Dealing with bank failure

| Updated on July 24, 2014 Published on July 24, 2014

Burdening banks with raising capital beyond a point will hobble credit growth

The Reserve Bank of India’s move to identify domestic systemically important banks (D-SIBs) is a result of the requirement that all member countries of The Basel Committee of Banking Supervision set up a regulatory framework for banks that ‘are too big to fail’. While this needed to be done to complement the existing framework for globally important banks or G-SIBs, it is pertinent to question the merit of subjecting our big banks to capital requirements over and above that stipulated under Basel III. Big Indian banks are smaller than most of their global counterparts in both absolute and relative terms. For instance, the eight US G-SIBs have combined assets equal to 70 per cent of the country’s GDP; in India, the combined assets of the likely six D-SIBs add up to only a third of its GDP. Moreover, our banks mainly engage in plain-vanilla lending and have very limited inter-connected financial exposures through over-the-counter derivatives and other exotic instruments. As a result, the risk of contagion from credit defaults is substantially lower. Also, bank failures are rare in India, unlike the US or the UK, where the likes of Washington Mutual and Northern Rock have gone belly up in recent times. Public sector banks (PSBs), which have implicit state backing, make up roughly three-fourths of all deposits and advances in India. This is why there was very little panic amongst depositors when the United Bank of India reported a surge of bad loans last year.

The RBI has proposed that D-SIBs set aside additional common equity capital; the amount will depend on their risk profile. Burdening banks with too much capital is counter-productive in a country where credit needs to expand 2.5 to 3 times more than real GDP growth. Additional capital will constrain the ability to lend which, in turn, will impact overall economic growth. It is doubtful whether higher capital adequacy alone can prevent the recurrence of Black Swan events such as the 2008 global financial crisis. Bank runs have to do with public perceptions regarding safety of deposits, going beyond mere capital provisions.

This is not to understate the risk that large PSBs pose. Their proclivity for lending to risky projects stems from a combination of political pressure and the confidence of a government bailout in the event of a crisis. But the way to deal with this is to tighten prudential norms on lending and conduct stricter assessments of non-performing assets (NPAs). The RBI has done well to coerce banks into formulating credit action plans for loans overdue for more than just 60 days — that is, well before they slip into the NPA zone. All in all, the key to prevent banks from going under is prudential lending rather than providing a buffer in the form of greater capital.

Published on July 24, 2014
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