Raghuram Rajan breaks silence on 80:20, says scheme was brought in to create jobs, boost free trade

Asked about the timing of the scheme's rollout, Rajan said the government's 80:20 proposal appeared to follow objective criteria and that its motive was clear: to give a fillip to free trading in gold and create jobs in the jewellery sector.

The former RBI governor also spoke about the recently reported Rs 13,640 crore Punjab National Bank fraud and said that the scam should have been uncovered sooner. He also said that had the RBI had any idea of what was going on at the time, it would have done everything in its power to stop it.

Below is the verbatim transcript of the interview.

Q: First for starters, we have to start with the frauds because that is the reason why we are asking this question who’ fault is it? Is it the fault of the owner of the bank, the auditor, the regulator or the management?

A: There is plenty of blame to go around, but it is important to first focus on why the fraud occurred and what systems were inadequate. In any such thing and I am sure the investigation will go into all these details, but why was this Letter of Undertaking (LoU) given. Why was it not recorded in the banking system? Did management take notice of it? Was it put before the board? And of course after that did the auditors pick it up, if they didn’t why didn’t they pick it up because auditors go branch by branch and then were the regulators instructions obeyed over time or were they not and why were they not obeyed? Of course the owner in this case the government which appoints the board members as well as the management what is their culpability in this whole thing. I think every facet has to be examined.

One of the important concerns about frauds that I had when I was at the Reserve Bank of India (RBI) was that we unearth them, but we never actually brought any of the culprits to book. So, one of the things we did was we said we need to bring together all the people involved both in unearthing as well as investigating and see how we can move forward. So, we sent a list of the big frauds to the Prime Minister’s Office to try and get some action on that. So, these are the kinds of things we need to figure out.

Q: When you were governor, many of these LoU’s were signed and used to get letters of credit and actually a letter when you were governor on August 03rd 2016 was sent to all the banks asking them to thoroughly scrutinise the SWIFT system, audit it. Looks like you all were sensitive that a problem can come from this SWIFT connectivity to the core banking system. Can the supervisor be blamed for not pushing hard enough to get their instruction implemented?

A: Before we assign blame, we have to know what happened and why it happened. In many banking systems there are so many ways of getting around the system. We have to understand that when a way is discovered for example with the SWIFT system it was the problem at Bangladesh Bank which unearthed the problems that were there. When the problem is discovered it is important that the regulators send the message to the banks that we have unearthed this problem, now fix it in your systems.

Of course after that the regulator basically assumes to some extent that the banks have fixed it. If they haven’t, we have to understand why the banks didn’t. I mean when they were told about a problem why wasn’t the problem fixed and I understand they were other reminders sent after that by the Reserve Bank and we have to understand why they weren’t obeyed. So, there is a fair amount of learning from this episode that we need to get. But surely there is plenty of responsibility to spread around.

Q: Hot from the oven news is that the Reserve Bank has banned LoUs. News coming in just about 10 minutes back. Way to go you think?

A: I can’t opine on current policy and I am sure they have looked at the issues. One of my concerns in India is that there is sometimes a very ---cavalier treatment of guarantees whether it is bank given guarantees or government given guarantees. We don’t think these are real and it is only when they are called upon by the entity that has relied on them that we understand that it is almost like giving a loan or in fact more than giving a loan because it usually called upon when the loan is in distressed. So, it is actually like providing equity. Unless we account for these properly there are huge contingent liabilities on the government balance sheet as well as on the bank balance sheet and it is important that we acknowledge them.

Q: You are speaking about pushing blame around and the government has picked up this 80:20 gold scheme as one of the ways in which people were allowed to make money. What are your comments on – you must have heard what the government said about this?

A: As far as I understand, the Punjab National Bank (PNB) scam started in 2011 and was unearthed in 2018. The gold scheme that is under the scanner at this point was something which lasted between May 2014 and November 2014. It seems to me very hard to argue that whatever happened then and I am happy to talk more about that, but whatever happened there was in any way related to the scam other than it happened in the same industry that there was gold involved. It is important to treat these has two separate issues. Happy to talk about the 80:20 because the actions there as far as I understand were justified, but I think it is important to keep it separate from the scam.

