More capital and liquidity: towards what end?
4 min read 18 Feb 2014, 01:38 PM ISTThe conclusions from the recent RBI paper on net stable funding ratio should get us worrying
Premium
Seldom do Reserve Bank of India (RBI) working papers attract as much attention as committee reports or discussion papers. That is partly due to working papers produced generally by academicians within the RBI fold, but more because committee reports and discussion papers have an element of fait accompli in them. They are supposed to be acted upon, with the tacit understanding that there will be minimal changes—one banker had quipped to this author that from the discussion papers to the final guidelines, RBI only corrects spelling mistakes.
But we will be doing a great disservice to each other if we let one recent working paper (Bhuyan and Srimany, January 2014) on NSFR (net stable funding ratio) pass without adequate debate. This is not the first paper of this nature, and has to be seen in conjunction with other literature (including from RBI) on the new banking regulation regime, defined by capital and liquidity, under the overall umbrella of Basel III.
The key conclusion from the NSFR paper is that lending rates need to go up by 40-50 basis points (bps, one-hundredth of a percentage point) to conform to the NSFR requirements. Other things remaining equal, Basel III’s counter-cyclical capital buffer (CCB) requirements too spell a rise in lending rates, to compensate.
What often gets ignored is that Indian banks have always maintained liquidity and capital buffers way above even prudential levels, let alone statutory levels. The most striking illustration is core or Tier I capital (mostly equity). For example, during 2001-2006—the reign of Basel I—when the minimum Tier I was 4.5%, HDFC Bank Ltd maintained an average Tier I of 9.2% (choice of a private bank for the example is deliberate, since a private bank’s capital planning is more autonomous, not subservient to the government’s convenience).
During 2007-2013, i.e. under the Basel II regime when the minimum increased to 6%, the average was 11.1%. So, the bank did not take advantage of the freeing up of capital during Basel II but continued to maintain an equally large buffer, possibly more than what growth considerations would warrant. And HDFC Bank is not an isolated case.
So the conclusion is disconcerting: even as Basel III Tier I minimum goes up to 7% including the CCB, Indian banks will tend to keep a similar buffer over and above that again, an observation noted in the NSFR paper as well.
It is highly debatable as to whether these levels of capital or stiff stable funding requirements are feasible or desirable in a capital-scarce nation with a comfortably low level of financialization as symbolized by the loan to gross domestic product (GDP) ratio of just 55% and largely retail deposits. Moreover, our own policy goals mandate directed lending with an implicit understanding that rates on them have to be low. There are several vulnerable borrower segments that are incapable of digesting higher lending rates. In a sense, this is analogous to the growth vs. inflation debate. In view of these country-specific peculiarities, a one-size-fits-all doctrine simply as self-righteous conformity to global norms may be counterproductive. Dani Rodrik, in his book The Globalization Paradox, has, on similar lines, elegantly argued against the global governance institutions such as Basel and the WTO.
Financial instability has increased due to structurally weakening credit quality. But have we not accounted for that through the already rising Tier I over the years? Stability can be improved sustainably only through reform of governance and processes in banks, and improving the institutional architecture for credit; hiking capital and liquidity requirements beyond a point is at best a facile short-cut.
The danger with these norms is that they could foster extreme levels of risk aversion, to the point of being dysfunctional, or risk-taking to deliver adequate shareholder returns, which could endanger rather than bolster financial stability.
It is amazing that there is so little resistance to the application of consistently rising Tier I capital requirements. One reason could be that capital for 70% of the banking system—public sector banks—comes from the fisc, for all practical purposes without any return-on-equity as a pre-condition. But that still does not explain the nonchalance of private sector banks.
This is not a clarion call for either an unchecked laxity on leverage or a lackadaisical attitude towards liquidity. We are all too acutely aware of the deleterious consequences of that. But we do have to admit that there are serious conflicts between policy goals and the objective of financial stability. And we need to recognize that capital and liquidity rules are more insidious in their impact on rates because they work in the background, “behind the scenes", unlike the more visible and headline-grabbing inflation-targeting.
The author has been a senior research analyst on financial services as well as other sectors at various investment banks, and is currently an independent consultant focusing on banks and financial services.
