Had it not been for the perverse incentive structures of US banking system that led to the financial crisis, this issue would not been so critically taken by the NRB. The US crisis has shown that the market is not self correcting and complete unfettered market does not work efficiently on its own. To the high priest of deregulation like Alan Greenspan this fallout was a slap on their face. Yet, if we infer that the financial crisis was a result of less regulation rather than inappropriate regulations, it could lead to further mistakes.
There are lessons to be learnt from the US crisis but not all of them have relevance to Nepali banking system. First, we need to understand that there is a fundamental difference between the banking model that existed in US and that of Nepal. The originate-to-sell model (in US) and the hosts of innovative banking products like Securitization, Collateralized Debt Obligation (or CLOs) meant that the banks did not have to face the consequences if any loan went bad. This is the problem of moral hazard which does not exist in our banks as a systemic risk. If a loan goes bad, the lending bank has to pick the losses which were not the case for the American banks. The Basel accord of capital requirement was faulty as it provided incentives to push the lending out of the bank’s balance sheet. Similarly, mark-to-market valuation method contributed in exacerbating the crisis. There is substantial evidence that regulatory and policy mistakes have contributed to roller coasting of the financial crisis and for those reasons new regulations have to be seriously attended to before being implemented.
By generalizing the causes of crisis and attempts to impose one-size-fits-all regulations could further increase the vulnerability of a financial system. Common capital adequacy rules, encouraging homogeneity in pricing risks, inappropriate incentive structure can potentially lead to higher level of risk. The banking products are becoming more sophisticated and tailor made and with this price comparison becomes difficult and standardized pricing of a fixed spread may not work. For example, a structured trade finance product (or a lending against contractual receivables) will be priced at a lesser spread than regular trade financing.
The increase in competition amongst the commercial banks may mean that a bank can come up with strategies to cater to tier II or tier III customers and earn higher interest rate on their assets but they could continue to strive for a cheaper deposits. Such a strategy seems perfectly plausible. Instead of capping the salary of a CEO, the policy should see that the incentive structure of a CEO’s salary do not encourage excessive risk taking and short sighted behavior. Instead of fixing a spread (which is against the free competitive spirit), it should be seen that banks which have strategically (or otherwise) taken ‘higher’ risks are required to have more capital and a better risk management framework. The American banks were actively engaged in hiding the risk they were taking by resorting to new innovative solutions by use of technology and computer aided risk modeling techniques. The regulatory system has to be designed to tackle the use of technology in managing (read hiding) risks and ensure complete and effective transparency.
In the last one decade, Nepali banks have made lots of money and that has been a cause of much concern and discussion. Are banks profiting at the cost of other sectors? The answer is partly yes and the fault also lies in the non-banking sectors that have, to a large extent, failed to benefit from the capital market. For reasons that need not be discussed, the private sector ( barring few names) have not been able to tap the capital market as efficiently as the financial institutions and thus have to resort to banks to borrow money allowing them to make more money. So, how can the banks be punished for their efficiency? The government owned banks (including the Nepal Bank Limited) charge less fees, so by all economic logics people should have rushed to these banks.
By generalizing the causes of crisis and attempts to impose one-size-fits-all regulations could further increase the vulnerability of a financial system. Perhaps what we need is a regulation that can inculcate good banking behavior and sound governance structure that can enhance the financial system to better serve the economy the way it is supposed to.
On the other hand, the public sector banks have provided better service and thus charge a premium for it. It’s a cost that is required to be paid. And if it is believed that the government banks (NBL/ Rastriya Banijya Bank) are cheaper, we should remind ourselves of the cost that we as tax payers are paying for the recapitalization of these banks. Under the various programs NRB has spent millions of rupees in getting these two banks out of the water. Who is paying for these? In some way or other, it is the tax payers’ money that is going into these banks. That is a huge cost that citizens of this country are paying and it is amazing that there is more concern about the high charges of the public sector banks than the largess that is being poured in resuscitating these two banks. NBL and RBB were too large and too sensitive to have been allowed to fail. That itself was the failure on the part of the central bank. In such a context, the emergence of the new banks has only helped the central bank to mitigate this too-big-to-fail risk.
And as long as NBL and RBB know that they will be saved under distress scenario and government will bear the consequences of their mistake, they will continue to do a poor lending job – a typical case of moral hazard. It can be recalled that many critics in the US suggested instead of bailing out the big banks, opening new banks with the same money would have probably added much to the economy. Thus, the question that ensues is do we want a financial system to emerge which will be less competitive, less efficient and vulnerable to bad banking practice? From that perspective, perhaps less regulation would be better than bad regulation. While the spirit of the new NRB regulation is welcome, it will be a challenge to see that it will bring a desired result.
History has proven that capping and limiting pricing will have less impact and probably does more harm than good. In respect to the US crisis, Joseph Stiglitz, the Nobel Prize winning economist said, “The ingenuity of a man knows no bounds and whatever system we design, there will be those who will figure out how to circumvent the regulations and rules put in place to protect the system.” Perhaps what we need is a regulation that can inculcate good banking behavior and sound governance structure that can enhance the financial system to better serve the economy the way it is supposed to.
Michael.Siddhi@bmibank.com
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