The last statement of the Reserve Bank of India Governor on monetary and credit policy (May 2004) had two important points in relation to the capital adequacy rules for commercial banks.

The first one, reading as follows, pertained to capital requirements relating to market risk. "…with a view to ensuring smooth transition to Basel II norms, it is proposed to phase the implementation of capital charge for market risk over a two-year period as under:

• Banks would be required to maintain capital charge for market risk in respect of their trading book exposures (including derivatives) by March 31, 2005.
• Banks would be required to maintain capital charge for market risk in respect of the securities included under available for sale category by March 31, 2006."

The second one required banks to start preparing for measuring credit risks in their portfolios, for a changeover to Basel II. The relevant paragraph reads as follows:

• "The Basel Committee on Banking Supervision would be issuing the New Capital Accord (Basel II) by end-June 2004, which is expected to be implemented by the end of 2006.
• As a well-established risk management system is a pre-requisite for implementation of advanced approaches under Basel II, it is proposed that:
• Banks should examine in depth the options available under Basel II and draw a road map by end-December 2004 for migration to Basel II and review the progress made thereof at quarterly intervals."

Basel II will also, for the first time, require regulatory capital for operational risks. In short, over the coming years, Indian banks' need for capital is likely to go up.

In this background, it intrigues me why the RBI has chosen to come out now, first, with a discussion paper on Ownership and governance in private sector banks  (July 2) and a revised directive on cross holding of capital among banks.

While the second circular, which limits cross holding of equity and debt capital between banks, makes eminent sense, the two together do create an impression that the central bank is trying to make it more difficult for banks to increase their capital.

And since this follows a clear indication that regulatory capital for market, credit and operational risks will go up, it makes the timing and rationale for the moves puzzling for an outsider.

The timing is also odd from a different perspective -- it was just a month or two ago that HSBC was permitted to hold equity of 15 per cent in UTI Bank.

Surely, the proposals in the discussion paper must have been under internal debate for quite some time before the paper was put out for comments. If so, how was the HSBC equity investment approved?

Again, surely, relatively smaller banks, like Federal Bank and South Indian Bank, benefit out of their association with a much larger and stronger institution like ICICI Bank -- and the shareholding of ICICI Bank in the other two is a manifestation of its commitment to the smaller banks.

One would have thought that the banking supervisor should really welcome such associations because in the event of any problems in the smaller banks there is a ready helping hand available.

Indeed, one could argue that such holdings of large, strong banks in their smaller sisters are a step towards the needed consolidation of the banking industry.

The case of Global Trust Bank is also relevant. It requires a huge infusion of capital and, without management control, nobody will be interested in putting up the kind of money needed.

The only interested investor seems to be New Bridge Capital, a private equity firm that has reportedly offered $ 200 million for a 40 per cent stake. The Centurion Bank kind of change in management, which recently occurred, would also be difficult if the ideas in the discussion paper were to become policy.

From the title of the discussion paper it seems that the driving force is improvement of corporate governance in banks -- a laudable objective.

On the other hand, well-spread shareholdings, or the absence of a significant/dominant shareholder, are no guarantee of effective corporate governance: neither Enron nor Tyco had any dominant shareholders.

In the ultimate analysis, effective corporate governance depends on the expertise, knowledge and articulation abilities of the chief executive -- and, equally, the knowledge of directors and the interest they take in the affairs of the bank.

The failure of effective corporate governance in UTI is a classic case -- clearly, the trustees failed to restructure the US64 portfolio even after a crisis in the fund and the report of the Deepak Parekh committee.

In short, both the timing and the substance of the proposals are difficult to understand. No wonder, perhaps, that the proposals were almost uniformly criticised in the media.

Tailpiece: A pernicious effect of subsidisation is, of course, wastage of resources. Let me narrate a personal experience. About four years ago, I moved to a new flat, slightly bigger than the earlier one.

The electricity bill was, however, three times more. My complaints fetched the engineer from the electricity company who found that the metering was correct.

Finally, it turned out that, through some error, my billing was being done at commercial rather than domestic rates. When I brought this to the notice of the electricity company, it was kind enough to change the billing basis and the bill has dropped.

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