The Attacks on RBI Governor Raghuram Rajan: Lessons from Stanley Fischer as a Central Banker

India and Israel show that fighting crony capitalism in countries where a small group of people has huge political and financial influence is sometimes a role only people with strong backing from outside the country can take on.

 

Stanley Fischer

The events surrounding the tenure of Professor Raghuram Rajan as governor of the Reserve Bank of India can seem familiar to those who follow the relations between central bankers, politicians and bankers.

 

On April 21, 2009, Professor Stanley Fischer, then the governor of the Bank of Israel and currently the Vice Chairman of the Federal Reserve, summoned Shari Arison to his office in Tel Aviv  for a very unusual conversation.

 

Arison, the billionaire heiress to her late father Ted Arison’s fortune was and still is the controlling shareholder in Bank Hapoalim – the biggest bank in Israel, which, in 2009, held 29 percent of the whole banking sector’s assets1)Israel’s Banking System – Annual Survey. 2009. Chapter 1: Developments in the Activity and Structure of the Banking System in 2009..

 

There was not much time for niceties. Fischer made it clear that he meant business: He told her that he had lost faith in the chairman of the bank, Danny Dankner. The message was clear: Dankner had to step down2)Sharon Shpurer and Ram Dagan. “Fischer Tells Arison: Dankner Is Responsible for Hapoalim Problems.” Haaretz, April 2009.

 

Fischer explained that there was mounting evidence of misconduct by Dankner that cast doubt on his ability to be the chairman of a large bank. The timing was very sensitive – banks in Israel and all over the world were still in the midst of the biggest financial crisis of the last 80 years.

 

Her reaction was surprising: Arison told Fischer she had full faith in the chairman – and walked out. Fischer was thrown into one of the biggest challenges of his life, one that was about not only  the stability of the banking system in Israel but also the standing of its regulator. If the controlling shareholder in the biggest bank ignored his direct instruction, he risked undermining the standing of the institution tasked with regulating the banks.

 

Immediately after the heated meeting with Arison, Fischer found himself under attack from some of the most powerful political players in Israel, including the local media. Editorials in the newspapers questioned his decision and warned that it would stain his reputation and risk the country’s financial stability.

 

After a few weeks of public fighting, with rumors of a police investigation, the chairman decided to step down. It was only when Dankner had stepped down, and Fischer had secured his status, that Fischer decided to share with the public the nature and power of the forces that were at play behind the scenes.

 

Careful and sophisticated as he was, Fischer decided to give an interview to the only newspaper that supported him. And in that interview, when asked to explain what was happening behind the scenes, he chose to quote a paper by Randall Morck, one of the leading experts in the world on corporate governance and political economy:

 

Around the world, large corporations usually have controlling owners, who are usually very wealthy families. Outside the U.S. and the U.K., pyramidal control structures, cross shareholding and super voting rights are common. Using these devices, a family can control corporations without making a commensurate capital investment. In many countries, such families end up controlling considerable proportions of their countries’ economies. Three points emerge. First, at the firm level, these ownership structures vest dominant control rights with families who often have little real capital invested – creating agency and entrenchment problem simultaneously. In addition, controlling shareholders can divert corporate resources for private benefits using transactions within the pyramidal group. The result is a poor utilization of resources. At the economy level, extensive control of corporate assets by a few families distorts capital allocation and reduces the rate of innovation. The result is an economy-wide misallocation of resources, and slower economic growth. Second, political influence is plausibly related to what one controls, rather than what one owns. The controlling owners of pyramids thus have greatly amplified political influence relative to their actual wealth. They appear to influence the development of both public policy, such as property rights protection and enforcement, and institutions like capital markets.3)Morck, Randall, Daniel Wolfenzon and Bernard Yeung. 2005. “Corporate Governance, Economic Entrenchment, and Growth.” Journal Of Economic Literature, Vol. 43, No 3, pp. 655-720.

 

Fischer quoted Morck’s paper on pyramids because he knew that the most powerful players in the Israeli political economy were the controlling shareholders in a few pyramids, and that they were also huge borrowers from Bank Hapoalim.

 

Fischer won the battle – and the war: First Dankner stepped down, then a government committee that Prime Minister Benjamin Netanyahu and Fischer commissioned was tasked4)Ethan Bronner, “Protests Force Israel to Confront Wealth Gap.” New York Times, August 2011. with addressing the pyramids’ concentration5)Tobias Buck, “Israel’s Connected Conglomerates.” Financial Times, August 2011. in Israel’s capital markets and private sector6)Vita Bekker, “Israelis aim for shift of balance in business.” Financial Times, September 2011., and recommended diminishing their power and breadth. And finally Dankner was indicted, convicted, and sentenced to two prison terms: one for his actions as the chairman of the bank7)Jasmin Gueta, “Dan Dankner’s Sentence Cut to Eight Months.” July 2014 (8 months) and one for a real estate bribery affair8)Steven Scheer, “Former Hapoalim chairman Dankner gets 3 years in jail for bribery.” Reuters, May 2013. (3 years).

