidity and securities.

Sunita Wadekar-Bhargava interviewed him soon after he addressed a seminar on money organised by Tata Consultancy Services in Bombay recently.

Is the much-harassed Indian banking industry learning anything from the crisis surrounding banks in other Asian countries?

Well, there are two things here.

First, one of the most important factors in the banking crisis in east Asia is macro-economic volatility. So if India can handle that, it will be OK. And it was macro-economic volatility on a number of dimensions, volatility on real estate prices, volatility in foreign exchange and volatility on the fact that they had borrowed externally a huge amount.

So I think if India does not have macro-economic volatility, it won't have a sudden depression in real estate prices and so on, then it will be OK.

India has a problem but that problem is not going to grow suddenly to a dimension where it cannot be resolved.

Second, to some extent, the problem largely exists in the public sector and in the finance companies. And as far as the public sector goes, there is always the government backing. So, yes, the deficit will increase but will the bank sector suffer? Yes, it will suffer because ultimately the tax-payer pays for all the problems in the banking industry.

If the finance companies go under, there I am a little bit more worried because they don't have the backing and it is possible you have runs (on them) and so on. But I think we are dealing slowly with the problems of finance companies.

With the current talk of globalisation and universalisation, how proactive can the government be in the banking industry?

There are two reforms which are overdue and which are really necessary. Venkitaramanan (ex-governor of the RBI) referred to one of them during the seminar. It was the reform of bankruptcy law and the reform of laws on lending.

Take the issue of collateral, whether you can repossess collateral. You have all these funny views that allowing a lender to repossess collateral is actually a bad thing, and it's reversion to the days when a moneylender came (into the picture).

In fact, it's really the opposite: when you allow collateral to be repossessed you enable poor people to borrow. Because now they can borrow against the asset they actually buy. Credit markets explode when you allow for repossession of collateral. We have all these legal impediments, stamp duty impediments. All these have to go. That is where the government can actually help.

You don't have to put money here, (but) change the rules and make the rules work efficiently. It's close to zero-cost way of working it out. But that's one line of attack.

The second line of attack in improving the financial market is the issue of improving corporate transparency and governance. Again the question one has to ask is: we keep complaining about the stock market being moribund and not moving, but what happened to all those people who cheated the public in the early 1990s? Nothing. They still travel around, stay in luxury hotels and so on.

Unless you take action against these people and show to the public that when they invest their money, they don't get cheated, who is going to put money in a new company?

There is no accountability. You need to bring that in. That doesn't involve a huge amount of cost. It involves a fairly careful definition of laws. What you want is the ability to punish fraud and not punish poor business judgement. India has the opposite. We punish poor business judgement through CBI inquiries, this and that, and we let fraud go completely unpunished.

Is that why financial institutions become risk-averse?

Absolutely. But at the same time, too much can be made of this factor that sometimes it becomes an excuse for laziness and not trying to find appropriate credits to lend to.

But there is also much truth to the fact that there is worry. And who is the one doing the worrying? After all, a middle class manager who doesn't have an independent source of wealth is worried about making these loans because he could have the CBI after him, his status quo and his name which is one of the biggest things he has.

So we have to recognise that there is such a thing as business judgement. And we need to change compensation practices such that you pay these guys adequate amounts and also that you withdraw the compensation when they mess up.

The private sector banks have already figured out how much compensation (to give) and it's not enormously out of line with what people get in the public sector. Yes, it may be an order of magnitude twice or thrice over.

The rules of the game are changing slowly in this age of takeovers and mergers. Do you see this happening anytime soon in the Indian industry?

Well, that could bring the good performers down. They force the good performers to take over the bad ones. Japan has been trying to do that and that is a recipe for disaster because the good get dragged down also.

What is needed however is a potential for public sector to be able to sell off its assets. Forget privatisation. It may be premature to talk of privatisation before you have governance. That could be a licence to steal if you have privatisation before adequate governance.

But the ability to sell off assets to the private sector can be very worthwhile because you have the paradox of a number of private sector banks building up new branches and building up new real estate at high cost. While there is over-capacity in the public sector, it has a branch across the street which is doing one-tenth the business.

Why not allow the private sector to take over the public sector branch premises? The ability to sell off and use the proceeds to have voluntary retirement schemes for the PSU employees could be worthwhile. But wouldn't mergers and acquisitions improve the state of things through a process of consolidation and restructuring?

The ability to merge is important but you don't want a merger without adequate governance. That could be a problem. You have these empire-building CEOs who basically want to build huge firms without increasing the profitability and the easiest way to do that is merge. You don't have governance controlling them. So you have huge empires performing miserably. So those two legal reforms are very important and the key to changing the finance sector.

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