The Web


 Latest Business news on mobile: sms BIZ to 7333

Home > Business > Business Headline > Report

The age of intermediation

Subir Gokarn | July 21, 2003 14:05 IST

The change of governorship of the Reserve Bank of India takes place at a rather confusing time for the Indian economy. Dr Jalan took office over five years ago when the Asian crisis was playing itself out.

Managing the impact of that crisis on the Indian economy took obvious priority. Looking back over the five years, the critical change in monetary management is that it has become a 24x7 exercise, driven by the compulsions of the global economy, rather than a set domestic timetable.

This is an important transformation, which has significantly improved the economy's capability to deal with international turbulence.

Having dealt with the problem of short-term uncertainty and volatility, Dr, Reddy's attention will undoubtedly be on longer-term concerns. Macroeconomic stability is clearly hardly an end in itself.

The main reason why it has become so much of a priority with central banks in developing countries is that it is viewed as a facilitator of the growth process. Cross-country evidence for the post World War II period shows that low and stable inflation, which implies conservative monetary management, characterises countries that have had superior growth performance.

The main reason for this appears to be the impact that stability has on expectations about the business environment and, through this, on investment. If an economy is investing and doing so in the right sectors, it cannot but grow.

Unfortunately, the last several years have been a period of investment drought in the Indian economy. Stability, for a variety of reasons, is not stimulating desirable levels of investment.

In India, one could argue, inflation control has positive welfare impacts because the majority of households do not have their incomes even partially indexed to inflation. Persistent inflation therefore worsens the income distribution.

However, as important a consideration as this is, it does not override the basic question. Having achieved macroeconomic stability, what more needs to be done to translate it into growth? And, what is the role of the central bank in this?

The answer to the first question has been debated widely. There is widely held opinion that pushing ahead with the second-generation reform agenda is necessary to get the investment ball rolling again on a sustainable basis.

Much of this agenda is clearly outside the domain of the central bank and all it can do as an institution is to keep emphasising the criticality of implementing the reforms. But, there is one element, on which it does have some influence. The ultimate impact of change in this area might be diluted by the stasis on other reforms, but that is no reason not to move on this front.

Investment activity has both demand and supply dimensions. The demand for investment funds is clearly driven by the overall business climate and the impact that it has on expectations. Macroeconomic stability plays an important role here.

The supply of funds is determined by the overall efficiency of the financial system. How good is it at intermediating between people who have money and people who have ideas? The efficiency of intermediation is, in turn, dependent on two factors.

The first is the structure of the financial sector itself. The more competitive it is, the more responsive to the changing profile of activities in the economy, the more effectively it will identify and finance good ideas. The second is the extent to which prudential regulation constrains lending activity.

The current state of financial intermediation in India can be viewed as a dilemma from the point of view of the central bank. The sector that is prudentially sound -- commercial banking -- because it is in the process of complying to a globally accepted set of norms, is relatively inefficient.

New private players and actively restructuring public sector banks are certainly taking the sector to higher levels of efficiency, but, at the end of the day, they do not seem to offer business borrowers an acceptable value-for-money proposition.

More so, as the sector moves towards universal banking, both long-term and short-term financial services are affected by the same cost factors. At the end of the day, individuals and the government are the only borrowers who seem to be able to afford what this sector has to offer. That raises the question: are these categories of borrowers getting the best deal?

On the other hand, the sector that can potentially play a very significant role in providing the growth stimulus -- the cooperative bank/NBFC sector -- is highly competitive but simply too weak prudentially to carry the burden.

Its role is significant because it is small, localised and nimble. It can spot emerging business opportunities far more quickly because it operates closer to the marketplace. It can screen borrowers more effectively because it has better access to local information.

It can tap into small pools of depositors that large banks would find simply too costly. But, it is a prudential nightmare, subject to all kinds of moral hazard problems, which limits its ability to mobilise funds.

To initiate a virtuous financing-investment-growth circle, what is ideally needed is a hybrid between the two sectors. The prudential strength of the commercial banking sector needs to be combined with the information advantages of the smaller, more localised institutions. Is this feasible, even possible?

One can think of a number of arrangements, which meet this objective. Here is an example. The strength of commercial banks is in deposit mobilisation (subject to some minimum scale of operation).

Their prudential management makes them relatively safe from the depositor's perspective. At least some of these resources could presumably be channelised to borrowers who are identified and screened by localised institutions, which specialise in lending.

To the extent that a single, large commercial bank is simultaneously lending to a number of 'loan producers', it is spreading its risks in keeping with its prudential requirements. The financial arrangement between the depository institution and the loan producer could be a direct loan, or it could be in the form of tradable loan-backed securities.

Needless to say, whatever the arrangement, each link of the chain between the depositor and the borrower would need appropriate prudential regulation and monitoring.

But, a series of institutions, which have relatively narrow areas of activity, may be easier to monitor than the same number of institutions engaged in virtually every kind of transaction.

The bottom line is that a desirable structure will be the one, which generates the lowest average cost of intermediation for a given level of safety (or equivalently, costs the least to regulate for a given level of intermediation efficiency).

The defining theme of Dr Jalan's governorship was managing macroeconomic risk in an open economy. An ideal one for Dr Reddy's tenure would be efficient intermediation for a growing economy.

7333: The Latest News on Your Mobile!

Share your comments

Article Tools
Email this article
Top emailed links
Print this article
Write us a letter
Discuss this article

Related Stories

Sleeping giant's wake-up call

Banking stocks braced

North Block directives for banks

People Who Read This Also Read

Bancassurance boom

Steel on the upswing

Now, customer is king for banks

Copyright © 2005 India Limited. All Rights Reserved.