 

In March 2014, when Netanyahu met with Chicago Booth Professor Luigi Zingales (one of the editors of this blog) to discuss crony capitalism, Netanyahu acknowledged  the above ideas when he said, “If you look at Israel, I think one percent of the businesses receive an inordinate amount of the loans. That means that a lot of other businesses that could have been successful didn’t receive loans. If that is based on connections, based on a club, then obviously you lose a lot of potential growth in the economy. So you have to implement reforms that guarantee the solidity of the banks, but also create competition among them.”9)Guy Rolnik, “Netanyahu: Corporate Media Is Responsible for Israeli Crony Capitalism.” TheMarker, April 2014

 

Fischer’s victory and the implementation of the concentration committee’s recommendations started a process of cleaning up the Israeli banks – reducing their exposure to large loans given to a few powerful business groups,  introducing reforms, and ultimately reducing these groups’ political power,.

 

Fischer has since put all these challenging events, that unfolded 7 years ago, behind him. Asked what he had learned, he said that he’d rather let sleeping dogs lie – but his ability to carry the day and start a process of cleaning up the Israeli banks is very relevant when reviewing what is happening today in India.

 

Raghuram Rajan, the governor of the Reserve Bank of India, has been under attack in the last few months. Before the end of his first term and impending decision on whether to extend his tenure for a second term, Indian politician and economist Subramanian Swamy called on India’s prime minister, Narendra Modi, to “kick out” Rajan.10)Subramanian Swamy, “PM Should Throw Out RBI Chief, Other ‘American’ Advisors.” Businessworld, May 2016.

 

Swamy criticized Rajan for his reluctance to lower the interest rate, in light of India’s high inflation. Interestingly, for people who followed Fischer’s tenure in Israel—the criticism against Rajan—a professor at the University of Chicago that has a green card has a familiar ring to it . Some of Fischer’s detractors used to complain that he was American, had spent most of his professional life in the U.S., and would go back to the U.S. following his tenure, which was eventually extended to two terms. (Fischer received an Israeli citizenship when he became governor, but still kept his U.S. citizenship.)

 

The idea that a powerful technocrat such as a central banker has to be native-born and to have spent most of his life in the country to be part of the culture, and to bear the consequences of his decisions together with the rest of the citizens, can be appealing and may have some merit to it. But the cases of Fischer and Rajan also offer the opposite perspective.

 

Although Rajan has been criticized for his interest rate policy, there are other big issues in the background. Since  taking over as governor, he has pressed banks to deal with bad debts – some of them extended to very powerful11)James Crabtree, “India to crack down on companies that fail to repay loans.” Financial Times, June 2015. players12)Bloomberg editorial, “India’s Central Bank Chief Is an Economic Asset.” June 2016. Rajan is careful with his words – but he is trying to deal with  crony banking in India.

 

Back to Fischer. His ability to stand against the most powerful forces in the Israeli political economy in 2009–2011 – the bankers, the big business pyramids, and the media outlets – stemmed not only from his expertise, but also because from his international reputation and his conviction that, at any point in time, if he got burned” and delegitimized in the local Israeli scene, he would still be able to go back to the U.S., to academia, or to the corporate world.

 

Sure enough, in 2011, Fischer submitted his candidacy to be the next managing director of the International Monetary Fund13)Dafna Maor, Haaretz Service and The Associated Press, “Bank of Israel Governor Stanley Fischer Submits Candidacy for IMF Chief.” Haaretz, June 2011., but he was rejected due to his age (67 at the time), because IMF rules set an age limit of 65 for the fund’s head14)Lesley Wroughton, “IMF boots Fischer from race for top job.” Reuters, June 2011. Instead, in January 2014, he was sworn in as the vice chairman of the Federal Reserve15)AP, Reuters and Haaretz, “Obama Nominates Former Bank of Israel Chief Stanley Fischer as Fed Vice Chairman.” January 2014..

 

The media’s ties to banks can be a very powerful mechanism to threaten regulators or to set a public agenda that is favorable to the status quo or the banks16)Zingales, Luigi. 2016. Are Newspapers Captured by Banks? Evidence from Italy. ProMarket.

 

The Israeli and the Indian media markets are both highly concentrated, with significant direct and indirect ties to big business groups and banks17)Indian banking: Of banks and bureaucrats.” Economist, June 2014. Most Israeli newspapers, or their owners, had significant outstanding loans to Bank Hapoalim at the time of the battle with Fischer. In India, although many times bigger than Israel, the media market is noncompetitive, there are no restrictions on cross-media ownership, and political parties and figures own or control increasing sections of the media18)Paranjoy Guha Thakurta, “Media Ownership in India-An Overview.” June 2012.. Two years ago, India’s biggest and wealthiest business magnate, Mukesh Ambani, bought Network 18, an Indian mass media company19)Megha Bahree, “Reliance Takes Over Network18: Is This The Death Of Media Independence?” Forbes, May 2014.

