Last refuge of license raj

An atypical 2-part essay on banking, regulation and decision-making

I cannot hear the phrase ‘banking license’ without thinking ‘license raj’. Recent hullabaloo on this front triggered an atypical essay.

I usually don’t write about a specific industry as I have no expertise in any of them. I am especially uninformed about banking. I have never owned a bank stock. I observe banks from a safe distance with suspicion and puzzlement (find me someone who claims to understand a bank balance sheet and I’ll show you a self-delusional liar). I view all sectors through a common frame of reference, as it enables internal consistency across decisions. It helps get big things right, like risk and business quality. If I have a general bias towards high return on capital and low debt, a natural corollary is to be wary of sectors which fall at the opposite end. No special cases or exceptions to a process.

While I have alluded to generic risks of lenders, I haven’t covered this license raj angle. Here’s a hotchpotch of thoughts on this topic.

Banking is the last refuge of license raj …

Across a spectrum of ‘unregulated’ businesses that I own, it would be batshit crazy for a third party to arbitrarily determine who can enter, what to charge or be charged, how balance sheet should be deployed, how to expand, who becomes next CEO, and even what a founder’s ownership can be. Yet, it’s shrugged off as normal in one place. It’s as anachronistic as a rotary dial phone or Anil Kapoor’s chest hair. I’ve never grasped how to fundamentally assess this unusual yet material risk.

… Maybe for good reason

I am aware of the standard-issue jargon used to justify heavy-handed regulation: systemic risk; too big to fail; maturity mismatch; self-fulfilling runs; fractional reserve nature; funder of last resort. My theory is that there’s a more fundamental buggy human quirk here. There’s something about turning money into more money that makes people go nuts. I should know since that’s what I do. It feels too easy. It scales too fast. Even a small cut out of shuffling around large piles is a lottery ticket. When easy money is given away now, with someone else (hopefully) collecting later, link between process and outcome is broken for years. It’s just one of those settings where human frailty gets magnified and reinforced till it reaches frenzied extremes. It makes Vegas seem tame.

No good way to run license raj

A setting where buggy humans lose their minds tempered by heavy-handed government control. Irresistible force, immovable wall. Most progress has come out of dismantling or bypassing license raj, not refining it. Since banking without high-touch regulation is risky, we are stuck with an unholy amalgam that makes it hard to get good outcomes. Then again, I don’t know how we can do better either. This isn’t a new problem. For thousands of years, religions have clumsily banned usury. Loan waivers entailed a group of borrowers beheading their moneylender or persecuting a whole group. Even economies with efficient judicial systems and functioning bankruptcy procedures experience ugly, recurring banking crises. Clamp down too tight, economy suffers. Be lax, bankers go so nuts that economy implodes. Given a disastrous legacy of nationalization and ‘phone banking’, our problems are way more messy. After decades, we basically have one unambiguously good bank and maybe one ambiguously good bank. All that regulators can do is to keep chipping away at the accumulated rot a little bit at a time and nudging the system along the right direction, as part of a decadal process.

No one cause of a bank going rogue, either

Messy world outcomes rarely tie in to a single explanatory variable (e.g. corporate ownership of banks). Just look at our troubled lenders, even outside of PSUs and cooperative banks. Former banker with new age bank. PSU-type bank that turned private. NBFC turned bank. Project financier turned bank. Old-gen private bank that adopted clipped-accent CEO and chic branding, literally putting lipstick on a pig. Majority of new licenses awarded in prior decades ended up on the spectrum between so-so and shotgun marriage. Many were founded by former bankers and raised early funding from patient investors. Some disasters had legacy problems while others had a clean slate. Apart from generally poor odds in this setting, it’s not clear if any particular pattern can be attributed to failure. Likewise, success seems serendipitous, linked to a peculiar set of people coming together to create a (counter) culture that let them keep their head when others were losing theirs. We’ve had a perfect role model for decades without anyone else coming close to copying them. Going rogue isn’t an Indian phenomenon either, as even a well run bank like Wells Fargo wasn’t immune to malfeasance creeping in.

How to award a license is a fascinating and intractable problem

It’s like in my business. It’s not hard to figure who’s trustworthy. It’s a holistic, subjective judgment call that’s grounded in history but difficult to parameterize. It takes little effort for RBI to figure out that Tata and Mahindra are fine. There’s no guarantee they’ll create another HDFC Bank, but any slip-up will be an error of judgment, not a breach of trust. If a dodgy NBFC at the other end of the reputational spectrum shows up, RBI knows that they’re the kind who steal from blind beggars. There may be a few in the middle, but it’s generally clear who can be trusted with others’ money. Unfortunately, a regulator can’t decide in this manner. It looks arbitrary and favouritism allegations will abound. They have to entertain every pre-qualified bidder and use some balanced-scorecard by committee thingy that ensures safe rather than sound judgment. It ends up substituting the difficult real question (who can be trusted with OPM) with an easier fake one (who ticks the boxes we made up). Those at the iffy end will try to game the process. Career-risk concerns lead to banning entire categories and a bias towards indisputably mediocre picks. In the past, pseudo-PSUs got licenses purely because no one could object to the template even though the candidate had an abysmal track record.

I empathize with the regulator

It’s a thankless job. Part administrator. Part detective. Part policeman. Part judge. Part auditor. Part kindergarten teacher. Get no credit for anything good, while getting full blame for others’ screw-ups. Unlike in my job, they can’t simply avoid hard problems. Worse, harder the problem, more likely it falls entirely into the regulator’s lap. One existential crisis per decade is par for the course. It’s like being Dhoni during a tough chase. It’s not just about handling Boult. Bhogle, Manjrekar, drunk fans in the stands and fat slobs on couches are all yelling advice: swing; scoop; run; get out; retire yesterday. Armchair commentators, has-beens and wannabes without skin-in-the-game are perennially doing harsh pre and post mortems. I don’t know much about the 25 bps this way that way stuff, but the banking supervision part of RBI’s job is a mug’s game. And I dare say, they’ve done a good job at that.

So, how about the hullabaloo around a recent RBI discussion paper that triggered this essay? Since it’s outside my domain and above my pay grade, I’ll limit myself to a few philosophical views about decision making in general and how it applies to banking-regulation context (in next essay, as this one’s too long already).