Last apprehension first.

Stability prescriptions vs structural problems

In the last few years, if one were to add up the profitability of investment banks and reckon the relative share of savers, investors and the intermediaries, it would be clear that the intermediaries and the banks are getting fatter at a faster rate than either savers or investors in the real sector.

This is mainly due to the distorted market structure where the banks hold the upper hand on both sides.

In implicit ways, the Basel norms, and its country-specific clones, are facilitating the process.

In conventional economics, savings and investments are supplies and demand curves of the same savings market, with the price being interest rates. But, increasingly, this market is being split into two distinctive markets — one, between the savers and the intermediary banks, and, two, between the intermediaries and the investors. The trouble is that the intermediary banks have the upper hand in both these markets.

Any regulation such as Basel norms, however well-meaning, acts as an entry or continuation barrier. Consolidation becomes a necessity. Some central banks have spliced Basel norms further with their own `size ensures safety' minimum capital requirements in value terms, which further shrinks the number of players. Thus, it pits the large number of retail savers against a few banks, and the savers are denied the benefits of `perfect' competition and higher price (interest) for their savings.

In addition, the banks merrily indulge in all kinds of obnoxious practices, such as siphoning, padding and inflating bills — offshoots of disproportionate market power.

So much so that the head of the largest credit card issuer in the UK publicly proclaimed not long ago that he loathes using his own cards.

On the investment side, again, the many retail borrowers, credit card users, SMEs, and larger corporates, to a somewhat limited extent, are pitted against a few banks. The price for funds keeps rising more than can be justified by the functions banks perform, such as aggregating funds, providing liquidity, credit risk appraisal, etc., compared to what a more competitive market could have ensured.

This means investors pay more and savers receive less and the resultant lower savings and investments can depress the economy's output.

Does it do enough on stability issues?

Commercial banks, whose primary source of funds is the savings and current deposits from retail customers, are increasingly investing in the stock market, risky instruments and derivatives on a proprietary basis. Or they fund clients who do.

While the profits on this belong to the shareholders and `whiz kids' in the form of bonuses, losses are offloaded onto the unwary savings and current account holders in case of bank failures. How is it ethical to pile such losses on those who have neither contractually nor implicitly authorised the banks to undertake such financial trapeze-jumping?

Since Basel's primary concern is risks, it had an obligation to create a fool-proof firewall between these two activities. It hasn't dealt with this question; the risk weights prescription is too benign to deal with this ethical question. What is worse is when, in certain countries, the ruling government and the central banks start using the banks funds as a policy instrument to prop up the stock market, a la India.

Second, the Statutory Liquidity Ratio (SLR). While mandated SLR investments are an excellent antidote for liquidity risks, they are a source of trouble themselves since their valuation fluctuates with the fluctuating interest rates.

With increasing globalisation and currency convertibility, the central banks' control over the host country's interest rates is progressively diluted. Shocks from one market transmit and percolate to others rapidly, and interest rate fluctuations are difficult to arrest.

This causes high volatility in the valuation of SLR instruments, which then becomes a big risk in itself. Particularly since they constitute quite a sizable portion of the balance sheet — often, one-fourth to one-third. Basel should have mandated that only instruments with neither liquidity risk nor interest rate risks would qualify for SLRs. Or it should have helped in creating such instruments. Or, as a compromise, prescribed only floating rate instruments (which exhibit reduced price volatility) as eligible for SLRs.

As things stand today, profits on notional valuation gains on SLRs (due to interest rate variations) can be distributed as dividends on ordinary stock in most countries, leaving the coffers empty when valuations suffer with increasing interest rates. Again, there is no reasonable ruling here.

There was a lot that needed to be done on the credit rating and assessment procedures of the banks in most countries. These are found wanting, time and again, in most countries. They come under fleeting scrutiny immediately after every crisis but fade from memory immediately thereafter. Common risk weights right across the globe may hardly be the antidote.

Last, several of the prescriptions have no proven basis on which to say that it ensures a maximum of 1 per cent (or any such level) failure rate. How can a single set of weights ensure same results right across the globe?

A corporate guarantee may be exercised in one country in one month, but when one is talking of a Dabhol (of Enron) in India, even a sovereign guarantee can take a generation to exercise. Standardised norms fail to capture the idiosyncrasies of individual markets. The trouble with encapsulating common sense is that it leaves us leaden-footed in a crisis.

Does it ensure effective financial systems?

In most emerging economies the reach of the formal systems has to substantially improve for the central bank's own good so that its monetary policy changes will have more depth and potency as well as enable its developmental initiatives impact faster.

Most informal markets have their own logic, their credit practices not exactly Basel-compliant, even if safe by convention; fragile by structure but excellent in track record and meeting social objectives (for example, micro-credit institutions in Bangladesh).

Basel norms may make banks shrink slowly from these and some others which are within the formal fold now, especially given their volume and high transaction costs — not exactly what a developmental economist would have ordered.

Perhaps Basel has to re-define its purpose to `evolving/developing effective financial systems' rather than just `financial stability'.

Like Keynes' prescriptions, which, however well meaning, could bury the unwary countries in a mountain of public debt, Basel norms could have a long-term debilitating effect on the savings and investments markets and lead to potentially harmful consolidation in banking sector. Its larger-than-life `saviour of the financial systems' image seems largely undeserved.

(The author works as VP Finance with JK papers. His views are personal. He can be reached at swaksha_ad1@sancharnet.in)

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