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Past Issue • Oct-Dec 2011

Post-Crises Financial Regulation

In the first of this two-part interview, Professor Krishnamurthy Subramanian talks to Anjan Thakor, John E Simon Professor of Finance and Director of the PhD programme, Olin Business School, Washington University in St Louis, on the current financial climate including banking regulations and the corporate bond market.

Research indicates that there is an explicit government guarantee for public sector banks in India, which might have been instrumental in the banking sector not feeling the effect of the financial crisis as much as their western counterparts. But in good times, this can impose significant costs. While the benefits from the entry of private players and the competition is recognised, the competition might lead to the banking sector becoming more fragile. What are your thoughts on this?

The full force of government guarantees behind the banking sector helps reduce its fragility during times of crises. The other advantage of state-owned banking from the standpoint of governments, is that it is easier to control the allocation of credit to specific sectors in the economy. But there are also substantial costs to this in the good times and during bad times. One cost is that state-owned banks, for political reasons and other reasons, can end up misallocating credit in the economy. This can cost economic development. A second cost is that, state-owned banking can create a false sense of security. You have to allow certain poorly-managed banks that don’t have good risk management practices to fail if they experience large losses. They have to feel the force of the market to create the right incentives. Unless you do that, you don’t create the necessary market discipline for banks to be efficient in risk management and allocation of credit...

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