Banks and FIs - what should be done?

The fragility of Indian banking has been a source of concern for many years now. We are now seeing a fresh rash of banks seeking help when approaching failure, and we are now paying the price for having not developed a mechanism for closing down banks in the last decade. The political pressures to rescue banks are hard to resist in any one specific case, and we now have a series of precedents which will make it harder when the first bank has to be closed down. Estimates of bank solvency, based on analysing the expectations of the stock market, suggest that most banks in India are bankrupt.

In this gloomy situation, what is the way forward?

Privatisation. The first and most important element of banking policy should be to get away from the public sector character of banking. Why is this such an important issue?

Just sell them off. There is a technocratic fantasy which is aired from time to time: of a world where the government pulls itself up by the bootstraps, undertakes a one-time project to cleanup the functioning of a PSU, before it is sold of "at a good price". This is an incorrect approach, for several reasons.

The new private owners will be better placed to make judgements about the positioning and re-engineering that should be done, as compared with the government. The new private owners will be more effective at cost-minimisation in such an effort, as compared with the government. If there is value that can be unlocked using a revamp of the PSU, then the private sector will see that (provided it is given enough information), and this will impact on the valuation in their eyes anyway. Finally, the scarce managerial resources of the government are better spent on producing public goods.

Hence, the modern understanding of privatisation puts a top priority on a transparent, competitive process through which PSUs are sold off, without making any attempt at first revamping them.

Reducing leverage. International thumb-rules for leverage in banking suggest that banks should normally hold around 10% capital, and get shut down when they are down to 2% and the shareholders are unwilling to bring in fresh capital. These cutoffs are much too low for Indian conditions, for several reasons.

Macroeconomic volatility in India is higher. Accounting data is less reliable. Credit recovery is inferior. The fledgling derivatives market does not yet adequately support the risk management objectives of banks. Bank closure takes much more time. All these problems suggest that the ceiling on leverage of banks should be set to lower levels in India as compared with that used in OECD countries (which are the focus of the Basle accord).

Hence, we should use lower standards of leverage in India. One plausible set of values may be: banks should be normally required to hold 20% capital, and the shutdown point should be set to 5% or so.

Harnessing the securities markets. The safest loan is one where daily marking to market can be done, and where collateral can be instantly liquidated at the first sign of distress. There is only one avenue through which such high-quality collateral can be found: liquid securities.

Hence, banks should greatly expand the extent to which their loans are backed by liquid securities. This is the easiest way through which banks can continue to lend without undertaking significant risks. It should be noted that this only works for liquid securities; a debenture or a share which is illiquid is not good enough. However, when liquidity is present, the volatility of the security does not adversely affect the risk management of the bank.

Closing down banks. When a bank drops below the required level of equity capital, the owners of the bank should be given a choice: either they bring in fresh equity capital to go back to the ceiling on leverage, or the shares of the bank are forcibly taken away by them and the bank is closed down.

The Deposit Insurance Corporation (DIC) is the instrumentality through which this is done. As of yet, the DIC is quite ill-equipped for the purpose. There are many illusions about the role of deposit insurance that are widely prevalent. For example, the recent usage of DIC funds to rescue Madhavpura Bank (and not close it down) was completely inappropriate; this reduces the DIC to a pot of capital which will get rapidly used up in rescuing a few banks.

The DIC is not a Florence Nightingale, it is the executioner. The job of the DIC is to ride into the battle when the going is difficult, find the wounded lying on the field, and kill them.

We need to explicitly design the steps through which bank closure will take place, and we need to design the institutional machinery that will make this work. Without a steady pace of closing down weak banks, there is no possibility of having a sound banking system.

In summary. Our first priority should be to sell off public sector banks. The second step is to establish the DIC as an entity which genuinely evaluates the leverage of banks, offers shareholders a chance to recapitalise weak banks, and closes down the bank when the shareholders choose to not do so. In the first year of the functioning of the DIC, 25-50 banks should be closed down. Once this is in place, the equity thresholds of 10% (normal) and 2% (shutdown point) should be raised to levels like 20% and 5%. In the meantime, carrot and stick should be used to encourage banks to improve their safety by emphasising loans against liquid securities.

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