The end of the financial year approaches. In April, the governor of the Reserve Bank of India will make a self-congratulatory statement, that the bank has successfully implemented Basel II norms. If he were right, it would certainly be something to crow about. Basel norms relate to infusing enough capital into banks to protect them against bankruptcy should their debts turn bad. In the first phase, the Bank of International Settlements had set the capital adequacy ratio as a straight proportion of the debts. In the second phase, it made minimum capital requirements a function of the composition of the debt as well. The risk carried by a bank depends on the size of the borrower, the business he is in, the competition he faces, the tenure of the loan, the use to which it is put, and the collateral, if any, that the bank has obtained from him. The capital a bank must have would ideally be determined from all these variables. That, however, would inject an element of judgment that a bank could use to under-insure itself. To prevent that, BIS worked out standard ratios based on some of the variables. However, three-quarters of bank loans in India are given out by government-owned banks. When they need fresh capital, the Central government indulges in a sleight-of-hand. It gives them its own securities. Its reasoning is that it is the sovereign government and can print any amount of cash it wants, so it can never go bankrupt. Its bond is as good as its cash. If banks run out of cash, they only have to go and sell the bonds.
This reasoning is so clever that the finance minister should try it out on the president of BIS. The oil sheikhs are sitting on vast reserves of oil, so they can never go bankrupt. Why not then require all the worlds banks to keep their capital adequacy requirements in the bonds of oil-producing countries? That may still carry the risk that a rich sheikh may not honour his obligation; so should not the banks be made to own oil reserves?
Only the finance minister thinks that he is strengthening his banks by giving them bonds. Even the governor does not think so in his heart. That is why he has not issued licences to any new private banks in 12 years; and, as his own Tarapore committee pointed out long ago, the absence of strong private banks is what stands between India and capital account convertibility. However, the strength of a banking system depends on the weakness of its worst bank. What India needs is not strong private banks but no government banks. If the government is serious about convertibility, it should sell off its banks. As long as it does not do so, it will continue to fake capital adequacy, while the RBI fakes convertibility.