In September last year these guidelines were relaxed even further based on the recommendations of a committee comprising of senior executives of the RBI and the Securities and Exchange Board of India (SEBI). The committee held that instead of setting a ceiling on bank investments in equity relative to incremental deposits, banks' exposure to the capital market by way of investments in shares, convertible debentures and units of mutual funds should be linked with their total outstanding advances and may be limited to 5 per cent of such advances. This was subsequently accepted by the RBI and is the guideline that prevails now.
 
As a result of these changes banks were vying with each other to invest their funds in the corporate sector and were picking up all forms of corporate paper - including bonds, debentures and preference shares. Driven by these signals a group of 21 public sector banks increased their investments in equities from Rs. 1,488 crore in 1997 to Rs. 2,293 crore in 1998. However, the RBI was sanguine about the risk of bank exposure to capital markets because such exposure was well below the much-relaxed ceiling. According to its Technical Comitteee set up to review guidelines regarding bank financing of equities, "The total investment in shares of the 101 scheduled commercial banks aggregated Rs.8,771.60 crore as on January 31, 2001 and constituted 1.97% of outstanding domestic advances as on March 31, 2000 and was well within the norm of 5% of the domestic credit stipulated in the RBI Circular of November 10, 2000. The total investments in shares of all the banks aggregated Rs. 6,324.11 crore as on March 31, 2000 and constituted 1.42% of the domestic credit."
 
This overconfidence has been subjected to a corrective in the form of growing fragility in the banking system. On the surface, the RBI still maintains a brave face while accepting that there are problems of fragility in the system. This emerges from the following paragraph in the RBI's Monetary and Credit Policy Statement for the year 2001-2002, that reveals the central bank's reading of the problem. "The recent experience in equity markets, and its aftermath, have thrown up new challenges for the regulatory system as well as for the conduct of monetary policy. It has become evident that certain banks in the cooperative sector did not adhere to their prudential norms nor to the well-defined regulatory guidelines for asset-liability management nor even to the requirement of meeting their inter-bank payment obligations. Even though such behaviour was confined to a few relatively small banks, by national standards, in two or three locations, it caused losses to some correspondent banks in addition to severe problems for depositors. In the interest of financial stability, it is important to take measures to strengthen the regulatory framework for the cooperative sector by removing "dual" controlby laying down clear-cut guidelines for their management structure and by enforcing further prudential standards in repect of access to uncollateralised funds and their lending against volatile assets."
 
Clearly, the RBI poses the problem as being largely restricted to the cooperative banking sector, where it arises not because the regulatory mechanism is not well defined, but because the structure of management and control has worked against the implementation of those guidelines. But its decisions in practice point to a greater degree of concern. Not only has bank scrutiny been tightened, leading to revelation regarding banks like the Nedungadi Bank, but bank exposure to stock markets is being curtailed.
 
As argued above, bank investments in equity constitute only one form of bank exposure to the stock markets. Advances against shares and guarantees to brokers provide other forms. Secondly, this exposure of the banking system and of those that lead the pack in lending against shares, is dominantly to a few broking entities. The evidence on the relationship between Global Trust Bank and Ketan Parekh only begins to reveal what the RBI's monetary policy statement describes as "the unethical ‘nexus' emerging between some inter-connected stock broking entities and promoters/managers of some private sector or cooperative banks." The rot clearly runs deep and has been generated in part by the inter-connectedness, the thirst for a fat bottom line and the inadequately stringent and laxly implemented regulation that financial liberalization breeds.
 
Thirdly, the liquidity that bank lending to stock market entities ensures, increases the vulnerability of the few brokers who exploit this means of finance. Advances against equity and guarantees help them acquire shares that then serve as the collateral for a further round of borrowing to finance more investments in the market. These multiple rounds of borrowing and investment allow these broking entities to increase their exposure to levels way beyond what their net worth warrants. Any collapse in the market is therefore bound to lead to a payments shortfall, that aggravates the collapse, and renders the shares that the banks hold worthless and the advances they have provided impossible to redeem.
 
Finally, by undertaking direct investments in shares while providing liquidity to the market, the banks are further endangered. To the extent that the liquidity they provide encourages speculative investment and increases stock market volatility, any consequent collapse of the boom would massively erode the value of the banks' own direct investments.
 
When all of this is put together, it is clear that the current level and pattern of exposure of banks to the stock market is itself worrying and the fact that this exposure has been increasing and may turn more pervasive is distressing. It is possibly for this reason that the RBI technical committee on bank lending against equity, while holding that the basic framework of regulation need not change, recently recommended that the five per cent ceiling on bank exposure to stock markets must not apply just to direct investments in equity, but to all forms of exposure including lending against shares and guarantees to brokers. The central bank has accepted and implemented this recommendation in the wake of the market collapse.
 
But this small step in response to the recent crisis, may prove extremely inadequate. Five per cent of advances, while small relative to total bank exposure, is indeed large relative to the net worth and the profits of the banks. Major losses as a result of such exposure can therefore have devastating consequences for the viability of individual banks. This is an obvious lesson emerging from the recent crisis that calls for strong corrective action. But given its blind commitment to financial liberalization, India's central bank appears reluctant to learn its lessons well.