Crisis In Banking Has To Come

Dr Rajan,

your next crisis is coming up 


in banking

By Adil Rustomjee (Published in First Post Business)

“The primary role of the central bank…is monetary stability, that is, to sustain confidence in the value of the country’s money. Ultimately, this means low and stable expectations of inflation…”. 

Or so said Raghuram Rajan, the new RBI Governor, in his first statement after taking over. But he has a problem rushing at him – and it’s not really about the rupee. The next lurch downwards in India’s financial crisis will come from the country’s banking system. The centre of gravity of the economic situation – the focus of policymakers’ attention – will move gradually from the currency markets to the nation’s banks. 

India’s system of repressed financing in the banking system will be exposed to its rotten core.  Recently, a 100 basis points (1 percent) rise in bond yields resulted in Rs 40,000 crore in bond losses that were swept under the carpet as the Reserve Bank of India (RBI) gave them “relief” in the form of mark-to-market waivers. Further rises in bond yields could  result in as much as Rs 100,000 crore in bond portfolio losses. 

This is besides the non-performing loans of about Rs 100,000 crore that will come up as the economy tanks.  Just six mid-sized companies – KS Oils, Kingfisher, and Deccan Chronicle among them – account for Rs 30,000 crore of this figure. Surely it is reasonable to assume that India’s over 6,000 public companies, almost a million private companies, and individuals, will account for the rest. The non-performing loan figure is also contingent on the RBI not providing further “relief” by fudging the non-performing loan recognition norms to suit banks. The grand total on the above two items will come to about Rs 200,000 crore. 

This will, in effect, wipe out a big chunk of the net worth of the banking system and force the government – which is going broke anyways – to recapitalise banks. Forget Basel 3, 4, or whatever. Recapitalising outside of the Basel 3 framework will itself be an almost impossible task. 

Consider the following. 

The banking system’s basic job in India is not lending as much as financing the government’s deficit. So, the Congress blows out the government’s expenditure with welfare programmes that are driven by the need for political gain. The government is basically putting in place the building blocks of the Indian welfare state, in a country that cannot afford it. Each building block is put in place every five years, just before a general election. NREGA, farm loan waivers, Food Security – the list goes on.  The government is using the political business cycle very effectively. Then there are the assorted subsidies. The government, in effect, is bribing the people with the people’s own money. 

The combination of subsidies and welfare programmes results in unsustainable domestic absorption. All this has to be financed through fiscal spending by the government, leading to large fiscal deficits. 

The fiscal deficit itself has to be financed. Much of the financing comes through the Indian banking system. The government does this through something called the “statutory liquidity ratio,” or SLR. The “statutory ratio” means that Indian banks are forced to use 23 percent of their deposits – net demand and time liabilities – to buy government securities (g-secs) and fund the fiscal deficit. That’s nearly a quarter of your money and mine that goes into this exercise. 

The banking system is thus forced to fund the government’s fiscal deficit at what – for the government at least – are very favourable rates. This system of repressed financing has been continuing in India for years. Remember also it’s not just the banks – the insurance companies and pension companies have their own “statutory ratios” to comply with. 

Needless to say, with the government having first claim on India’s limited capital pool at very favourable concessional rates of interest, the remaining capital has to get bid for by the private sector at higher rates. The private sector finds it difficult to do so at higher rates, and so gets “crowded out”. 

Consequently, the cost of capital – the interest rate – remains permanently high. Positive net present value projects start getting unviable at the margin. Investment activity collapses. Sounds familiar? 

Lazy banking 

Remember, however, that this suits the banks too. India’s banking system is basically owned by the Indian government. As much as 75 percent of it, in fact.  With the government as the owner, the banking system is subject to severe “principal-agent” problems. 

Without getting into complicated explanations of principal-agent problems, consider its stylised result. If India’s public sector bankers make a good loan, they just continue making their small fixed salaries. If they make a bad loan, the Central Vigilance Commission (CVC) sits on their heads, and starts investigations. 

Naturally, with this sort of  tradeoff, the  tendency is to make almost no loans at all. 

So what do the banks do with the money you and I deposit in the banking system? Banks simply loan a big chunk of it to the government by buying the government’s paper, and funding its fiscal deficit. In fact, the banks park more than the government’s “statutory ratio” requirement in the g-secs market. 

India’s system of repressed financing is actually for the banks’ benefit too. This results in what (former RBI Deputy Governor) Rakesh Mohan memorably called “lazy banking”. This is the tendency of the Indian banking system to just fund the government, rather than get on with the hard job of finding good companies and  individuals to lend to. 

