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Financial reform and bank fragility

C. P. Chandrasekhar

Jayati Ghosh

INDIA'S post-Budget stock market collapse is still taking its toll in the banking sector. After the Madhavpura Mercantile Cooperative Bank (MMCB) and Global Trust Bank (GTB), the most recent bank to come under a cloud and lose its chief executive is the small, but relatively high profile Nedungadi Bank from the South. These banks were till recently considered leaders in their league, with a reputation for dynamism and good management.

Unfortunately, the very factors that gave them this reputation, namely their ability to innovatively exploit the opportunities offered by a liberalised financial order, were also responsible for their fall from grace. This is the principal lesson emergin g from the evolving story of financial fragility being unraveled by the regulators and the financial media. But the full story begins with financial liberalisation itself.

Financial reform or liberalisation, is an omnibus concept that is not easily delimited. In India, for example, such liberalisation has involved various measures that touch on diverse aspects of the financial sector's functioning. In the banking sector, w hich dominates India's financial system, the reform has involved three major sets of initiatives.

First, those aimed at increasing the credit-creating capacity of banks through reductions in the Statutory Liquidity and Cash Reserve Ratios, while offering them greater leeway in using the resulting liquidity by drastically pruning priority sector lendi ng targets. This was combined with greater flexibility in determining the structure of interest rates on both deposits and loans.

The second was to increase competition through structural changes in the financial sector. While the existing nationalised banks, including the State Bank of India, were permitted to sell equity to the private sector, private investors were permitted to enter the banking area. Further, foreign banks were given greater access to the domestic market, both as subsidiaries and branches, subject to the maintenance of a minimum assigned capital and being subject to the same rule as domestic banks. Finally, a degree of `broadbanding' of financial services was permitted, with development finance institutions being allowed to set up mutual funds and commercial banks, and banks themselves permitted to diversify their activity into a host of related areas. The br oad trend is towards a form of universal banking.

Thirdly, to render this competition effective in influencing bank functioning, banks have been provided with greater freedom in determining their asset portfolios. They were permitted to cross the firewall that separated the banking sector from the stock market and invest in equities, provide advances against equity provided as collateral and offer guarantees to the broking community.

All these initiatives, had an immediate impact on the functioning of banks, with banks choosing to modify their credit portfolio and diversify out of their overwhelmingly dominant role as credit-providing intermediaries. To start with, non-food credit it self was increasingly being diverted away from the priority sectors (such as agriculture and the small-scale sector), industry and the wholesale trade, to other areas such as provision of loans to individuals for purchases of consumer durables and invest ment in housing and towards lending against real estate and commodities. While this shift increased the interest incomes that could be garnered by the banks, it also increased their exposure to the euphemistically-termed `sensitive' sectors, where specul ation is rife and returns volatile.

Secondly, investment in securities of various kinds gained in importance, bringing in its wake a greater exposure to stock markets. This was indeed a part of the reform effort. As an RBI-SEBI joint committee on bank exposures to the stock market noted: ` `Globally, there is a shift in the asset portfolio of banks from credit to investments keeping in view the fact that investments are liquid and augment the earnings of banks. The Committee feels that banks' participation would also promote stability and orderly growth of the capital market.'' The impact of this on scheduled commercial banks in India, which point to the sharp rise in investments by banks, which to a significant extent is due to bank preference for credit substitutes.

Initially, the investments were largely in safe government and other approved securities which, in the wake of financial and fiscal reform, were offering banks relatively high returns. Bank holdings of these securities crossed the floor requirement set b y the SLR. But in time, with the returns being offered by non-SLR securities of different kinds on the rise, banks have tended to move in that direction as well.

Over the last four years there has been a sharp increase in investments in non-SLR securities with the share within such investments accounted for by loans to corporates against shares, investments in private equity and in private bonds, debentures and p reference shares also increasing over time.

These, however, are aggregate and average figures and conceal the differential distribution of such exposure across different kinds of banks. Such differentials have been substantial. Consider, for example, bank lending to sensitive sectors such as commo dities, the real estate and the capital market. While, the sum total of such lending is still small, there are some segments of the banking sector, especially the old and new private sector banks, that are characterised on average by a much higher degree of such exposure.

Taking the exposure of banks to the stock market alone, it can be seen to occur in three forms. First, it takes the form of direct investment in shares, in which case, the impact of stock price fluctuations directly impinge on the value of the banks' ass ets. Second, it takes the form of advances against shares, to both individuals and stock brokers. Any fall in stock market indices reduces, in the first instance, the value of the collateral. It could also undermine the ability of the borrower to clear h is dues. To cover the risk involved in such activity banks stipulate a margin, between the value of the collateral and the amounts advanced, set largely according to their discretion. Third, it takes the form of ``non-fund based'' facilities, particularl y guarantees to brokers, which render the bank liable in case the broking entity does not fulfil its obligation.

