Remembering, praising Dr Reddy and financial sector reforms

Blogs and media is talking a lot about this piece from Joe Nocera from NYT. Nocera tries to answer this question- How India Avoided a Crisis?

My hope in traveling to Mumbai was to learn about the current state of Indian business in the wake of both the credit crisis and the attacks. But in my first few days in this grand, sprawling, chaotic city, what I mainly heard, especially talking to bankers, was about America, not India. How could we have brought so much trouble on ourselves, and the rest of the world, by acting in such an obviously foolhardy manner?

The author visits some Senior Indian bankers and says the most important factor was RBI’s previous Governor – Dr Reddy:

But there was also another factor, perhaps the most important of all. India had a bank regulator who was the anti-Greenspan. His name was Dr. Y. V. Reddy, and he was the governor of the Reserve Bank of India. Seventy percent of the banking system in India is nationalized, so a strong regulator is critical, since any banking scandal amounts to a national political scandal as well. And in the irascible Mr. Reddy, who took office in 2003 and stepped down this past September, it had exactly the right man in the right job at the right time.

“He basically believed that if bankers were given the opportunity to sin, they would sin,” said one banker who asked not to be named because, well, there’s not much percentage in getting on the wrong side of the Reserve Bank of India. For all the bankers’ talk about their higher lending standards, the truth is that Mr. Reddy made them even more stringent during the bubble.

Unlike Alan Greenspan, who didn’t believe it was his job to even point out bubbles, much less try to deflate them, Mr. Reddy saw his job as making sure Indian banks did not get too caught up in the bubble mentality. About two years ago, he started sensing that real estate, in particular, had entered bubble territory. One of the first moves he made was to ban the use of bank loans for the purchase of raw land, which was skyrocketing. Only when the developer was about to commence building could the bank get involved — and then only to make construction loans.

Then, as securitizations and derivatives gained increasing prominence in the world’s financial system, the Reserve Bank of India sharply curtailed their use in the country. When Mr. Reddy saw American banks setting up off-balance-sheet vehicles to hide debt, he essentially banned them in India…..

Seeing inflation on the horizon, Mr. Reddy pushed interest rates up to more than 20 percent, which of course dampened the housing frenzy. He increased risk weightings on commercial buildings and shopping mall construction, doubling the amount of capital banks were required to hold in reserve in case things went awry. He made banks put aside extra capital for every loan they made. In effect, Mr. Reddy was creating liquidity even before there was a global liquidity crisis.

Incidentally, I had written about similar RBI moves (an updated paper here) to minimise bank lending to real estate in Dec 2007. However, it was in a different context as in this paper I argued it is important that Central banks look at asset prices and prevent bubbles(atleast minimise their fallout). I used above highlighted policies to show how RBI was managing asset prices in monetary policy (it is also called leaning against the wind policy).

Coming back to the article, I was actually looking whether bankers liked RBI’s policies then:

Did India’s bankers stand up to applaud Mr. Reddy as he was making these moves? Of course not. They were naturally furious, just as American bankers would have been if Mr. Greenspan had been more active. Their regulator was holding them back, constraining their growth! Mr. Parekh told me that while he had been saying for some time that Indian real estate was in bubble territory, he was still unhappy with the rules imposed by Mr. Reddy. “We were critical of the central bank,” he said. “We thought these were harsh measures.”

For a while we were wondering if we were missing out on something,” said Ms. Kochhar of Icici. Banks in the United States seemed to have come up with some magical new formula for making money: make loans that required no down payment and little in the way of verification — and post instant, short-term, profits.

As Luis Miranda, who runs a private equity firm devoted to developing India’s infrastructure, put it: “We kept wondering if they had figured out something that we were too dense to figure out. It looked like they were smart and we were stupid.” Instead, India was the smart one, and we were the stupid ones.

Ms. Kochhar said that the underlying risks of having “a majority of loans not owned by the people who originated them” was not apparent during the bubble. Now that those risks have been made painfully clear, every banker in India realizes that Mr. Reddy did the right thing by limiting securitizations. “At times like this, you tend to appreciate what he did more than we did at the time,” said Mr. Kapoor. “He saved us,” added Mr. Parekh.