This system is doubly profitable for the banks because of their access to low-cost current and savings account deposits, and because of the oligopolistic cartelisation of the banking system. 

To understand this, remember hundreds of millions of Indians have current and savings accounts (CASA) on which the banking system pays little to no interest. The current accounts pay no interest, and the savings accounts had regulated interest rates of 4 percent till recently. The RBI deregulated the savings account interest rates, and banks are technically free to pay what they wish. 

An oligopoly 

But remember also that the banking system is a closed oligopolistic cartel. Despite the savings bank account rates being freed, banks – barring a handful – have held on to interest rates at 4 percent. Self-serving rationalisations are routinely spouted by bankers on the media channels justifying this situation. So the banks get money from the Indian public through current and savings accounts, on which they pay negligible interest, and lend on to the Indian government at yields of x8 percent. 

This is one of the neatest carry trades in financial history. The trade is even more profitable because of the very low risk weights assigned to g-secs. The weights are so low – just 2.5 percent of the full capital ratio – that banks have to set aside a very low amount of their capital for lending to the government. 

Remember also that the change in the Indian savings rate funded this for years. 

Higher savings entered the system, the government confiscated it through the g-secs market, blew it up on subsidies and welfare schemes, but in the following years the savings rate went up even more, which allowed the system to continue. 

Unfortunately, the savings growth rate is negative, and the government’s fundamentals are collapsing. 

This Ponzi scheme is therefore coming to an end. 

“Relief, really?” 

Now this is a pretty spectacle. The banking system has loaded up on the Republic of India’s paper, paper that, because of the severe deterioration of the government’s finances, is in danger of being declared junk. India’s banking system has effectively loaded up on what may become junk bonds. 

The government’s paper was supposed to be risk-free, backed by the “full faith and credit” of the Indian government. But guess what? It turns out the Indian government is not risk-free, and it inspires little “faith and credit”. Notice that the Indian government is slowly going bust, funding the welfare programmes and assorted subsidies. 

As a result, like any borrower whose financials are deteriorating and whose paper is publicly traded, the prices of g-secs should fall and yields should rise (prices and yields move in opposite directions). It turns out, there is only so much repression one can do even in a repressed market. The terrorized folks who call themselves bond traders in Mumbai have a “daddy knows best “ attitude towards the RBI -  brought about by years of financial repression. But even they can be pushed only to a point. Push them more, and they start becoming bond market vigilantes. Something like that may happen in India going forward. In fact, India needs the bloodless discipline of the bond market to put its finances in order. Presently, instead of that discipline, every time bond yields rise, the RBI throws a set of rules at the bond market, that only the RBI seems to understand. 

As yields rise and bond prices fall, the banking system will get exposed to massive mark-to-market losses on its bond investments. 

Something like this happened this August, with a rise in yields of 100 basis points. This resulted in almost Rs 40,000 crore in losses on banks’ bond portfolios, a big chunk of the entire banking sector’s annual profits. A harbinger of things to come. When this happened,  what did the banks do ? They ran to the RBI, for something called “relief”. 

The RBI promptly provided “relief”. 

The g-sec bond portfolios are held by banks in various buckets – available for sale (AFS) and held to maturity (HTM) and so on. In fact, there are so many buckets that soon we will certainly have an ABC and XYZ bucket too. So some bureaucrat at the RBI changed the proportion that could be parked in various buckets, changed a percentage here, and an accounting rule there, and guess what?  
Rs 40,000 crore in mark-to-market losses disappeared! 

This is wonderful, marvelous, amazing. 

When g-sec bond prices go up, the banks make profits on their bond portfolios. When they fall, the banks should make losses. But no. They don’t make losses. They get “relief” and the losses magically disappear! Aaaall is well. The Ponzi scheme is kept on the road. It is this sort of nonsense that offends my old fashioned Parsi sense of propriety. It is also the reason the outside world loses confidence in us.

 The result of all this hera pheri is bank balance-sheets in India are opaque and bizarre. They simply cannot be trusted. The banks have effectively “captured” the RBI into regulating the banks the way the banks see fit, and not necessarily the way in which the RBI desires. This is classic regulatory capture, if you will, an idea first articulated by George Stigler. The RBI is playing along as the consequences of a systemic banking crisis are unthinkable. After all, if that happens, the RBI will be left to pick up the pieces. 

A rise in g-sec yields, to 10 or 10.5 percent (for 10-year paper) will result in close to Rs 100,000 crore in bond losses for the banking sector. This, together with the net non-performing loans of  Rs 100,000 crore – itself contingent on the RBI not fudging recognition norms to provide more “relief” -  means potential losses of Rs 200,000 crore. 

