On a Friday evening, I was glancing at the Reserve Bank of India’s (RBI’s) Weekly Statistical Supplement while taking the elevator. I noticed that the daily actual cash balance of banks with RBI as a percentage of average cash balance was in a tight range of 100.3% to 103.4%. Then I happened to glance at the plaque inside the elevator which read “Maximum: 20 persons/ 1,360 Kg". I wondered what if 21 people climbed in or, say, the cumulative weight exceeded the recommended weight by 5%. Would the elevator break down? The answer is clearly no. Engineered products generally have a lot of in-built buffers to take into account the vagaries of nature and human behaviour. One cannot say the same thing for the banking sector in general.
Bankers have developed precise rules to calculate and account for risk. But just because they are precise, are they right?
If a borrower does not pay on time, a grace period of 90 days is given before an NPA (non-performing asset) is recognised. One wonders why a grace period is given and why is it such a precise number of days? After all, the borrower always knew she had to pay the money on that specific day.
If the borrower continues to remain in default, the bank starts recognising losses in a staggered manner over three years. They compute such losses and give them a peculiar term called ‘Loss given Default’. Isn’t default a loss? Not to a banker it would seem.
In a business where liabilities (mostly deposits) have to be serviced regularly, how can prudence allow a bank not to recognise a default as a loss? Imagine that a patient comes in with a cardiac arrest and the doctor says, let us wait for 90 seconds before we do something. And if the heart does not resume beating in 365 seconds, then we will declare the patient 20% dead and only after 1,000 seconds will we declare the patient completely dead.
Bankers may argue that unlike engineered systems, business is unpredictable. In fact, every engineered system has to deal with the unpredictable—natural events (such as an earthquake) and inconsistent or irrational human behaviour. But, other than a completely unplanned development, a borrower not making a payment on the prescribed date has to be deliberate. How can it be otherwise?
Smart engineers, therefore, create a buffer to account for such unplanned events. But banks work on the opposite principle—they account for income much faster (by daily accrual) than they account for losses (by precise yet arbitrary rules). Rarely does one see a bank fully provide for even recognised NPAs (HDFC Bank Ltd is one of the few exceptions). If the regulator changes the rule and says that an NPA is to be recognised and fully provided for the day the borrowing misses its payment schedule, and upgraded when it is paid, would it not remove subjectivity and make banking less risky? Insurance accounting seems more prudent where it requires companies to create incurred but not reported (IBNR) reserves.
Banks will then argue that such buffers will raise the cost of funds to the borrowers. But is that the right way to frame the issue? The right way to look at it is to compare the ‘cost of the buffer’ to the ‘loss of not having the buffer’ and not to ‘savings generated by not having the buffer’. When a bank fails, the loss is the sum total of loss borne by the depositor plus lower economic growth due to lower credit growth, plus any loss borne by the taxpayer. A good engineer will shudder not to build adequate buffer in spite of the cost, for she has no government to bail her out, and customers are indeed happy to pay for the extra safety. How many bankers would want to wire their homes without circuit breakers so that they can save on costs?
Taxpayers are angry at such bailouts. They are forcing regulators to cut bankers no slack. A citizen initiative in Switzerland, called the Vollgeld Initiative, has collected the requisite number of signatures required to put the issue to a national vote. This initiative calls for stopping commercial banks from creating money. Not many of us realise that money in a bank account is an IOU (I owe you—an informal document that acknowledges a debt owed) of the bank, while money withdrawn from an ATM becomes an IOU of the RBI.
Most money in the economy is actually created by commercial banks when they lend (yes, lending creates deposits and not the other way round). In India, 86% of money (M3) is commercial bank money and only 14% is sovereign money (currency). The Swiss initiative, therefore, is calling for money to be created only by the sovereign or central bank (in other words, 100% cash reserve ratio). That way, any misdeed of a commercial bank will not impact its depositors. Or, extending this argument to its logical end, such deposits may pay little but would be completely safe and banks will end up looking more like non-banking financial companies (NBFCs), where, to lend, they will have to raise money based on their credit worthiness but will have no recourse to the taxpayers in case of a failure. Some facets of this are already visible in India. Payments banks can only invest in government paper and universal banks are being incentivised to raise bank bonds to lend to infrastructure.
Another peculiarity of debt is that it is treated better than equity as far as taxation goes (read more here: http://mintne.ws/1L2zpqK ). The recently proposed rules of US Treasury (on tax inversions) seek to plug this loophole. If this is a start, the future may see a more equitable tax treatment of debt and equity, thereby reducing demand for loans in the economy. Banks have done an enormous service to finance growth of economies. But their failures have burdened taxpayers. Taxpayers want changes. Banks need to adapt themselves to this future.
Huzaifa Husain is head equities, PineBridge Investments India.