Regulatory Failures And Limited State Capacity: Lessons From The PMC Bank Saga

It is no secret that the Punjab & Maharashtra Co-operative (PMC) Bank episode highlights what has been known — and discussed for long: our limited state capacity!

The entire episode of PMC Bank reflects the level of regulatory oversight and the extent of ignorance of external auditors, who failed to discharge their fiduciary duties.

Luckily, the deposits of all savers are secure, and the Reserve Bank of India (RBI) has relaxed the withdrawal limits first from Rs 1,000 to Rs 10,000 and now to Rs 25,000. Could the RBI handle the situation better? Possibly yes.

But that’s a separate issue altogether and it is subject to a lot of subjective judgement so one can’t really answer it with certainty.

What is certain is that there’s been a regulatory lapse — and this lapse is not the first such lapse. A major reason behind the NPA crisis, apart from growth slowdown, is the lack of a formal system to check the reckless lending practices going on at that time.

Not all such NPAs are instances of fraud. Some of them are genuine and viable projects that are no longer feasible because of a change in the macroeconomic environment.

The big change is to do with the fact that we’re now in a period of low inflation, often under 4 per cent in contrast with the high-inflation period between 2006-2013. This low inflation means low nominal growth but of course, our real interest rates didn’t fall enough to ensure that this macro change was well reflected in the cost of capital.

It is therefore worth highlighting that had our rate cuts been more aggressive — and there were no transmission problems — we may have well seen a smaller number of NPAs.

But beyond interest rates, another instance of lapse was when Yes Bank managed to show a lower level of NPAs to the RBI. The decision to oust the promoter at such a time is also questionable.

If there were problems with respect to the disclosures, then this amounts to a case whereby the RBI should impose severe penalties on the management and the auditors but ousting a promoter at such a time could subject the bank to different kinds of risks.

We’re seeing some of these risks play out in front of us now as depositors, shareholders and stakeholders have little faith left on the management of the bank.

These are macro risks that have been induced by the regulator and they reflect the lack of a cohesive understanding of the second-order effects of its decisions. Their inability to discharge their regulatory duties suggests the limitation in state capacity and its impact on our growth.

This limited state capacity is going to be more problematic as technology evolves thereby making regulation more and more difficult. Going forward, we may need to deploy greater resources and augment technology to ensure effective regulation.

But, more importantly, it is imperative that we fix the likely causes for regulatory lapses and the only way to do it is to tighten the stakeholders by putting in place a predictable punishment mechanism that acts as a deterrent for all stakeholders — regulators, auditors, and management of companies.

The best way to do this would be to consider banking frauds and contract violations as economic crimes that require a specialized, swift judicial mechanism. Therefore, the act of punishment and of regulation must be separated and the regulator must be held accountable for failing to discharge their duties.

The penalties must be financial in nature for the stakeholders involved with some small amount of jail-time for severe offenses. It is important for regulators to be independent, but their independence should not come at the cost of accountability and it is precisely this spirit in which we should consider such a judicial mechanism.

This will also solve the problem associated with inordinate delays when it comes to enforcement of a contract, which is critical for a $5-trillion economy.

The PMC Bank crisis is an opportunity for us to reform our regulatory system and put in place a mechanism to penalize regulatory lapses, thereby disincentivising collusion between regulators, bank management and corporate sectors.

As far as genuine errors are concerned, the system must be flexible enough to forgive genuine mistakes. It is also important to simultaneously put in place a system of incentives for good regulatory performance.

It is important for the regulator to understand that it is not their job to limit the growth of an industry, but they should instead focus on how to further improve its growth. Therefore, a good regulator is one who regulates the least but does so effectively, thereby empowering the players who operate within the sector.

The recent regulatory lapses are an opportunity to fix a system that has been broken for decades.

A combination of three pills is likely to fix our regulatory problems for a long period of time. Therefore, the government must: 1) invest in enhancing the state capacity, 2) separate the adjudication power from the regulator and 3) put in place an incentive structure for better regulatory performance.

All of these three things are long term projects and will take time to materialize but they’re essential for the government’s vision of a rules-based economy.