In the aggregate the sum total of such exposure of the scheduled commercial banks appears limited. As the RBI's technical committee on bank financing of equities noted, as on January 31, 2001: ``The total exposure of all the banks by way of advances agai nst shares and debentures, including guarantees, aggregated Rs 5,600 crore, comprising fund-based facilities of Rs 3,385 crore and non-fund-based facilities, that is, guarantees, of Rs 2,215 crore.'' Such exposure constituted 1.32 per cent of the outstan ding domestic credit of the banks as on March 31, 2000.

However, there is much that these figures conceal. To start with, the aggregate level of exposure across the banking system hides the fact that the `overall' exposure on the part of some of the private sector banks, whose `dynamism' has been much celebra ted and used as the basis for privatisation of public sector banks, has been far in excess of 5 per cent.

As figures collated by the RBI's Technical Committee reveal, at the end of 2000, the exposure to the stock market by way of advances against shares and guarantees to brokers stood at 0.5 per cent of total advances in the case of public sector banks, 1.8 per cent in the case of old private sector banks, 4.8 per cent in the case of foreign banks and a huge 15.3 per cent in the case of eight new private sector banks.

Thus, the so-called `dynamic' private banks which are seen as setting the pace for the rest of the banking sector, and are attracting depositors by offering them better terms and better services, are the most vulnerable to stock market volatility.

When it comes to non-performing assets (NPAs), however, the differentials seem to point in a completely different direction. The ratio of NPAs to total assets was higher in the case of the older public sector and private sector banks, and were lower in t he case of the new private sector banks and the foreign banks, most of which are new entrants into the banking scene in India. But these differences are more because of the effects of age, with the older banks having over the years accumulated such NPAs at a slow pace, and not having been subjected to provisioning and prudential norms of the kind that have been put in place after the process of liberalisation began. Corrective measures launched recently have begun to reverse these high NPA ratios.

What would be more crucial is to assess whether, in recent times, the rate of increase of NPAs has tended to be faster among the private sector banks that have a greater exposure to sensitive sectors in general and the capital market in particular. Adequ ate evidence to make such an assessment is not available yet. But there is some evidence to that effect.

Thus, Nedungadi Bank, which was one of those with a high exposure to capital markets has seen an increase in the ratio of its gross NPAs to assets from 4.6 per cent in 1996-97 to 8.4 per cent in 1999-2000, and market rumours have it that the ratio would have gone well into the double-digit range after the recent stock market collapse.

However, till the recent collapse, the fact that the exposure of banks to the stock market has not on average been too high, has encouraged the RBI to be lax with regard to restricting the movement of banks into such `sensitive' activities. Till very rec ently, RBI guidelines regarding bank exposure to the stock market applied only to direct investment in shares. Even these had been substantially relaxed not too long ago.

According to guidelines issued in October 1996, when banks were being encouraged to investment in stocks as part of the process of financial liberalisation, banks were permitted to invest up to 5 per cent of their incremental deposits in the previous yea r in stock markets. Initially, investments in debentures/bonds and preference shares were included within this 5 per cent ceiling. However, as stock market performance was increasingly accepted as an indicator of the success of reform, and the government was under pressure in 1997 to revive flagging markets, it sought to encourage banks to invest more in the markets. This was done, in April 1997, by taking debentures/bonds and preference shares out of the calculation of the limit. This made the ceiling only relevant for investment in equities.

Further, the 5 per cent ceiling on investments in equity shares was to include loans to corporates to help them meet the promoters' contribution to the equity of new companies. That is, banks could provide `bridge finance' against shares, for companies p lanning to raise resources from the market for new projects, on the expectation that the loan will be repaid when such resources are raised.

In an associated move, the minimum maturity on commercial paper issued by corporates was brought down from three months to 30 days, allowing them to use such instruments for extremely short-term accommodation. The net result of all this was a substantial increase in the flexibility banks enjoyed with regard to making `corporate' investments, especially in financial instruments that are known to be risky.

In September last year, these guidelines were relaxed even further based on the recommendations of a committee comprising senior executives of the RBI and the Securities and Exchange Board of India (SEBI). The committee held that instead of setting a cei ling on bank investments in equity relative to incremental deposits, banks' exposure to the capital market by way of investments in shares, convertible debentures and units of mutual funds should be linked with their total outstanding advances and may be limited to 5 per cent of such advances. This was subsequently accepted by the RBI and is the guideline that prevails now.