People conflate this all the time and I think this seems to be diversion of public interest rather than a focus on the key issues which are important. Why is it that our banking system is leaking so much? How do we prevent the leaks especially when there is so much new money going into the banking system as re-capitalisation?

Q: This 80:20 scheme goes as liberalisation of the number of people who could import but it looks like only some people benefited. How would you answer to that charge?

A: What happens with a number of issues is, the RBI is supposed to talk with the government, the government sort of is often the prime mover and the RBI is then supposed to ask whether the policy can be implemented and then announce the policy.

On the 80:20 gold scheme remember the circumstances in which it was brought about. We had a foreign exchange crisis in 2013 and there was a great sense that the current account deficit was getting out of control, a big part of the current account deficit was big purchases of gold as real interest rates were strongly negative. So, when the public was moving into gold in a big way the government thought that perhaps one stop gap arrangement - a temporary arrangement would be to reduce the imports of gold. So, it brought in this 80:20 scheme which said that out of every 100 grams that you import of gold, you have to re-export 20 gram and there are a few entities - State Trading Corporation etc and a few public sector banks that would be allowed to import. That had a very important effect in quelling the imports of gold which also meant that the pent-up demand to some extent for gold was building up because our jewellery industry was at a loss given that gold had been stopped.

At this point the commerce department started arguing that maybe we should have some liberalisation and we should open it up to more players to import gold so that there is more free flow of gold into the system.

Obviously with any liberalisation if you actually implement it, gold imports will go up, the question is who was allowed to implement? There as I understand it and again I have to collect this information at a distance - the department of trade in the commerce ministry has a criterion of who it nominates as star exporters, star trading houses, prime exporters and that objective criterion was available and as I understand it, that criterion was then used to say here are the guys who can import.

The whole objective was to bring down the premium that had built-up in the gold trading because of the constraints on supply side. So, liberalisation would have brought down that premium considerably.

Why were we able to liberalise? Because we had weathered the first part of the crisis, we had built up reserves somewhat. There was a little more confidence that things were a little better. Further the ultimate aim was this was a constraint on our industry, on industry which employs a lot of people, so the ultimate aim was to get rid of it completely. The scheme that is under controversy was run during the first few months of the NDA regime and finally it was done away with in November 2014.

Like any constraints that are imposed on a market system, there would have been some people who made money and some people who didn't. The people who didn't make money objected against the people who did make money but the people who made money were objecting against others, this kind of thing keeps going on. Ultimately the idea was to bring back free trading, that's what happened and that is a good thing.

Q: The charge is that the circular came on May 13 when a regime change was in the offing and therefore in a sense malafide in intent?

A: I don't want to go into that. I understand this is a big issue in parliament. The point I think is important to remember is that this is a period of rapid regulatory changes, we were dealing with foreign exchange crisis. There were a number of adhoc schemes, adhoc arrangements and I can see that there could have been some arguments made that this new government is going to take time to understand, maybe we need to bring it in, I don't know what the rationale was behind the government at that time. However the point from our perspective at RBI was to understand whether there was any objective criteria for doing what was being done, the logic being that we had weathered the foreign exchange crisis, that in fact there were constant representations from the gold industry that there was a shortage of gold and to some extent there was pent-up demand which was potentially creating other problems. So, our job was to see is this done in a reasonable way. I have not been able to go back to the circulars that were issued and the underlying discussions.

What happens in this cases is, the department takes care of it and talks to the government and issues them but as governor I do bear responsibility for any actions of the RBI.

Q: Could you have said no?

