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Business News/ Opinion / Online-views/  Making banks safer without killing growth
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Making banks safer without killing growth

Increases in bank capital should be gradual and coupled with structural reforms and better regulation

Illustration: Shyamal Banerjee/MintPremium
Illustration: Shyamal Banerjee/Mint

With the new government firmly in the saddle, spurring economic growth is a prime goal. A robust banking sector is central to this agenda. How does one make Indian banks safer while ensuring they become engines of growth?

The 2008 global financial crisis highlighted how the instability of major banks can cripple the real economy and affect people’s well-being. A key part of the policy response to the crisis was a call for higher bank capital. Basel III, the international regulatory standard on capital adequacy, raised the minimum bank capital requirement from about 8% risk-weighted capital to about 10.5%-15.5% (including countercyclical, systemic, and contingent capital convertible bond buffers). Some jurisdictions opted for even more capital. For example, Switzerland is enforcing 19% bank capital for its largest banks. Influential economists (such as Admati and Hellwig in their book The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It) are suggesting that regulatory bank capital be raised further to about 30%. There are discussions in several international quarters on whether Basel III requirements are enough. For now, the Reserve Bank of India (RBI) is raising capital requirements for Indian banks broadly in line with Basel III. This article asks whether that is enough for making India’s banks safe and what is the optimal path for getting there.

Higher bank capital has many virtues. It serves as a financial buffer, forcing bank shareholders to internalize losses and reducing the probability of bank failure. Furthermore, by increasing shareholders’ skin in the game, it induces a more cautious approach to risk-taking. But there are also concerns that urging banks to raise capital too rapidly can reduce the supply of credit. The credit supply concerns related to higher capital requirements were vivid in many (already troubled) European countries. Academic research estimates suggest that banks can cover about 50% of new capital needs by reducing lending, a major cause for concern.

What is then the correct path in the difficult trade-off between making banks safer and preserving lending to maintain growth?

Building on previous work by Lev Ratnovski of International Monetary Fund, we gauge an estimate for optimal bank capital from the lens of addressing one of India’s biggest financial sector vulnerabilities—elevated non-performing loans (NPLs). How high should bank capital be to absorb expected NPLs during a future banking crisis?

Looking at a sample of a dozen emerging markets (including Brazil, Mexico, Indonesia and Turkey), we find that NPLs rose to a peak of 18% to 20% during episodes of banking crises since the 1970s. In a globalized world, this could be a good benchmark for peak NPLs in India if a banking crisis were to occur. This corresponds to possible losses of about 12-13% assets (using 65% as an estimate of loss given default). Around 2% of that can typically be absorbed by earlier provisioning. This leaves loan losses net of provisions of 10-11%.

Bank capital may need to be somewhat higher when there is variability amongst banks and some realize higher losses than others, or because banks need extra capital to continue operating after absorbing losses. But there is also an argument why capital can be somewhat lower: as discussed above, higher regulatory capital reduces risk-taking incentives. On balance, with a margin of safety of about 0.5%, one could suggest that a 10-11.5% capital-to-total-assets ratio, corresponding to 15%-17% risk-weighted capital ratio (applying a conversion factor of 1.5) would offer banks enough capital to fully absorb most asset shocks of magnitudes observed in comparable emerging markets over the last 50 years.

How does our estimated 15-17% optimal capital compare with India’s bank capital today? On aggregate Indian banks now hold 9-10% capital. But once banks start issuing the loss-absorbing contingent capital and RBI mandates a few additional percentage points as countercyclical capital for select banks, on average Indian banks are likely to land into the identified 15-17% optimal capital range over the next few years. This is comforting as it broadly seems that Indian banks are on track to adopt capital ratios that help absorb most shocks that (based on historical data) may hit emerging economies. (Of course there will be costs the government will incur in recapitalizing public sector banks and the banking system is still inexperienced in issuing contingent debt capital.)

Beyond optimal capital ratios, there are two additional considerations to keep in mind. First, it is important to complement bank capital increases with deep structural reforms of the banking sector. The most pressing problem is dealing with weaker banks, which are far from minimum required capital ratios, and the challenge will be to bring these banks to an acceptable common minimum level. An increase in capital requirements can be an opportunity to put pressure on laggard banks to merge with healthier institutions over the next few years.

More stringent financial sector regulation (e.g. ceilings on lending to interrelated companies), better corporate governance, sounder managerial decisions in giving out loans and a faster liquidation process in dealing with loan defaults are other essential measures to make the Indian banking sector safer.

Second, any increases in bank capital should be gradually paced over time. While high bank capital may not be exorbitantly costly over the long run, the costs of raising bank capital quickly might be sizable, mainly arising from banks meeting capital requirements by reducing bank lending. All this suggests that banks should increase their equity slowly over a period of time, preferably backloaded to the time when GDP growth picks up.

To sum up, the analysis establishes some good news. With an increase in capital requirements, to 15-17%, Indian banks will become safer and able to withstand most banking crises that historically affect emerging economies. Higher capital ratios (19-30%) being debated in several quarters internationally are not necessary. To avoid hindering growth, increases in bank capital should be gradual. And it should be complemented with structural reforms and better regulation.

Pranjul Bhandari is a Mason Fellow from the Harvard Kennedy School of Government.

Comments are welcome at theirview@livemint.com

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Published: 16 Nov 2014, 11:56 PM IST
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