Banks on their own cannot always ensure ‘good’ outcomes. There is a need for regulation. This, however, does not imply that each and every part of the banking system needs to be  regulated.

The recent financial crisis has drawn attention to under-regulation of banks (particularly investment banks) in the US, and rightly so. However, the Indian story, as we will see, is quite different. While there are parts of the financial system in India that are in need of more regulation (the non-bank financial intermediaries), India is still more a case of over-regulation. So there is no contradiction in saying that while the US needs to regulate more, India needs to regulate less.The hasty conclusion drawn by some in the recent past that the Indian banking system did not witness a crisis because it has not been highly liberalised is not quite correct.

Every case of liberalisation is not a case of an increase in vulnerability, and every case of regulation is not a case of ensuring prudent behaviour.High reserve requirements We have had over-regulation or financial repression in Indian banks in various ways. Let us look at the high cash reserve ratio (CRR) requirement, high statutory liquidity ratio (SLR) requirement, and barriers to opening new banks.The CRR requirement in India is 5 per cent (it was even higher in the past). Reserve requirements have been declining worldwide. The central banks of Canada, Switzerland, New Zealand, and Australia have eliminated reserve requirements entirely.It may be argued that a reduction in CRR can make a bank vulnerable because banks would then have low cash reserves. These fears were indeed valid in the past when the lender of last resort (LLR) was not present and deposit insurance did not exist.Given the LLR facility at present, there is no need for banks to keep large cash reserves, and given the deposit insurance facility, they need not fear a run.

The SLR requirement in India is 25 per cent (it was as high as 40 per cent earlier). In contrast, such a requirement is not imposed on banks in the developed countries such as the US, the recent financial crisis notwithstanding. This suggests that the SLR requirement is dispensable as far as prudential management is concerned.

It is true that the SLR requirement serves another purpose in India. It helps the government finance its deficits in a non-inflationary way, and without increasing the government’s external debt.

With the SLR requirement, the government is getting committed funds from commercial banks to finance its deficits — the gap between expenditure and taxes.Tax-GDP ratio In what may seem a digression, note that the tax-GDP ratio in India is small compared to that in most developed countries. In the latter, the tax-GDP ratio roughly varies from 30-40 percent. On the other hand, in developing countries such as India, the ratio could vary from about 10 per cent to 20 per cent. At present, the difference between the tax-GDP ratios between the two kinds of countries is too large to be explained by differences in their development. Tax collection is also a function of how effective the administrative tax machinery is, how appropriate taxation laws are, and how committed we are to a welfare state. The government needs to improve its tax administrative machinery and its tax laws so that the tax revenues can be increased relative to the GDP. This will then enable the government to remove the SLR requirement, which is being used as a substitute for fiscal reforms.Barriers to banking There are serious barriers to entry into the banking sector in India. It is true that in the 1990s,after the general liberalisation in the economy, some new private sector banks were set up.

However, there has been a major slowdown in giving new licences thereafter. Banking is different and the way to take care of its special place is to have the LLR, capital adequacy norms, deposit insurance, and banks’ supervision. The special place of banks does not imply that the RBI refuses to issue new licences even to sound applicants.It may be argued that the RBI has limited manpower to carry out supervision which is why it cannot have too many banks to look after. But the RBI is a very large organisation. It could grow further, if required.

It is important to remove or at least reduce barriers to entry for the simple reason that we still do not have adequate or competitive banking.Under-regulation of banking can make an economy vulnerable to a socially costly financial crisis, as it did in the US. On the other hand, over-regulation creates istortions, affects allocative efficiency, and decreases output. So, just as there is a rationale for removing under regulation in the US, there is also a case for removal of over regulation in India.

Financial repression Reducing financial repression can lead to higher output. But this is not the only effect. It can even increase overall stability. Repression in banking leads to many people shifting to the more volatile financial markets. We need to reduce repression in banking and, thereby, decrease the size of the financial sector that is subject to greater volatility.Given that LLR, deposit insurance, capital adequacy and supervision of banks are in place already, there is hardly any need to impose further restrictions such as CRR and SLR for the purpose of prudential regulation. Barriers to entry into banking can be relaxed. The US went through a financial crisis not because their CRR and SLR requirements were low. Also, their failures cannot be attributed to their policy of letting new banks come up more easily. There were other reasons.

The idea of a welfare state is a good one. However, it does not require that banks are overregulated.

(The author is Associate Professor, School of International Studies, Jawaharlal Nehru University, New Delhi.)