Lazy bankers

Growth in non-food credit has been slow despite the pick up in the growth of the manufacturing sector this year.

At the same time, commercial bank investments in government securities are higher than reserve requirements. Does this indicate that there is no demand for bank credit at current interest rates, or does it suggest that banks prefer to invest in government bonds than to lend to industry?

Maybe, a little bit of both. This could partly be due to corporates borrowing abroad cheaply, however this is not a complete explanation.

All borrowers are not able to borrow in international markets. So what explains the lack of bank credit growth at a time when industry appears to be on a path to revival?

Given the large fiscal deficit and the huge appetite of the government to borrow, it seems that banks are taking the easy way out.

Some months ago, Deputy Governor of the Reserve Bank of India, Rakesh Mohan, criticised banks in India for being "lazy bankers", which consists of buying government bonds beyond reserve requirements. What are the compulsions driving 'lazy banking', and what are its consequences?

One 'standard path' towards profitability for banks consists of absorbing and managing credit risk. In this, the bank seeks to earn 'the credit spread', or the premium between deposit rates and the interest rates available when lending to firms or to individuals.

In India right now, the ballpark numbers involve borrowing at 6 per cent and lending at 11per cent, giving a handsome spread of 500 basis points.

Over the last decade, banks have learned that this spread does not come easy. Banks are extremely leveraged, and small failures by borrowers to repay lead to big problems for banks.

In India, on average, banks have equity capital, which is only 5 per cent of assets, i.e. a 20 to 1 leverage ratio. This implies that a 100 per cent loss on just 5 per cent of assets is enough to make the bank insolvent.

In order to earn the credit spread, banks need to establish a sound credit process. This involves credit evaluation at the time of making decisions to give loans, ongoing systems for monitoring credit exposures and taking pro-active action before a loan goes bad, and strong systems for maximising recoveries once a loan goes the non-performing asset way.

A sound credit process requires good databases and models that estimate the riskiness of various borrowers. It also requires well-incentivised, well-motivated staff.

Particularly in the area of NPA recoveries, the sheer dynamism and motivation of the staff has an enormous impact upon the recovery rate.

If a bank is able to put together a sound credit process, then it does indeed have a plausible business plan. However, this is a genuine challenge. It is particularly hard for many PSU banks, which have weak staff, weak decision processes, and a lack of tradition in exploiting data and models.

Many PSU banks suffer from political interference in giving out bad loans and easing up on enforcement against NPAs.

What is a bank to do when it understands that it does not have a credible credit process, and probably never will? A second business plan that can be adopted is to invest in risk free government bonds.

When the yield curve has a normal upward slope, the bank focuses on the difference between short-dated interest rates and long-dated interest rates.

If a bank is able to borrow at the short end of the curve using demand deposits, and buy long-dated government bonds, then it stands to earn the term spread.

When the long end of the yield curve was at 10 per cent, and the average cost of funds at the short end was 2 per cent, this was a handsome term spread of 800 basis points.

Thus, failing to have a good credit appraisal and risk monitoring process can make purchase of government securities with high long-term rates an attractive proposition.

In this situation even though a portfolio consisting of floating rate loans would have implied much less interest rate risk, banks choose a portfolio with a large component of long dated fixed rate government securities.

The bank may aim to hold these securities till maturity to benefit from the higher interest rate. If it believes, due to its past experience, or due to the nature of its depositors, that its current and saving deposits are not likely to be withdrawn easily, or are 'core' in nature, it will expect to earn a good net interest income without serious risk.

However, this strategy may not be very profitable when the spread between short and long rates is low. Indeed, buying long bonds would expose the bank to interest rate risk without offsetting this risk by higher interest income earnings. There seems to be little sense in this strategy.

But that is not always the case. The strategy of investing in long dated government debt may still make sense and the bank may choose to take this risk if it is expecting the yield curve to shift.

In other words, it places a bet on interest rates moving down. In the last two years banks have made huge profits by betting on interest rates moving down.

The longer is the duration of his investment portfolio the higher will be the profit a bank expects to make when there is a drop in interest rates.

Banks are nudged along this path by poor rules on interest rate risk regulation and lower regulatory capital requirements, which encourage 'regulatory capital arbitrage' bearing interest rate risk instead of credit risk.

Banks thus face a choice between two ways to make a living: To build a sound credit process, or to speculate on interest rate risk. In India, some major banks have chosen to emphasise the credit process. The two largest banks in the system, SBI and ICICI Bank, seem to be trying this. They do not carry much interest rate risk.

Interest rates have gone down systematically in recent years. Further, expectations of further softening have been raised.

Hence, many banks have setup their balance sheets to speculate that interest rates will go down. This has led them to steadfastly buy long government bonds. This may be an important reason for the unusual flattening of the yield curve.

This is a paradoxical situation. A flat yield curve reduces the profits from borrowing at the short end and buying long bonds. At the same time, purchases by banks seeking to speculate on dropping interest rates have been strong enough for the yield curve to  flatten out.

Hopefully, with the pick up in manufacturing, the demand for credit will be higher. This, in addition, to flat yield curves, and reduced expectations of further large declines in interest rates should motivate banks to improve their credit processes, and return to the business of giving bank credit.

The author is at ICRIER. These are her personal views