The Government and RBI enjoined upon Scheduled Commercial Banks and Regional Rural Banks to roll out BC-ICT-CBS (Business Correspondent- Information & Communication Technology- Core Banking Solution) – leveraged financial inclusion plans to excluded rural areas. In delivering credibly,leveraging technology is a sine qua non .

LEVERAGE OPTIONS

It would be instructive to consider the business model of a typical safe, and sound, bank.

A bank is characterised by relatively high financial leverage, which, in turn, is measured by what is known as Equity Multiplier (EM), which, in turn, is nothing but total assets of a bank divided by its common equity/ shareholder funds. Multiplying this leverage (EM) by what is called Return on Assets (ROA) gives Return on Equity (ROE) for a bank.

Typically, safe and sound banks have had historically an average ROA of about 1 per cent and a reasonably safe EM of about 15, implying an average equilibrium ROE of about 15 per cent. In the recent period, the Indian banking system has had leverage of about 13 to 14 times.

In this context, another key financial parameter is what is known as Net Interest Margin (NIM) which is the difference between interest earned and interest expended as a percentage of a bank’s assets. For Indian banks, NIM has varied between 2.5-3.5 per cent. If we deduct ROA from NIM, we get what can be called non- interest cost of intermediation.

In fact, it is this critical parameter (NIM-ROA) which can be controlled by leveraging technology.

All else being equal, technology leverage in a bank can typically significantly reduce this non-interest cost by delivering humanly impossible exceptional speed, efficiency and volumes in banking transactions and, therefore, for a given NIM, increase ROA, or for a given ROA, ROE and EM, significantly reduce NIM and thus borrowing costs for bank customers. In the first case, higher ROA and hence ROE, enhance shareholder value, making the bank less risky and thus reducing equity risk and deposit insurance premia and potentially keeping taxpayers out of harm’s way. Thus, either way, Technology Leverage (TM) delivers value to all stakeholders viz., shareholders, uninsured depositors, borrowers, taxpayers, in particular, and the real economy, in general.

Higher leverage for banks is critical to efficient and effective monetary transmission.

DOUBLE-EDGED SWORD

But since higher leverage is a double-edged sword, it increases, through leverage multiplier, both profits and losses and, therefore, needs to be handled with care.

This, in turn, is ensured by effective regulation and supervision of banks for uninsured depositors and deposit insurance for small depositors.

While assuming financial risks directly contributes to financial returns, technology risks do not contribute incremental returns directly but only indirectly.

Almost exactly like financial leverage in a bank, Technology Leverage also signifies potential downside risks to ROA and, therefore, ROE. But in combination with the already inherent financial leverage, Technology Multiplier (TM) and Equity Multiplier (EM) make for what I would call ‘leverage on leverage’ or ‘super leverage’ like options on futures and derivatives on derivatives.

This is attested to by recent infamous technology glitches/snags at Royal Bank of Scotland (RBS) and Lloyds Banking Group. RBS is paying about $200 million in compensation to its 17 million technology-disenabled customers due to a massive technology meltdown which locked them (customers) out of their accounts for three weeks!

Another example of a technology glitch is that of Lloyds Banking Group’s ‘Faster Payments’ designed to ‘speed up’ cash transfers going slow after it was hit by a glitch delaying wage and bill payments. If only to complete the Technology Leverage/ Multiplier backlash story, one cannot but refer to the recent case of Knight Capital which went belly up due to a $440 million loss in a matter of less than 45 minutes – literally $10 million per minute, and that too ‘involuntarily’ – because of a technology glitch in its High Frequency Trading (HFT) algorithm system.

ALGO-DRIVEN SPEED

This simply meant that it was not humans but ‘Technology’ that was in complete control and command for it is humanly impossible to lose $440 million in 45 minutes through what was a preposterous ‘buy high- sell low’ algo-trading!

The sheer speed of algo-trading left just no response time for just-in-time human intervention. This is simply because Technology Leverage / Multiplier being symmetrical also ‘saves’ time in reverse during a backlash, delivering losses in multiples as it delivers benefits / cost savings in multiples of speed and volumes. Even if humans, unlike Technology Multiplier / Leverage, do not have leverage, unethical and rogue traders / executives in banks can, and do, piggyback ride Technology Leverage as indeed illustrated by the Nick Leesons and Jerome Kerviels.

Be that as it may, high frequency trading, based on complex algorithms, is trading by computers and not by humans. The long and short of this very elaborate overview of the downside risks of technology is to be alert to the very real and extreme risks which leveraging technology can expose banks to, thus having adverse consequences not only for the shareholders of banks but also other stakeholders such as uninsured depositors, deposit insurers, borrowers and unsecured creditors.

It can significantly raise equity, credit and deposit insurance premia and, in the extreme case, threaten systemic financial stability with potential implications of taxpayer-funded bailouts.

HUMANS, NOT MACHINES

To conclude, my purpose was to alert (people) to the upside potential and downside risks of the so-called Technology Multiplier (TM), a close cousin of the well known Equity Multiplier (EM) and no more, no less.To paraphrase Einstein, “Technology is a good servant, but a bad master.”

Therefore, the key in leveraging technology in banking is humans being in control, command and on top of technology and not the other way around. We need to resist the temptation of cutting corners when it comes to investing in technology in-house as opposed to mindless, indiscriminate and injudicious outsourcing driven and motivated only by considerations of cutting costs to the bone at any cost.

(The author is a former Executive Director, Reserve Bank of India.)

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