This, gentle reader, is a big chunk of the banking system’s net worth! India’s banking system is tottering. 

Forget meeting Basel accord targets. The government now has to recapitalise the banking system outside the Basel framework.

 And at the rate it is going, it will not have the money to buy shoelaces, let alone recapitalise the banks. 

Oh dear. There goes the Indian banking system. Was that a giant flushing sound you just heard? 

Interestingly, the Indian public is buying gold. They are doing it for other reasons, notably inflation protection. But this is not a bad habit at all, given the parlous state of banks.  This keeps a chunk of their savings out of the banking system. The public does not know all this, of course. 

How could they? 

Even the economists at the Mumbai brokerages haven’t articulated this as yet. The Indian public is doing the right deed for the wrong reason. Nice. 

Tall Order, Tall Man 

Ending India’s system of repressed financing will not be easy. The biggest stakeholder in the system – the government – has the most to lose. The new RBI Governor has his task cut out for him. 

Misguided efforts to tighten liquidity and raising interest rates to defend the currency puts at risk the stability of the Indian banking system. And yet rates – and yields – must rise. With inflation consistently above bond yields, India seeks to make economic history by becoming perhaps the first country in the world to control a severe inflation problem with negative real interest rates. This presents an existential dilemma. The alternative is to wing it by muddling through, and hope inflation falls. This is what the government has been doing to date with disastrous results. 

Most importantly, the Union of India’s pipeline to cheap concessional financing through the device of the “statutory ratio” must be cut.  The government must be made to pay the same risk-adjusted interest rates that we all do. This is the only thing that will reduce the Indian government’s profligacy. Using the FRBM – the Fiscal Responsibility and Budgetary Management Act – will not work. The government can always abrogate it, if it feels like it. This is exactly what the Congress did some years back to fund its welfare schemes and subsidies. Using the FRBM to control government spending is like giving the alcoholic the key to the cupboard where the bottle is locked up. He can always open it later.  Far better to cut the sharabi’s financial allowance, and make it difficult for him to buy his daru. 

Bond markets and monetary transmission will have to be overhauled to bring them into equilibrium. No less a panjandrum than the SBI Chairman was recently quoted as saying that the “effective” repo rate was at 10 percent. So now India has a repo rate set by the RBI, and an “effective” repo that is much higher, according to the SBI Chairman! 

Wholesale violence will have to be committed on India’s bond markets to prevent this sort of dysfunctional nonsense from manifesting itself in the future.  Mere tinkering with reform won’t do here. 

Ending the banks’ regulatory capture of the RBI is a process, not a goal. Of key importance, is keeping rules clear and transparent, ending all exceptions to those rules, and resisting the tendency to provide “relief” to those smooth talking bankers in their blue suits. This is easier said than done. 

Work will be required on improving quality in that most unglamorous of areas – government statistics. India’s economic statistics are so abysmal that it is a wonder the government can make any policy at all. 

Consider the most basic statistic – GDP.  GDP measured at factor cost leads to a 5 percent growth rate. Measuring it from the demand side (consumption/investment) leads to a growth rate of just over 2 percent. 

The same government figures measuring the same phenomenon lead to a second figure that is half the first!  Naturally, the government and the chattering classes will tom-tom the higher figure. 

Similarly, as Devangshu Datta has presciently pointed out in a recent Business Standard article, the government conveniently uses the WPI to deflate nominal GDP. If it used the CPI to deflate nominal GDP (even at factor cost), the growth rate falls to 2 percent again! Anecdotally, it would seem the lower figure of 2 percent is the GDP growth rate. 

The terrible public mood and the fact that most Indian industries are in recession – not slowdown – also points to that. Of course, the most important measure is privatisation of the nation’s banking system. This will end the chronic absurdity of most of the banking system being owned by the government in a market economy. 

This is a political decision that must be made in Delhi at the highest level. This may never happen, and yet it must come. 

Agency problems in the Indian banking sector caused by government ownership are too severe, almost terminal in fact. Consider, for example, that most of the non-performing loan problem is in the government-owned banks. All this will require monetary statesmanship of the highest calibre. And all this will require Raghuram Rajan to think of India, and not the Congress/UPA’s spending plans. Now that is a tall order for a tall man. 

Adil Rustomjee Adil Rustomjee is an investment advisor in Mumbai.  

http://www.firstpost.com/business/dr-rajan-your-next-crisis-is-coming-up-in-banking-system-1112429.html