Three weeks ago, on May 23, M Rajeshwar Rao, Deputy Governor, Reserve Bank of India, made an important but somewhat mystifying motherhood speech at the Conference of Directors of Banks. The conference was organised by the RBI for its main wards, the public sector banks. The basic message of the short speech was to tell the bank boards to shape up. The full saying however is “shape up or ship out”. Understandably, Rao could not say the last bit. The speech was a comprehensive list of instructions to public sector bank boards on how to get their respective managements to act professionally and effectively.
These instructions included transparency on the part of the management and assessment of risk and regular reporting to the boards. Rao then said something that would be impossible for PSB boards to do, namely, “If management is not meeting expectations, Boards should take suitable action, including replacing the management”. He, however, did not specify how any board could do that in India. Nor did he explain what he meant by management. Rao also referred to the principal-agent problem of economics. What he failed to notice is that this is exactly the relationship between the RBI and the PSBs, the government and the PSBs and the government and the RBI. In a nutshell, the principal-agent problem comprises situations of conflict of interest between principal and agent. In India the problem is particularly complex because where the PSBs are concerned, as the owner the government is the principal and the RBI is also the principal in its avatar as banking regulator. This has worsened the principal-agent problem: should a bank chairman heed the bank’s owner, in this case the government, who appoints him (or her), or the regulator who is also a principal but can’t really punish the agent?
Rao could have talked about the “agency costs” these conflicts impose on all sides. These costs refer to situations where the principal is unable to ensure that the agent always acts in the principal’s best interests. The problem in India is that the best interests of governments and regulators don’t overlap very much. Indeed, in PSBs the majority shareholder, which is the government, often wants the management to act against its own interest in a variety of well-known ways. In such a situation, there is little that the boards and regulators can do.
How is this peculiar Indian problem — where a bank board must dance to the tune of two bosses — to be resolved? The answer lies in the fact that the RBI thought it fit to invite only the PSBs to the meeting. It clearly thinks that the private sector bank boards don’t need the guidance. But those boards also have two principals — shareholders and the regulator — and there is far less conflict of interest there. It’s this conflict that Rao should have dwelt upon in his speech.