The focus of banking sector reforms in India has been public sector banks. But recent media reports suggest that some of India’s private sector banks may be in trouble.
With limited supervisory capacity, no resolution capability, and old laws, the only solution the Reserve Bank of India may have to the problem is to make a healthy public sector bank like SBI acquire them. This will not be good news.
How to judge the fragility of a private bank
As a member of the public, how is one to assess the soundness of a private bank? When a borrower does badly, the bank and the RBI work hard on covering it up. Most recent data is not available. But stock market speculators have strong incentives to peer inside the bank and understand the health of the lending portfolio.
The stock market deletes losses from the claims of the bank, including from the companies to which loans have been given. This influences share prices of banks. Hence, the key ratio to look at is the deposits of the bank divided by their market capitalisation.
As an example, consider Axis Bank. With deposits of about Rs 5 lakh crore, and equity market capitalisation of about Rs 2 lakh crore, this gives a ratio of deposits/Mcap of about 2.5. This is a reasonably healthy value.
As a thumb rule, values of 4 or lower are a comfortable environment. The latest available data gives us the following ratio for private sector banks in India.
The table above shows all private Indian banks, sorted by the deposits/Mcap ratio (the latest deposit data is from June 2019). This throws up numerous names with values of worse than 4.
Let us pause to understand the meaning of a ratio of 10. This means that, in the eyes of the speculators on the stock market, for each Rs 10 of deposits from the public, the bank only has a buffer of Rs 1 of equity capital.
The table shows a weakness in seven banks: Federal Bank, Yes Bank, Karur Vysya Bank, Lakshmi Vilas Bank, Karnataka Bank, Dhanlaxmi Bank and South Indian Bank.
We now try to see if we can get a more recent estimate of these figures. If we use the September 2019 market cap numbers, we find that Yes Bank also shows weakness. Even assuming zero growth in deposits since June, the ratio of deposits to market cap is above 21. All the other banks remain in the same health as in June.
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How regulation can fight the fragility of banks
How does banking regulation produce safety? A capable banking regulator does two things. First, it constantly forces the bank to do correct accounting of its assets. The assets must be counted at the prospective sale value. When a borrower comes under stress, this must be immediately recognised as loss. Second, the banking regulator must demand reduced leverage.
It is bad when unsophisticated households lose their bank deposits, when a private bank gets into trouble. This induces a loss of confidence in banking and, more generally, in the financial system. That is why everywhere in the world, policy makers have looked for a way to protect unsophisticated households. This is done through a financial ‘resolution corporation’ or RC.
The RC plays two roles. First, it watches over private banks, and moves in to execute a rapid bankruptcy process when the bank is in trouble, but before the bank is bankrupt. This imposes less turmoil upon the economy than would have been the case if a bank went to the Insolvency and Bankruptcy Code when it is unable to pay creditors.
Second, the RC pays out deposit insurance to unsophisticated households. In India, each individual is protected up to a total value of Rs 1 lakh held in all deposit accounts with a given bank, put together.
At present in India, we have a deposit insurance corporation, DICGC, which pays Rs 1 lakh to an individual, summing across all the accounts held with the bank. The trouble is the DICGC is a mere paybox. It plays no role in thinking about when to intervene in a bank, and in running a smooth bankruptcy process.
The Financial Sector Legislative Reforms Commission (FSLRC), which was led by Justice B.N. Srikrishna, designed the required new RC arrangement. It is essential to have this RC, if we are to have private banks and private insurance companies. The first Modi government had proposed but withdrawn an FRDI Bill, which used the law drafted by FSLRC.
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Revive FRDI Bill
It is essential to revive and enact the FRDI Bill, in addressing the foundations of the failure in Indian finance.
At the same time, we should be modest in our expectations. Building a complex institution like the RC is a multi-year job. We cannot expect to just hire a few people and rent an office and expect that it will work. Like all modern organisations, an RC involves complex issues of organisation design, process design, writing process manuals, building IT systems that encode process manuals, training the staff. It takes about three years to build a government agency.
As a consequence, even if the FRDI Bill is enacted tomorrow, for some years, there will be no capable RC. This means that the problems of fragile private banks in 2020 and 2021 will have to dealt with, without the benefit of a capable institutional mechanism for doing this. However, it is important to start the process now so that we have parallel supervisory capacity, in case the RBI remains deficient, and we have a resolution mechanism for those banks that fail.
In the meantime, the only provision in the law to deal with failing private banks is forced mergers.
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The author is an economist and a professor at the National Institute of Public Finance and Policy. Views are personal.