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 US 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% of the whole banking sector’s assets.
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 down.
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.
A barrage of criticism
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.”
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.
A happy ending
Fischer won the battle – and the war: First Dankner stepped down, then a government committee that Prime Minister Benjamin Netanyahu and Fischer commissioned was tasked with addressing the pyramids’ concentration in Israel’s capital markets and private sector, 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 bank (eight months) and one for a real estate bribery affair (three 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.”
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 seven 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.
Meanwhile, on Mint Road...
Raghuram Rajan, the governor of the Reserve Bank of India, had been under attack for several months before he announced on Saturday that he would return to academia when his term ended in September. 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.
Swamy criticised 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 had 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 US, and would go back to the US following his tenure, which was eventually extended to two terms. (Fischer received an Israeli citizenship when he became governor, but still kept his US 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 criticised 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 powerful players. 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 delegitimised in the local Israeli scene, he would still be able to go back to the US, 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 Fund, 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 head. Instead, in January 2014, he was sworn in as the vice chairman of the US Federal Reserve.
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 banks.
The Israeli and the Indian media markets are both highly concentrated, with significant direct and indirect ties to big business groups and banks. 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 media. Two years ago, India’s biggest and wealthiest business magnate, Mukesh Ambani, bought Network 18, an Indian mass media company.
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 needed him specifically. In fact, some countries do it quite regularly: Bo Rothstein said that many experts that serve on government committees in Sweden come from outside of Sweden.
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.
This article first appeared on the ProMarket blog of the Chicago Booth School of Business.