[Dec 2007, Volume 4 Quarterly Issue] Pdf File size - The IIPM Think ...

MORE MARKETS, LESS GOVERNMENT
sidered two major commercial banks,
one regional rural bank and one private
commercial bank from the southern
states of Tamil Nadu and Kerala. The
estimated transaction cost was 3.68 percent
of the loan amount if the loan was
delivered through a direct lending
channel. The literature on micro-credit
(see (Ghatak, 2000) and (de Aghion
and Gollier, 2000)) argues that group
lending to the poor through Non-Governmental
Organization (NGO) and
Self Help Group (SHG) may be an efficient
method of credit delivery system.
In 1991, the RBI initiated the policy of
encouraging direct linkages between
the banks and NGO and SHG due to
the presence of high transaction costs.
Puhazhendhi (1995) estimated the financial
intermediation of NGO and
SHG reduced transaction costs by between
21 and 41 percent relative to the
direct lending channel. In spite of these
efforts transaction costs remain high
even after a decade of reform. The estimated
opportunity cost of existing
high transaction costs in India is
still high. 8
Though heading in the right direction,
prudential norms are yet to reach
global standards. The pace of restructuring
nationalized banks through privatization
is slow. This is mainly because
nationalized banks’ balance
sheets are weak due to accumulated
NPA over the past three decades. The
government needs to clean up balance
sheets by recapitalization and other
measures in order to make these banks
more attractive to investors. Given recent
trends on the magnitude of NPA
(Table 5) the cost of restructuring appears
to be very high, particularly since
it is already running very high deficits.
Such liabilities on the government to
revive the banking sector (contingent
liabilitie000s), are significant in the
case of India. The impact of contingent
liabilities is now examined.
4.2. Contingent Liabilities
The financial sector in transition and
developing economies is characterized
by poor regulatory and enforcement
systems, and inadequate disclosure of
information which may lead to a high
incidence of NPA. When the banking
sector is in stress, out of legal obligation
or political compulsion the central government
has to rescue the banks. Such
public financing by government represents
its contingent liabilities and can
potentially lead to a large increase in
public debt. Because of their uncertain
nature these contingent liabilities are
unbudgeted and, hence, are hidden fiscal
risks. Contingent liabilities are also
important because the government cannot
achieve its long-run objective of a
sound fiscal system without addressing
the problem. Explicit contingent liabilities
are specific obligations which the
government has to settle under a contract
or a law. These include obligations
issued to state governments and public
sector banks, etc. The government can
foresee such guarantees and includes
them in its budget constraint. 9
However, contingent liabilities or implicit
liabilities are uncertain and their
realization is dependent on the probability
of particular events. Sometimes,
these events could be totally exogenous
to government policy, e.g., an earthquake
or any other natural disaster.
Most of the time, these liabilities are a
result of government policy. One interesting
example is a guarantee extended
by government to foreign creditors of
domestic banks. These guarantees may
lead to moral hazard problems in the
banking sector as banks may take high
risks, eventually leading to default on
foreign loanswww, and pressure on the
government to bail them out because of
It is argued that under current ineffi ciencies in the banking
sector, any efforts by government to ensure macroeconomic
stabilization or restructuring will involve an offsetting
effect, adversely affecting the initial policy objectives,
which will transmit mainly through the financial sector
public expectations or political compulsion
(For a detailed model see (Sharma,
2004)). One relevant case study in this
regard is the crisis in the UTI mutual
fund discussed in section 5.
Contingent implicit liabilities are
normally calculated after the event occurs,
as they are dependent on the probability
of the triggering event, the actual
loss and the amount government
pays to bail out the system. (Polackova,
1999) notes the financial systems represent
the most serious contingent implicit
liability. For example the cost of
resolving past banking crises varies
from around 1 percent of GDP (Thailand
1983-87) to around 55 percent of
GDP (Argentina 1980-82) depending
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