RBI : Too much regulation may lead to danger of shadow banking

Sunday, May 8, 2016,11:55 IST By Metrovaartha A A A

New Delhi | Warning against excessive banking regulation, RBI Governor Raghuram Rajan said this may lead to activities shifting to shadow financial system and admitted to the lack of know how for such businesses.

The outspoken Governor also appeared to disapprove of the lower interest rates to boost growth, saying low rates actually lead to people saving more rather than spending. Delivering a lecture here tonight, Rajan also suggested that the definite slowdown in branch expansion by foreign banks in India could be due to regulation among other reasons.

What happens when you put pressure on one side of balloon? It balloons out on the other side. So is there a danger that by regulating the banks so strongly, we have shifted activity not just risky activity but human capital to shadow banking system, he said at a lecture here.

While shifting risky activity may be good thing, but if smart people are also shifted out into the shadow financial system then I don’t know if a less smart bank is less risky, he said. Rajan said the central bank knows how to regulate banks and has regulated them. But we don’t know how to regulate the shadow financial system and we haven’t regulated that as much, he said.

It may be argued that it was the smart guys who took the bank down but smart guys also do the risk management as also correct valuations, Rajan said, while asking, Is a less smart banking system more of a risk or less of a risk that is the question we should ask ourselves? Shadow banking system typically refers to the financial intermediaries involved in facilitating the creation of credit across the global financial system, but whose members are not subject to regulatory oversight.

This may include unregulated activities by regulated institutions and has mostly escaped regulation primarily because it did not accept traditional bank deposits. The Reserve Bank Governor said the idea or intent behind regulation was to reduce complexity and financial engineering while creating risks for the banking system. But in that process have you also reduced the ability of the banks to take needed real sector risks anymore. And that is the question we have to ask, he said.

While it is being asked where the real investment was taking place or where the economic growth was, we have regulations which could again have the potential to pull (away) banks from taking on real risks, he said as he put lending to small and micro enterprise in that category.

Also, there was a definite slowdown in the expansion of branches of foreign banks in India. That has slowed down tremendously since the 2008 financial crisis. And one could argue that it is a fall out of the global financial crisis and the regulation, he said. Rajan said, in a global financial crisis, banks have access to central bank window in case of liquidity shortage, but non-banks won’t have access to the window to be able to cope.