Is the Entry of Corporate Houses in Banking Sector a Real Worry?

Former RBI governor Raghuram Rajan and deputy governor Viral Acharya have jointly penned an article where they have criticized Narendra Modi government’s move of allowing big corporate houses to enter in the Indian banking sector. They said,

Allowing Indian corporate houses into banking will lead to the concentration of economic and political power in these business houses and the exchequer could be faced with significantly higher bailout costs if these banks were to fail.

And,

The history of such connected lending is invariably disastrous — how can the bank make good loans when it is owned by the borrower? Even an independent committed regulator, with all the information in the world, finds it difficult to be in every nook and corner of the financial system to stop poor lending. Information on loan performance is rarely timely or accurate. Yes Bank managed to conceal its weak exposures for considerable periods.

In this article I am going to rebut both Rajan and Acharya. I will show that the real worrying issue is not corporate houses’ entry in the banking sector, but the presence of the Indian central bank RBI itself. RBI is the 900 pound gorilla in the room that everyone is ignoring since time immemorial. RBI is the root cause of most of our economic miseries like inflation, business cycles, income and wealth inequality (poor becoming poor and rich becoming rich phenomenon) and the presence of a behemoth welfare and warfare state, which it enables, which doesn’t allow the wealth generating sector of the economy to do its wonders and lift billions of people out of their poverty and misery.

To understand how RBI is responsible for above cited problems we need a short discussion of how our banking system works. That discussion now follows.

First, it is not possible for me to discuss the full details of how our modern money and banking system function so at the outset I am going to direct my readers to two essential books of Murray Rothbard which will help them in understanding money and banking in great detail. These two books are, What has Government Done to Our Money and The Mystery of Banking.

Now, our modern banking system functions on the basis of a system called the fractional reserve banking (FRB). Historically banks evolved as a warehouse where people used to deposit their property (gold money mostly) for safekeeping for a fee. In return of this deposit the banker will give them a deposit certificate (an IOU). Upon return of this certificate, the banker used to return the deposited property to the depositor. During the whole period of deposit, bankers used to keep the property with them only, and so this system is known as the 100% reserve banking system. Over a period of time bankers realized that they can loan the deposited property to third party borrowers and pocket interest as extra revenue! This was the beginning of our modern day fractional reserve banking because now bankers only kept a fraction of originally deposited property. This system is illegal as it represents embezzlement or misappropriation of depositor’s property. Whenever bankers made a mistake in giving loans and they were caught in bankruptcy, because the borrower defaulted on the loan and so banker couldn’t return property to the depositor on time, they used to get heavy punishment in the form of imprisonment and liquidation of their assets to repay the creditors. As we know, the system of fractional reserve banking generates inflation i.e., it increases the supply of money and fiduciary unbacked credit in the market. A banker by loaning out 90 rupees out of depositor’s 100 rupee deposit generates 90 extra rupees in the economy over and above the original deposit of 100 rupees because the depositor is also using his 100 rupees in a savings account simultaneously. But this system of fractional reserve banking in an environment of free banking, i.e., a banking system which is not centrally regulated by the central bank like the RBI, is inherently limited in its fraudulent nature. In a free banking system commercial banks cannot generate unlimited inflation because they will be caught issuing too much unbacked money and credit by its competitors when their clients will come asking for their money in the clearing houses (please read Chapter VIII, P. 111 onwards in Rothbard’s book on banking to understand fully how this happens).

But as Central banks came into existence, this limit on commercial banks’ fraudulent nature was lifted. Central banks came into existence because bankers colluded with the authorities (King/Queen or the modern State/government) to make sure they can endlessly generate inflation to fund the welfare warfare state (Chapter IX, Rothbard’s book). It was a nexus between these two parties to systematize the process of legal plunder of the society on a vast scale. This is why having a central bank like RBI is deadly dangerous for the Indian economy. In its absence, no commercial bank can inflate without limits. Market competition will make sure that each commercial bank and its customers, i.e., market participants themselves, efficiently regulate each other. There is no need for any central regulator like the RBI to regulate the banking market. Market participants can very well regulate themselves.