As a result of these changes banks were vying with each other to invest their funds in the corporate sector and were picking up all forms of corporate paper -- including bonds, debentures and preference shares. Driven by these signals a group of 21 publi c sector banks increased their investments in equities from Rs 1,488 crore in 1997 to Rs 2,293 crore in 1998. However, the RBI was sanguine about the risk of bank exposure to capital markets because such exposure was well below the much-relaxed ceiling. According to its Technical Committee set up to review guidelines regarding bank financing of equities, ``The total investment in shares of the 101 scheduled commercial banks aggregated Rs 8,771.60 crore as on January 31, 2001, and constituted 1.97 per ce nt of outstanding domestic advances as on March 31, 2000, and was well within the norm of 5 per cent of the domestic credit stipulated in the RBI Circular of November 10, 2000. The total investments in shares of all the banks aggregated Rs 6,324.11 crore as on March 31, 2000, and constituted 1.42 per cent of the domestic credit.''

This overconfidence has been subjected to a corrective in the form of growing fragility in the banking system. On the surface, the RBI still maintains a brave face while accepting that there are problems of fragility in the system. This emerges from the following paragraph in the RBI's Monetary and Credit Policy Statement for the year 2001-2002, that reveals the central bank's reading of the problem:

``The recent experience in equity markets, and its aftermath, have thrown up new challenges for the regulatory system as well as for the conduct of monetary policy. It has become evident that certain banks in the cooperative sector did not adhere to thei r prudential norms nor to the well-defined regulatory guidelines for asset-liability management nor even to the requirement of meeting their inter-bank payment obligations. Even though such behaviour was confined to a few relatively small banks, by natio nal standards, in two or three locations, it caused losses to some correspondent banks in addition to severe problems for depositors.

``In the interest of financial stability, it is important to take measures to strengthen the regulatory framework for the cooperative sector by removing `dual' control by laying down clear-cut guidelines for their management structure and by enforcing fu rther prudential standards in respect of access to uncollateralised funds and their lending against volatile assets.''

Clearly, the RBI poses the problem as being largely restricted to the cooperative banking sector, where it arises not because the regulatory mechanism is not well defined, but because the structure of management and control has worked against the impleme ntation of those guidelines. But its decisions in practice point to a greater degree of concern. Not only has bank scrutiny been tightened, leading to revelation regarding banks like the Nedungadi Bank, but bank exposure to stock markets is being curtail ed.

As argued above, bank investments in equity constitute only one form of bank exposure to the stock markets. Advances against shares and guarantees to brokers provide other forms. Secondly, this exposure of the banking system and of those that lead the pa ck in lending against shares, is dominantly to a few broking entities. The evidence on the relationship between Global Trust Bank and Ketan Mehta only begins to reveal what the RBI's monetary policy statement describes as ``the unethical `nexus' emerging between some inter-connected stock broking entities and promoters/managers of some private sector or cooperative banks.'' The rot clearly runs deep and has been generated in part by the inter-connectedness, the thirst for a fat bottom line and the inade quately stringent and laxly implemented regulation that financial liberalisation breeds.

Thirdly, the liquidity that bank lending to stock market entities ensures, increases the vulnerability of the few brokers who exploit this means of finance. Advances against equity and guarantees help them acquire shares that then serve as the collateral for a further round of borrowing to finance more investments in the market. These multiple rounds of borrowing and investment allow these broking entities to increase their exposure to levels way beyond what their net worth warrants. Any collapse in the market is, therefore, bound to lead to a payments shortfall, that aggravates the collapse, and renders the shares that the banks hold worthless and the advances they have provided impossible to redeem.

Finally, by undertaking direct investments in shares while providing liquidity to the market, the banks are further endangered. To the extent that the liquidity they provide encourages speculative investment and increases stock market volatility, any con sequent collapse of the boom would massively erode the value of the banks' own direct investments.

When all of this is put together, it is clear that the current level and pattern of exposure of banks to the stock market is itself worrying and the fact that this exposure has been increasing and may turn more pervasive is distressing. It is possibly fo r this reason that the RBI technical committee on bank lending against equity, while holding that the basic framework of regulation need not change, recently recommended that the 5 per cent ceiling on bank exposure to stock markets must not apply just to direct investments in equity, but to all forms of exposure including lending against shares and guarantees to brokers. The central bank has accepted and implemented this recommendation in the wake of the market collapse.

But this small step in response to the recent crisis, may prove extremely inadequate. Five per cent of advances, while small relative to total bank exposure, is indeed large relative to the net worth and the profits of the banks. Major losses as a result of such exposure can therefore have devastating consequences for the viability of individual banks. This is an obvious lesson emerging from the recent crisis that calls for strong corrective action. But given its blind commitment to financial liberalisa tion, India's central bank appears reluctant to learn its lessons well.