A: Let me put it this way, any policy has ramifications both positive and negative. The positive ramifications of any liberalisation is that you increase the imports of the object that you have stopped in order to facilitate more work in industry. There was an arguments that a lot of workers have been laid off because of a shortage of gold, we need to re-employee them. So, you have to look at that positive aspect. Second, we did not want to liberalise fully because we did not want the flood of gold to come in, we have to do it in steps. If you want to do it in steps obviously you have to pick somebody to import. There is already the public sector which is importing, you are not stopping them from importing, so in a sense this is a liberalisation you are adding more people. That has to bring down the premium on gold which was partly the objective. When you pick them the question is what objective criteria do you follow? If there is a definition by the department of trade that was what the government picked and told us this seems reasonable and we looked at the definition and that seemed reasonable. I presume that is the process we followed and we went out and in consultation with the government issued the circular.

Now the new government if it thought this was an issue of importance could have acted immediately. As I understand it took some time to see how this process worked and eventually when we had more foreign exchange under our belt we did away with the schemes. So, to some extent I think procedures were followed what is important in these situations.

Q: Let me comeback to the reason why I invited you about reorganising public sector banks or re-imagining them. Would you say ownership is an issue? I mean in the sense if the PNB fraud had happened at a private sector bank would RBI have been easily able to supersede the bank like it did in Global Trust Bank in 2003? Do you think ownership is what we have to attack therefore?

A: I think a system with public and private banks can work reasonably. The question is are the incentive structures in the public bank appropriate and this is something we need to examining very carefully. What happens in these kinds of situations how much does the management know, what length of tenure does it have, what incentives does it have to find out what is going wrong and put this appropriate systems in place and what kind of monitoring does the board do? Is the board composed of engaged professionals who understand risk management and who ask the right questions about risk management procedures.

One of the things we did during my time was we got rid of a whole set of box ticking requirements we had for the public sector boards. We asked them to focus on the five or six big issues that they needed to keep the bank appropriately managed. Now we also need to ask questions about who appoints these board members and on what basis and how the board members are compensated. One of my concerns was that we compensate public sector board members at a much lower rate than the private sector can compensate. So, even in the market for board members the public sector it at disadvantage even if you had a perfectly good procedure for appointing them.

Of course the Bank Board Bureau was supposed to appoint them, but that never actually happened. We need to look at all this and see if the governance of the banks by the government is being done in an arm’s length professional way as were suggested during the various Gyan Sangam or in fact we haven’t moved away from that still and more needs to be done. These are important questions to ask.

Q: We did have the Bank Board Bureau, but several managing directors were changed without telling them or without telling their own boards. So, do you still think that within the current system of overwhelming government domination we can run these banks better?

A: No, we have to change that system. Under the current system the boards have no responsibility for appointing the management. If they have no sort of stick over the management, they don’t chose the compensation for the management particularly, if don’t they have appropriate sticks over management what control can they have. If everything comes from orders from the ministry as opposed to the board determining things including the appointments of the board then essentially you have taken off powers from the board, rendered it fairly toothless and then you expect it to manage the bank in the banks best interest. We need to think very seriously about public sector banks governance reforms. One of the experiments that was tried during my time was to try and bring in private sector people at a lateral level.

Of course you want to be careful about doing too much of it, but one of the problems in doing that of course is that private sector people shy away from coming into the public sector banking system except very few are motivated by patriotic reasons. You can’t rely on that to get a large pool of people into the system. So amongst the things we have examine the governance of the public sector banks are the boards appropriately appointed and appropriately incentivised and appropriately empowered. The management, does the management have adequate pay compensation etc. but do they have adequate tenures also. Are they appropriately qualified for the job that they have? We are putting people in charge of Rs 5-10 lakh crore at these banks and we need the best people in the country to do it. To do it in a reasonable way. Of course they have to have the ability to hire good people, to bring good people into their jobs as executive directors, as head of risk management and so on.

The public sector was a great repository of talent, but over the years because of variety of issues including hiring fees, including constraints on whether they can hire on campuses or not their ability to recruit talent as been greatly diminished. Ultimately, the issue is not of pay. Public sector banks pay much more up to a certain level than private sector banks, typically at lower levels. It is only at the higher levels that they pay less and that precisely where you need the best talent. So, we need to think about public sector pay also how to rectify it in a way that there is more pay for performance but also gets good people in there.