The record of RBI in doing its job of a regulator is abysmal as former governor Rajan and deputy governor Acharya themselves mentioned in their article. If RBI is so inept in regulating the banking sector or managing the economy, e.g., endless inflation, business cycles and inequality generated by it, then what is the need of having it at the tax payers’ cost? We must abolish RBI and then corporate house entry in the banking sector will not be a problem at all. Free banking system will make sure those corporate houses do not loan money to unworthy customers or themselves. And if they will be careless or greedy then they will be caught cheating and will go bankrupt which will put them behind the bars and liquidate their assets to repay the creditors.

Rajan and Acharya said that, Even an independent committed regulator, with all the information in the world, finds it difficult to be in every nook and corner of the financial system to stop poor lending. Information on loan performance is rarely timely or accurate. Yes Bank managed to conceal its weak exposures for considerable periods”. This shows that Raghuram Rajan and Viral Acharya are ignorant of the ideas of the Nobel prize winning economist F A Hayek who in his famous article The Use of Knowledge in Society showed that one of the main functions of the market and its price and profit and loss system is to provide all the necessary information to the participants so they can take appropriate action. For disseminating or using information we do not need the RBI. Market itself can provide all the necessary information to the participants because this knowledge/information is fragmentary and only actual participants are aware of it. Any central planning agency cannot have that knowledge in the useful form. More importantly than Hayek, the 20^th century dean of the Austrian School of Economics Prof. Ludwig von Mises brilliantly explained that any kind of socialist central planning, RBI is the monetary central planning authority, will necessarily fail because in the absence of market prices it cannot economically calculate and solve the economic problem of ‘what to produce, how to produce and for whom to produce’.

And Rajan and Acharya saying that the exchequer will have a huge cost for bailing out big corporate house own banks assumes that such banks needed to be bailed out in the first place? Why make such assumption? Why bailout anyone at the cost of the tax payer (and not exchequer)? As was the original practice, any bankrupt bank must be liquidated and its assets, with all assets of its owners/directors etc., must be sold to repay the creditors. And those bankers must be jailed or hanged till death if their customers die because of their bankruptcy like what happened in the case of Mumbai’s PMC Bank. This way is the ethical, efficient and legal way of dealing with so-called too big to fail crony companies. But, as I have already mentioned above, in the free banking system without the RBI, no bank will become too big to fail as its inflating operations will be checked and regulated by other market participants themselves. Also, as Murray Rothbard brilliantly explained, the impossibility of socialist calculation also limits the size of any firm. In a true free banking system no bank can become too big to fail. The solution of the problem that Rajan and Acharya talk about is not RBI but a free market system in the banking sector with other sectors of the economy.

As far as the concentration of power goes, it is already heavily concentrated in Delhi with the central government thanks to the funding of that State by its central bank RBI! It seems Rajan and Acharya are also ignorant of the science of power analysis. It is that state via its central bank RBI is now trying to share some of that concentrated power to its cronies like these corporate houses who are, in turn, are the prime funders of the ruling political party. This corporate government nexus is created and made strong by the RBI. Now I know someone like Rajan can retort by saying, but RBI is an independent and autonomous institution whose role is to help the Indian economy grow so how can it do all the things that I am saying it is doing?   My reply to that is, no it is not. RBI is not an independent and autonomous institution. That is a big lie. It is fully owned by the government of India since nationalization in 1949, and any institution that is outright owned by the central government can never be independent of its influence and direct control. This idea of central bank’s independence and autonomy is being floated by the mainstream economists like Rajan to misguide the public in believing that RBI is some God like institution out there to cure the Indian economy when reality is that it itself is the prime cause of most of our economic problems!

Conclusion

It is the RBI that has enabled the state to concentrate all powers in Delhi. In the absence of RBI no commercial bank, no matter owned by which corporate house, will be able to cheat anyone without going bankrupt and its owners’ assets liquidated to repay the creditors. And RBI is not an independent authority and its performance has been an utter failure which makes it an incompetent regulator of the banking sector. Market forces can very well regulate the banking sector in the absence of RBI.

Thus the entry of the corporate sector into the banking sector per se is not at all a big worry for India. Contrary to Rajan and Acharya, the big worry actually is the presence of India’s central bank RBI itself. As long as RBI exists, India cannot progress, period.