Thank god for this honesty. I was actually thinking most would say we knew it is a bubble and appreciated RBI’s stance etc. The reality was no one liked RBI and its stance on financial sector. Then it was fashionable to talk about financial innovation, modern finance, scaling up finance, unleashing financial sector reforms (and more of jazz words) etc etc. I am actually wondering what experts who criticised RBI then have to say now? ( I have actually read the “then critics” change their stance towards some other issues)

Actually all this must be  deja-vu for Dr. Reddy. RBI was praised highly even in 1997 when Asian Crisis hit all and India escaped. I remember reading tons of literature which praised RBI for not opening Indian financial sector and  foreign capital account; thus minimising the fallouts of the crisis. And here we go again. It is much the same story and this time we have been impacted more because of more liberalisation since that period. I can’t even think of the scenario if we had implemented any of those fancy reforms. Again am not against liberalisation but these are just facts.

There are a couple of thoughts that come to my mind looking at the developments. One, financial sector always loves Greenspan theories in times of growth and loves Dr Reddy’s theories in times of crisis. This is applicable vice-versa was well. Which is the right approach? With Greenspan agreeingthat he overestimated that private sector can manage its ills on its own, the seesaw seems to have tilted in Dr Reddy’s favor.

Second thought is more perplexing. The economists that favor extensive financial sector reforms (I still have to figure what that means though) often say countries that go for extensive financial sector reforms grow much faster (the comparison is usually given between Korea and India). The financial crisis would also effect them more but the benefits (high growth) is worth the costs (crisis). Hence, it is always better to as they say unleash financial sector. Will this crisis change the way we perceive things?

Third thought is economists often complain that people have short memories. This applies to economists as well. I am sure after the crisis is over, the same ideas would gain momentum again – financial innovation, modern finance, scaling up finance, unleashing financial sector reforms etc etc. This would make my second thought irrelevant for time-being.

Fourth, I think somewhere down the line we miss the fact that financial sector is much more abstract and complex then we think it to be. It requires a lot of other things in place (legal system, governance, statistics system etc) and there is no way we can have all of them together. Then apart from finance we need reforms in doing business as well. It has to be a part of ongoing reforms (not a laundry list though) and not an exclusivity.

Fifth, we don’t know how people take on risks – are they risk averse or risk lovers? In theories we are always taught man is risk averse, but reality is quite different. Reading through this crisis and others, he seems to be a risk lover and this differs across economies.  In some he may be loving risk much more than others. However, what we get is similar sorts of suggested reforms across economies. The places where people love risk more should have a more stringent financial regulatory system. I know it is difficult to assess risks across economies but then we could be considerate with reforms as well.

Overall, financial sector reforms have benefits but have costs as well. What is frustrating is most reform reports overstate the former and ignore (at most just a casual mention) the latter. It will be great if it is given a holistic perspective (if possible have a behavioral economist in the reform team as well).


6 Responses to “Remembering, praising Dr Reddy and financial sector reforms”

  1. Shanu Says:

    Read your blog.Liked it.Here is mine.Kindly read and post comments.

  2. Prashant Says:

    It was gratifying to note that the performance of the prev. governor has come in for praise. If the memory serves well, during the last two years of Dr. Reddy’s term, certain cabal of columnists (Ajay shah, Ila patnaik to name a few) who champion the so called ‘financial innovation’ were so critical of the conservative ways of Dr. Reddy that pink papers were full of their derisive articles insinuating that regulatory ignorance and inertia are masquerading as conservatism especially in not giving free rein to securitisation and credit derivatives in India. It was nice to hear deafening silence from them in the aftermath of subprime crisis!!!

  3. War on VAR « Mostly Economics Says:

    […] The discussion starts with this article from Joe Nocera on VAR. (BTW, Nocera created quite a storm with his articlepraising Dr Reddy). The article was criticised by Yves Smith of Naked  Capitalism Blog calling it […]

  4. Would crisis have been mitigated if Yuan was free float? « Mostly Economics Says:

    […] it they need to come up with better arguments and better research to support their views.  As I said earlier, RBI’s approach is always appreciated in these times of crisis. I still do not understand […]

  5. A look at dynamic provisioning in Spanish Banks « Mostly Economics Says:

    […] was also not liked by the banking industry then. However, bankers ended praising  Dr Reddy as global crisis hit Indian […]

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    […] the critiques like it or not, RBI has fared much better in this crisis (which is usually the case with RBI). I have been reading a lot of speeches of many central bankers and am surprised by the amount of […]

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