Banks given too long a rope

Civil servants and central bankers are generally reticent on how political uncertainties impinge on economic and financial issues.

Typical of his lead from the front approach, RBI Governor Raghuram Rajan is forthright in his foreword to the financial stability report No. 8, December 2013.

While the global economy has to watch the impact of the US Fed’s tapering of quantitative easing, Rajan stresses that in India there is an additional source of uncertainty from the ensuing general election. He feels a stable new government would be a positive for the economy.

Six years into the global financial crisis, economic agents look for some certainty in the current environment. The governor candidly admits that the tapering could be disruptive for India.

The report highlights the fact that failure of a major corporate or a major business group could trigger a contagion in the banking system due to the exposure of a large number of banks to such corporates. And the interconnectedness in the banking system could cause losses due to the contagion, over and above the direct losses on account of a failure of a large corporate group.

The RBI notes that the proportion of risky assets in total assets of banks is becoming broad-based and the stressed assets-advances ratio has risen to as high as 10.2 per cent in September 2013. Five sectors — infrastructure, iron and steel, textiles, aviation and mining — account for 53 per cent of total stressed advances.

Too Big to Fail There is a strong perception that the state will support institutions which are ‘Too Big to Fail’. What is more alarming is that in India, no bank would be allowed to fail.

This perception has been strongly reinforced by the track record since the 1960 Palai Central Bank failure, after which no bank has been allowed to fail.

The state has bailed out failing banks. Such a perception results in excessive risk taking and the longer authorities allow this perception to continue, the greater will be the risk taking.

Ultimately, at some point of time, a bank will need to be allowed to fail and even though this may be traumatic, it has to be allowed to take place.

In this context, the need for ‘Prompt Corrective Action’ (PCA) cannot be over-emphasised. The concept of PCA was mooted 15 years ago. Fears that there could be runs on banks have resulted in PCA being put on the back-burner. The RBI needs to seriously consider strengthening the PCA regime and the action should be put in the public domain. Such a regime would strengthen the system as weaker banks would grow at a slower pace.

Growth-Inflation Dynamics The RBI report shows growth differentials between the industrial countries and the emerging market economies (EME) is narrowing, while inflation rate differentials are widening.

This trend could trigger large capital outflows from select EMEs. A few years ago, discussions in international confabulations were focused on a few, large EMEs being the locomotive of growth of the global economy. In contrast, today, there is talk of the ‘Fragile Five’ — Brazil, India, Indonesia, South Africa and Turkey.

In this context, Indian authorities should give immediate attention to bringing about a significant and enduring reduction in inflation rate.

As the financial stability report aptly points out, the global financial crisis was perpetuated by a prolonged period of low interest rates and excess liquidity and the response to the crisis was precisely to lower interest rates and increase liquidity.

Sooner or later, the music has to stop and the dislocation could be very intense. Here, India should use the breather of gradual US tapering to reduce its vulnerability with strong monetary-fiscal policies.

Savings Accounts The report rightly stresses that high inflation has affected purchasing power consumption and inflation-adjusted returns on assets. This is particularly so for inflation-adjusted returns on bank deposits, which has resulted in a fall in net financial assets as a percentage of GDP.

In contrast, non-financial assets seem to yield better inflation adjusted returns. Further, the differential tax treatment of bank deposits, capital market instruments and non-financial assets creates a bias against bank deposits. This underscores the need to reassess monetary-fiscal policies in relation to savings instruments.

Further, one of the biggest challenges to the financial system is the skewed Central Government debt repayment profile. The desire of the Government to keep the cost of its borrowing down has resulted in excessive short-term debt. Redemptions by the Centre stand at Rs 95,000 crore in 2013-14, which will rise to a staggering Rs 168,000 crore in 2014-15. This will be the single most important challenge to the fisc in 2014-15. It is here that the Government will have to pay the price of not having set up a Consolidated Sinking Fund, which was formulated by the RBI as far back as 1996. It is sad that today’s generation has to pay for the sins of the previous generation. In sum, the RBI’s financial stability report has provided signal service by presenting a realistic analysis of the problems in the ensuing period. It is now for policymakers to bite the bullet — caveat emptor (buyer beware).

(The author is a Mumbai-based economist)

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