 

Rajan’s ability to go after crony banking, or the habit of extending bad loans to insolvent business groups, could be derived exactly from his tenured position at the University of Chicago and his international prestige. While these characteristics are used against him by his detractors, it may very well be the reason that India needs him specifically. In fact, some countries do it quite regularly: Bo Rothstein, who we interviewed just recently, said that many experts that serve on government committees in Sweden come from outside of Sweden20)Guy Rolnik, “ProMarket Interview: Bo Rothstein on the Role of Government in Market Economies.” ProMarket, May 2016.

 

Fighting crony capitalism in countries where a small group of people has huge political and financial influence is sometimes a role only people with strong backing from outside the country can take on.

 

Disclaimer: The ProMarket blog is dedicated to discussing how competition tends to be subverted by special interests. The posts represent the opinions of their writers, not those of the University of Chicago, the Booth School of Business, or its faculty. For more information, please visit ProMarket Blog Policy.

References   [ + ]

1. Israel’s Banking System – Annual Survey. 2009. Chapter 1: Developments in the Activity and Structure of the Banking System in 2009.
2. Sharon Shpurer and Ram Dagan. “Fischer Tells Arison: Dankner Is Responsible for Hapoalim Problems.” Haaretz, April 2009.
3. Morck, Randall, Daniel Wolfenzon and Bernard Yeung. 2005. “Corporate Governance, Economic Entrenchment, and Growth.” Journal Of Economic Literature, Vol. 43, No 3, pp. 655-720.
4. Ethan Bronner, “Protests Force Israel to Confront Wealth Gap.” New York Times, August 2011.
5. Tobias Buck, “Israel’s Connected Conglomerates.” Financial Times, August 2011.
6. Vita Bekker, “Israelis aim for shift of balance in business.” Financial Times, September 2011.
7. Jasmin Gueta, “Dan Dankner’s Sentence Cut to Eight Months.” July 2014
8. Steven Scheer, “Former Hapoalim chairman Dankner gets 3 years in jail for bribery.” Reuters, May 2013.
9. Guy Rolnik, “Netanyahu: Corporate Media Is Responsible for Israeli Crony Capitalism.” TheMarker, April 2014
10. Subramanian Swamy, “PM Should Throw Out RBI Chief, Other ‘American’ Advisors.” Businessworld, May 2016.
11. James Crabtree, “India to crack down on companies that fail to repay loans.” Financial Times, June 2015.
12. Bloomberg editorial, “India’s Central Bank Chief Is an Economic Asset.” June 2016
13. Dafna Maor, Haaretz Service and The Associated Press, “Bank of Israel Governor Stanley Fischer Submits Candidacy for IMF Chief.” Haaretz, June 2011.
14. Lesley Wroughton, “IMF boots Fischer from race for top job.” Reuters, June 2011
15. AP, Reuters and Haaretz, “Obama Nominates Former Bank of Israel Chief Stanley Fischer as Fed Vice Chairman.” January 2014.
16. Zingales, Luigi. 2016. Are Newspapers Captured by Banks? Evidence from Italy. ProMarket
17. Indian banking: Of banks and bureaucrats.” Economist, June 2014
18. Paranjoy Guha Thakurta, “Media Ownership in India-An Overview.” June 2012.
19. Megha Bahree, “Reliance Takes Over Network18: Is This The Death Of Media Independence?” Forbes, May 2014
20. Guy Rolnik, “ProMarket Interview: Bo Rothstein on the Role of Government in Market Economies.” ProMarket, May 2016

7 comments

  1. I wonder if this (regulatory capture) explains the apparent Fed desire to raise interest rates when neither the price level nor the NGDP level has returned to pre-crisis trends.

  2. It will be interesting to investigate just how vigorously our “Rockstar Guv” chased the NPA issue before his Annual IHC 2015 talk and after. I remember making one observation and asking two questions at the meet, one of which he was reluctant to answer because he believed he belonged to the debt side of the equation and considerations such as whether space exploration redefined our habitat – both entrepreneurially or otherwise – was truly a question for the Elon Musk’s of the world to answer and really not for him. Although, he did engage with the idea of GM crops as a Europe approved idea that he was not averse to if the Indian government warmed up to it. As for my observation that the two Rajan’s of that afternoon – one talking to us and the other being dragged to Tihar – could be two sides of the same coin, was only an observation and needed no response. However, later as Rockstar Guv was leaving the IHC premises he did indeed, to his immense credit (pun intended) , give my exhortation contained in a single phrase, worded differently from the Shakespearean : ” look into thy debt:equity ratio”, much silent attention.

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