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Banking Reform in India∗ - page 42 / 57





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targeting of loans without reforming the incentives of the loan officers.

There are probably a number of steps that can go some distance towards this goal, even within public banks. First, to avoid a climate of fear, there should be a clear separation between investigation of loans and investigations of loan officers. The loan should be investigated first (could the original sanction amount have made sense at the time it was given, were there obvious warning signs, etc.) and a prima facie case that the failure of the loan could have been predicted, must be made before the authorization to start investigating the officer is given. Ideally, until that point the loan officer should not know that there is an investigation. The authorization to investigate a loan officer should also be based on the most objective available measures of the life-time performance of the loan officer across all the loans where he made decisions and weight should be given both to successes and failures. A loan officer with a good track record should be allowed a number of mistakes (and even suspicious looking mistakes) before he is open to investigation.

Banks should also create a division, staffed by bankers with high reputations, which is allowed to make a certain amount of high risk loans. Officers posted to this division should be explicitly protected from investigation for loans made while in this division. This may not be enough, and some extra effort to reach out more effectively to the smaller and less well- established firms will probably be needed, not just on equity grounds, but also because these firms may have the highest returns on capital. A possible step in this direction would be to encourage established reputable firms in the corporate sector as well as multinationals to set up small specialized companies whose only job is to lend to smaller firms in a particular sector (and possibly in particular location). In other words these would be the equivalents of the many finance companies that do extensive lending all over India, but with links to a much bigger corporate entity and therefore creditworthiness. The banks would then lend to these entities at some rate that would be somewhat below the cost of capital (instead of doing priority sector lending) and these finance companies would then make loans to the firms in their domain, at a rate that is at most x per cent higher than their borrowing rates. By being small and connected to a particular industry, these finance companies would have the ability to acquire detailed knowledge of the firms in the industry and the incentive to make loans that would appear adventurous to outsiders.


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