Q: One question on this, Montek Singh Ahluwalia thought so and I am asking you when I interview him is the answer bringing down government stake below 50 percent, so that you are free from all these recruitment constraints?

A: That is an experiment we should try with a few public sector banks. But until you get the governance right, you want to make sure that the board once you bring the stake down below 50 percent is able to govern the bank. Otherwise, if you have a bank which is not governed by anybody neither the government nor the board and management has no oversight you could get fairly bad outcomes. I would say the first criterion is to strengthen the governance. There is a chicken and egg problem. It may be hard to strengthen the governance without first distancing the bank from the government. We need to work on both at the same time.

Q: The Reserve Bank has issued a circular almost pushing all the bad loans of vintage loans to the National Company Law Tribunal (NCLT) in the next six months. It is a fairly strong circular and it is almost looking like AQR2 and it might put 3-4 percentage points more of already stressed loans into NPAs, but it looks like it will be the last sweep do you think that is the way to go?

A: I think it is important that the NCLT shows some proof of the concept that is we must bring some of these resolutions to a conclusions. The banks must get their money back, so they be able to unwind some of the provisions they have made. I think that is important that the timeframe that has been given should be adhered to as far as possible and some of these knotty questions that have risen who can bid and who can’t bid should be resolved with some clarity. I think if we do that then there will be a growing consensus that there is this NCLT which works and which is a resolution of last resort if nothing has worked we can go there. Which then means that all the out of court systems of resolution that we have in place will have a much better chance of working because banks way before it goes to the NCLT and the promoter can sit down and say what makes more sense now so that we don’t have to go into a resolution which can be painful for both of us.

I would be very much like to see those first few cases that went in, resolved and resolved with some degree of success in the sense that the firm is put back on track. The bankers get a fair amount of money back and we move forward.

Q: Are we on the verge of a trade war or do you think this one increase in tariffs from President Trump will pass?

A: Given the recent news on Rex Tillerson it is very hard to predict what this administration will do both for the good and the unpredictable.  My worry is that the big issue which is the trade imbalance with China hasn't been addressed as yet. There are measures that are floating through Washington especially using Section 301 on unfair trade practises which are still to be seen and those have to do with intellectual property and so on, issues which are very dear to the Chinese heart. So, my worry is that we haven't seen the end of this process yet. In fact we maybe at an early stage and there is more to come. So, I would not rest easy saying that we are done, I think there is more to come.

Q: The US jobs data came in really excellent, do you think the FED has to now hasten rate hikes and as a consequence are we going to see some asset bubbles burst?

A: On the first question, the jobs data also said that wage growth was not as strong as previously feared, so it had a good news bad news effect. Good news was strong labour market growth and the wage growth that some people want to see more of wasn't huge. However it also brought comfort to the FED that their pace of tightening was reasonable but at this point not significantly behind the curve. So, I think they will continue between 3 and 4 hikes this year, certainly one this month which they have prepared the markets well for. There is a lot of leverage which has built-up post crisis, so there will be pain points. Leverage requires easy money, requires a lot of liquidity and to when the interest rates go up and liquidity becomes harder to come by, the lessons of leverage come back to hit you.

So, there is an issue there. There will be points, it is hard to know where. We will find out as interest rates move up.

Q: What about that quote attributed to you, that you warned Rahul Gandhi and the Prime Minister on Nirav Modi?

A: They say you leave India but India never leaves you. Social media seems to have fascination for attributing complete rubbish to me and this gets its own life. So, absolute rubbish.

I wish the RBI had known of the scandal when it was happening. If we had, we would have stopped it. The truth is, this is something that was off the books, it didn't come on to our radar screen because it was completely opaque to us.

We need to understand what went on there and how we stop it. As you just said, the RBI has taken some measures in this regard.