Developmental Dimension to Financial Sector

Summary

Delivered on 6 May 2010 at the Sixth M. R. Pai Memorial Award function in Mumbai and published as a Forum of Free Enterprise booklet, Dr. Y. V. Reddy’s lecture revisits the role of the financial sector in economic management in the wake of the 2008–09 global financial crisis. Speaking as a former Governor of the Reserve Bank of India (2003–08) and earlier Deputy Governor (1996–2003), Reddy treats the award as recognition of the RBI’s work on depositors’ interests and uses the occasion to argue that the post-crisis ‘rebalancing’ of financial regulation under discussion globally must give equal weight to developmental objectives, not only to stability.

Reddy traces the long arc from the post-colonial era of financial repression — when banks were nationalised and credit was directed to development priorities — through the worldwide deregulation movement that began around 1980. He acknowledges that deregulation produced real gains in efficiency, intermediation and the growth of equity, debt and forex markets, but argues that excessive deregulation in many economies enabled large, too-big-to-fail institutions, predatory lending in housing finance, and the systemic risks that crystallised in 2008. He carefully distinguishes between the consequences of soft regulation in advanced financial centres (USA, UK, parts of Europe) and the more cautious paths followed in Asia, India and China, which suffered less.

The core argument is that the rebalanced regulatory regime now being designed — through bodies such as the newly constituted Financial Stability Board, counter-cyclical and macro-prudential measures, the Volcker rule on bank activities, and stiffer capital prescriptions for systemically important institutions — risks confining itself to stability alone while ceding developmental finance entirely to market forces. Reddy contends that since the financial system already requires regulation to dampen cyclical fluctuations, there is no principled objection to using public policy to channel finance toward structural transformation, financial inclusion and productive investment, provided extremes of both over-regulation and under-regulation are avoided.

Applied to India, the lecture endorses neither a return to the regulatory regime of the 1970s nor an unbounded deregulation. Reddy points to the hollowing of traditional bank lending to agriculture and SMEs, the troubles of urban co-operative banks under softer regulation, and the migration of banks away from depositors toward fee income and capital-market activity. The speech closes on a depositor-centric note: banking is being treated ‘as a public utility’, and the evolving regulatory framework must remember that ‘there are no banks if there are no depositors.‘

Key points

• Reddy frames the speech as a delayed personal tribute to M. R. Pai and treats the Sixth M. R. Pai Memorial Award as recognition of the RBI’s work on depositors’ interests.

• Argues that the 2008–09 global financial crisis has forced a worldwide reassessment of the role of the financial sector and of the policy framework within which it operates.

• Distinguishes between deregulation as efficiency-enhancing reform and excessive deregulation, which he holds responsible for too-big-to-fail institutions, predatory housing finance, and the migration of banks away from traditional lending.

• Welcomes the post-crisis institutional response — counter-cyclical and macro-prudential regulation, oversight of the shadow banking system, and the Financial Stability Board — but warns that rebalancing risks treating only stability while ignoring development.

• Maintains that since the financial system already needs regulation to dampen cycles and large asset bubbles, there is no principled reason to oppose using public policy to direct finance toward structural transformation, financial inclusion and productive investment.

• Argues that India’s gradual liberalisation, cautious capital-account opening and continued role for public-sector banks insulated it from the worst of the crisis and yield lessons relevant to the global rebalancing debate.

• Cautions that under softer regulation many newly licensed Indian private banks and urban co-operative banks deteriorated, while traditional lending to agriculture and SMEs was hollowed out.

• Closes with a depositor-centric framing of banking as a public utility, insisting that any new regulatory balance must protect retail depositors — ‘there are no banks if there are no depositors.’