The moral hazard headache

Prasenjit Chakrabarti/Sudipta Sen | Updated on September 23, 2021

RBI’s G-SAP 2.0 may hinder banks’ credit offtake

The Indian economy has bounced back, recording a growth rate of 20.7 per cent in the second quarter. Although the high growth figure may be due to the base effect as the economy had severely contracted in Q2 a year back, there is no denying that it is one of the highest jumps in growth rate amongst its peer countries. Credit is due to the government and the RBI for their efforts in co-ordinating the fiscal and monetary policy to steer the economy to the high growth path. In boosting growth, RBI's Government Securities Acquisition Programme (G-SAP) needs a special mention. Recently, the RBI announced the extension of the G-SAP programme — G-SAP 2.0.

Under the G-SAP 2.0 programme, the RBI will conduct open market purchases of government securities worth ₹1.2 lakh crore across the various maturity spectrum. The programme aims to ensure the orderly evolution of the yield curve such that all segments of the yield curve remain liquid. G-SAP 2.0 is the Indian version of quantitative easing, which has been the go-to monetary policy to pull economies out of recession after the global financial crisis.

In quantitative easing, central banks pump money into the economy through the banking system, with the tacit belief that the banks will pass on that liquidity to the rest of the economy in the form of credit, thus propping up the productive activity in the economy.

Nevertheless, despite the RBI’s flurry of liquidity measures, the credit growth of the Indian banking system suggests that the pass-through has been remarkably stagnant. The current annual credit and deposit growth rates for the scheduled commercial banks are 10 per cent and 6 per cent, respectively, raising serious concerns about the pass-through.

The ownership pattern of government securities reveals that the commercial banks hold approximately 40 per cent of government securities. The massive quantitative easing programme under G-SAP may flatten the yield curve and inflate the prices of government securities held by the banks, causing an increase in the banks’ equity.

Perverse incentives

This creates a problem of moral hazard for the banking system. The inflated equity paints a healthier picture of the balance sheet and the overall financial performance of the banks; banks are incentivised to hold more government debt rather than searching for new avenues of credit growth.

Additionally, the Indian banking system has one of the highest gross non-performing assets (GNPA) to total asset ratio globally. Post-Covid stress scenarios estimated by the RBI pegs it at an aggregate GNPA ratio in the range of 12.5-14.7 per cent. In such a scenario, the inflated equity is more likely to entice the banks in evergreening the bad loans rather than quality lending.

The RBI has also recently announced four variable reverse repo rate (VRRR) auctions to absorb ₹13 lakh crore of excess liquidity from the system. The simultaneous announcements of G-SAP 2.0 and VRRR auctions may send a mixed signal to the market about the policy stance of RBI and may create further hurdles for credit growth. Although it seems that the VRRR is initiated to reduce inflationary pressure in the economy (inflation is currently at 5.7 per cent, in the upper band of the inflation target set by the MPC), it may entice banks to park the excess liquidity provided by G-SAP 2.0 to VRRR (earns a rate higher than the ongoing money market rates), further hindering the new credit growth.

The RBI has done a remarkable job in harmonising the monetary policy with the fiscal policy to pull the Indian economy out of the growth rut, but the moral hazard and the incentive problem existing in the banking system may push the financial markets along with the economy into a quagmire.

Chakrabarti is Assistant Professor (Accounting and Finance Area), IIM-Ranchi, and Sen is Assistant Professor, Jindal School of Banking and Finance, Sonipat

Published on September 23, 2021

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